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Workshop on Bankruptcy
May 17–19, 2001
St. Louis, Missouri
This packet contains a set of facts, a problem, and a statement of issues to be addressed, along with some assumptions we will make for classroom purposes. Also attached are some materials that inform resolution of the issues presented. It is assumed that students are familiar with the materials in the Transnational Bankruptcy chapter of Warren & Westbrook, 4th Edition. A student whose memory of those materials is a big vague after a couple weeks in Aspen might want to review them, because they provide the basic information and framework for the discussion. Ideally, read the facts and issues, then the materials, then the facts and issues again. We won’t begin to cover all the issues in two hours, but we’ll have fun trying. I look forward to contributions from every student. No one should worry about wrong answers, because all of this is far too new to have any wrong answers.
The facts are based on a recent international bankruptcy case, although they have been significantly altered and simplified for classroom purposes. For example, the country was not South Africa and none of the real firms mentioned were actually involved in the case, except for the share-certificate depositories in New York and London, which are always involved in such cases.
HYPOTETHICAL
United States Bankruptcy Court
District of Colorado
| In re Galactic Securities, Inc., | X |
| Debtor | X |
| X | |
| X | |
| X No. 0001 | |
| X | |
| X | |
| X | |
| X | |
| X |
Fact Statement
As more fully described below, the captioned debtor and several affiliated companies (collectively “Galactic”) were part of an international group of companies providing investment services to investors, most of whom are located in the Republic of South Africa. Most of the Galactic companies are now insolvent and are in bankruptcy or receivership in the United States and elsewhere. An estimated 1,500 investors had investments with Galactic (the “investors”). Most now face the certainty of recovering from Galactic less than they should receive, the liquidators having so far recovered approximately $100 million of assets as against an estimated $400 million in claims for money and property. The collapse of the Galactic group resulted from a combination of adverse market conditions, incompetence, and fraud.
It appears that some of the investors might have claims for the recovery of specific assets of Galactic or from the identifiable proceeds of sale of those assets (“proprietary claims”). Because there are too few assets to satisfy all legitimate investor claims, approval of proprietary claims would increase the recoveries of those who obtained such approval and would reduce the recoveries of other claimants. Resolution of the proprietary claims by litigation could be a very complex, time-consuming, and expensive process in the circumstances of these companies and their international operations.
A Protocol (hereafter the “Protocol”) has been approved providing for coordination of the worldwide administration of the Galactic cases among two of the countries involved. Inter alia, the Protocol assigns to the United States Bankruptcy Court the task of determining proprietary claims. It assigns to the Bermuda court the responsibility for distribution of the Galactic assets. Pending before the English court is an application for approval of the Protocol and dismissal of the English case.
The Galactic companies included GSBER Services, Inc., a corporation organized under the laws of Bermuda with employees in that jurisdiction (hereafter “GSBER”); GSUK Services, Inc., a non-resident corporation organized under the laws of the United Kingdom (hereafter “GSUK”); Galactic Securities, Inc., a corporation organized under the laws of Delaware and registered with the U.S. Securities and Exchange Commission (hereafter “GSI”); and Galactic, Inc., a corporation organized under the laws of Delaware (hereafter “Inc.”). GSI and Inc. were and are headquartered in Denver, Colorado. GSBER was incorporated in 1992. From 1992 to 1996, the investors had GSBER investment management contracts.
Starting in 1996, because of changes in South African tax law, all investors were meant to become customers of GSUK, although it appears that many of them did not sign new GSUK investment management contracts. (The GSBER and GSUK management agreements are hereafter the “GSBER management agreement” and the “GSUK management agreement” or collectively the “management agreements”). However, all investors got GSUK account statements after that time and it seems likely that, from that time, instructions, both oral and written, for the purchase of securities were given to GSUK as the investment manager. The GSBER monthly account statements always listed a Bermuda address and the GSUK statements listed its registered office (that is, its formal address at a corporation-agent-service company ) in London. All investors were customers of either GSBER or GSUK.
At all material times, GSBER had a contract with GSI and Inc. through which much, if not all, of the accounting and securities trading aspects of its business were conducted. After its formation, GSUK purchased most, if not all, of the GSBER business assets and entered into a similar agreement with GSBER, the result of which was the furnishing of the same services, and all other services necessary for GSUK’s business, to GSUK by GSI and Inc., except for the investor account and mailing services provided by GSBER as described below. These two agreements for services are hereinafter called the “service agreements.” The purchase agreement from GSBER to GSUK is hereafter called the “purchase agreement.”
The GSBER management agreement with investors was stated to be governed by the laws of Bermuda. The GSUK management agreement with investors, the purchase agreement from GSBER to GSUK, and both service agreements stated they were governed by the laws of New York. The purchase agreement and both service agreements excluded choice-of-law rules from the governing law but the management agreements did not. The two management agreements with investors also called out the New York courts as the forum for resolution of any disputes relating to the contracts.
At all times, most of the Galactic employees worked for the two American companies, GI and GSI, at the Denver headquarters. There were no employees and no operations in the UK. In Bermuda, there were seven employees who got the computer processing results each month from Denver, addressed the statements to the investors, and sent them back to Denver for mailing. The only books connecting each investor by name to that investor’s accounts, and listing the addresses of the investors, were in Bermuda and were protected by its confidentiality laws.
Prior to 1996, investors made investments through Galactic by payment directly to GSBER’s bank account in New York or by payment in South Africa forwarded to that account. Starting in 1996, these payments went to GSUK’s bank account in Denver and then to the GSBER account in Denver. Investors funds were not segregated, but cash amounts were carried on the books of Galactic and stated on regular account statements.
There were two types of investments made by investors. The first related to investments called “Major Securities.” A Major Securities investment involved the purchase of a security issued by a company other than Galactic, as, for example, AT&T or British Telecom (“BT”). Virtually all the securities were purchased on stock exchanges in New York or London. The investor would direct purchase of a specific amount of a specific security and pay a sum necessary for that purchase to Galactic as described above. The requested security would be purchased by GSI from external sources through a New York or London broker or from a store of such securities already in the name of GSBER. The securities would not be segregated, but would be part of a general pool of securities held by the brokers with whom GSI dealt or by a clearing house like Cedel Luxembourg. In either case, all such securities were held in the name of GSBER. The transfers to the investors took place only on the books of Galactic, but thereafter the investor’s monthly statement would show, for example, “1000 shares of AT&T,” in the investor’s account. The management agreements provided that Galactic was entitled to hold such shares in common accounts, not segregated by owner, and to deal freely with such shares, the shares being segregated only by book entry. The agreements also stated that the shares so commingled might be held in the name of Galactic at a broker or clearing house. To the extent an investor was credited on the books of Galactic with an interest of this sort in specific securities, the investor was an "MS” (Major Securities) investor.
The other type of investment related to “Galactic Investments.” These were investments in securities issued by Galactic itself. It does not appear that these investments related to any specific assets to be purchased or held by Galactic, except for its general statements that they were to involve assets relating to certain types of investments, as, for example, investments in “Tiger” economy companies in Asia. These investments were essentially investments in securities (especially promissory notes) issued by Galactic and did not relate to specific assets to a legally relevant extent. To the extent an investor was invested in Galactic securities in this way, the investor was an "GI” (Galactic Investments) investor.
Following the financial collapse of Galactic, voluntary liquidation proceedings were brought in England and Bermuda on behalf of GSUK and GSBER respectively. Thereafter, proceedings under section 304 of the United States Bankruptcy Code were brought in the United States Bankruptcy Court for the District of Colorado (Denver) on behalf of the liquidators for GSBER and GSUK. On the same day, involuntary bankruptcy proceedings were brought in that district against GSBER, GSUK, and Inc. Protective injunctions were issued in the section 304 proceedings and an Order for Relief has been entered in the GSUK involuntary bankruptcy. In addition, a receivership proceeding was brought by the United States Securities and Exchange Commission against several of the Galactic companies in the district court in Denver. All of these cases remain pending. It is clear that each of these cases are within the jurisdiction of the courts in which they were filed.
As noted above, subsequent to the filing of these proceedings, a Protocol was agreed by the liquidators and others and has been approved by Bermuda and United States courts, including the district court where the SEC receivership is pending.
The assets of Galactic consist of general assets (its headquarters building, office equipment in various offices, etc.), some investments (e.g., a resort hotel in South Africa), and accounts at large brokerage firms in New York and London in which Major Securities were held in large amounts in the name of Galactic, without allocation among its customers (“pooled accounts”). All of these securities were originally purchased as a result of customer instructions; none were purchased by Galactic for itself. Some holdings are equal to the total claims for those holdings by customers. (E.g., the number of AT&T shares in those accounts equals the number of AT&T shares listed in Galactic’s accounts as owned by its customers.) Other holdings contain less than the total holdings by customers. (E.g., the number of BT shares in the pooled accounts is approximately one-third of the total number of BT shares listed as owned by Galactic’s customers on its books, because Galactic sold the rest and misapplied the proceeds in its frantic efforts to survive.) In five cases, only one customer bought a particular company’s shares-for example, the Zulman family bought GE shares and no other customer did. In three of those cases the pooled accounts include exactly the number of shares that customer bought, in one case they contain one-half the number of shares bought, and in one case the accounts include no shares of the sort the customer had ordered.
All of the company shares and bonds in the pooled accounts are physically deposited with clearing houses in New York and Luxembourg. They are listed on the depositories’ books (that is, their computer records located in Ireland) as belonging to the large brokerage firms with which Galactic had accounts. Thus, for example, a purchase of 100 shares of AT&T by Galactic customer Joe Smith would become part of a block of 1,000,000 shares of AT&T held by the clearing house Cedel Luxembourg, of which 100,000 would be listed on Cedel’s books in the name of Merrill, Lynch, of which 25,000 shares would be listed on Merrill’s books in the name of GSBER, of which 100 shares would be listed on GSBER’s books in the name of Joe Smith. For the most part, Galactic’s books appear accurate as to the listing of customer entitlements to specific securities and the customers received appropriate account statements each month.
In general, most of the assets of Galactic recovered are securities that fall within category of Major Securities. Only a small percentage (about $10M) of the assets are general assets not subject to possible proprietary claims by MS investors. All of the accounts described above as in the name of “Galactic” are specifically in the name of GSBER, but about 45% of them appear to be attributable to customers who signed agreements with GSUK. The accounts in GSBER’s name holding Major Securities are carried in the New York and London offices of major brokerage firms. The certificates for the Major Securities are deposited in clearing houses in New York and Luxembourg. The remaining assets of material value are in Denver.
The Problem
You are the United States Bankruptcy Judge assigned this case. The liquidators are Boyd and Co., a worldwide accounting firm that has been appointed as Trustee in Bankruptcy (or the local equivalent) in each of the three proceedings. The trustees have asked the court (you) for instructions as to the proper standard for distribution of the $100 million in assets (net of any encumbrances) they have gathered or hope to gather in the next few months. Lawyers representing the various claimants (MS investors (250M), GI investors (145M) , and general trade and bank creditors (about $5M total) have argued for their respective positions. The MS investors argue that as owners they are entitled to substantially all the assets of Galactic, except about $10 million in miscellaneous assets other than securities. The GI, trade, and bank creditors argue for a pro rata distribution of the entire pool of assets, including the Major Securities.
The MS investors are further divided as follows:
Position (i) Those who demand tracing to specific assets, including some who can show they were the only customers who bought GE stock through Galactic and that Galactic is holding exactly the amount of stock they had bought.
Position (ii) Those who argue that the customers should share in each block of stock without specific tracing. For example, all who held AT&T stock would share in the proceeds of the sale of AT&T stock. Because the Galactic holding of AT&T is equal to the totals listed for those who bought AT&T through Galactic, they will be paid the full current value of the stock. Galactic’s holdings of BT stock equal about one-third of the BT stock listed against customers’ names, so all of the proceeds of the sale of the BT stock would be shared among those customers pro rata.
Position (iii) Those who argue that all MS investors (but not GI investors) should share pro rata in the proceeds of sale of the entire pool of Major Securities owned by Galactic.
There is also a difference in position between those who signed agreements with GSBER and those who became customers after 1996 and therefore signed agreements with GSUK. The former argue that the latter have only claims against GSUK, which is merely an unsecured creditor of GSBER. That position would, for example, eliminate the GSUK customers who bought BT stock from sharing pro rata in the proceeds of the sale of the remaining BT stock, thus leaving more for the GSBER customers who bought BT through Galactic. The GSUK customers argue that all Galactic customers became customers of GSUK (as reflected on their monthly statements), regardless of the formality of executing new agreements, especially given that the agreements with GSBER and GSUK were virtually identical. The GSUK customers say all investors therefore have claims only through GSUK, which in turn is the only claimant to the Major Securities held by GSBER.
Notes:
There are two keys to the entire problem. One is the holding of securities in “street” name, a phenomenon described in the Article 8 material mentioned below and in a number of law review articles. See, e.g., James S. Rogers, Policy Perspectives On Revised U.C.C. Article 8, 43 UCLA L. Rev. 1431 (1996). Together with worldwide trading of securities, it means that investors through their brokers own rights to shares issued and physically held in many different jurisdictions around the world. The second is the special nature of a general default by a multinational with operations, assets, and creditors in many jurisdictions. Such a default can and often does generate proceedings in more than one country.
Set forth below are the issues to be addressed and the legal assumptions which you are to adopt in addressing them. The assumptions are designed to make the discussion manageable in a single class by avoiding in depth analysis of British and Bermuda law, but the materials for this class include a limited introduction to British law through excerpts from two important authorities on the subject. Those who are interested in pursuing that subject will want to read the relevant portions of those books, as well as the views of the leading British scholars and practitioners in a 1998 colloquium at Oxford. The Oxford Colloquium on Collateral and Conflict of Laws, Butterworths Journal of International Banking and Financial Law, Special Supplement [1998].
Issues:
A. What should be the distribution of the Galactic assets and why (having reference to the assumptions below)?
1. What analysis would be applied if there were no Protocol among the courts? What choice-of-law analysis would apply in each court and what results might follow? (Include a focus on the specific litigation that might ensue.) What is the impact of the choice-of-law clauses in the various contracts? Does that impact depend on the type of issue involved? Would or should the choice-of-law analysis be affected by each court’s view of the proper forum for the case and, if so, how? What importance should be attached to the appointment of Boyd and Co. as worldwide liquidator?
2. Do the analysis and likely results change because of the adoption of the Protocol? Does the answer to that question suggest implications for lawyers, courts, and international law reformers?
B. After you decide this case, you are asked to write a law-review article analyzing the present international system with regard to securities holdings in insolvency cases and suggesting reform. What will you say and suggest? (Feel free to suggest adopting international agreements, but have in mind the difficulty and delay in devising such agreements and bringing them into force.)
Assumptions:
For these purposes, assume:
a) Some courts have held that a U.S. bankruptcy court should apply the conflicts rules of the state where it sits as to state law issues, although the law is not very clear or well-settled. (If interested, you might look at In re Griffin, 245 B.R. 291 (2000) (but note that the parties’ agreement about British law in that case almost certainly gets it wrong (see below))).
b) The current uniform version of Article 8 (and related articles) is in force in New York and Colorado without material variation from the uniform version.
c) As to proprietary claims against a mass of fungible property, British common law (there is no relevant statute) traditionally has taken MS investors Position (i) above (strict tracing), but current thinking among scholars and expert lawyers in the securities field in the U.K. favors the Article 8 approach, which is roughly MS Position (ii). On the other hand, 1) the U.K. literature focuses on Article 8’s solution to the problem of security interests in shares, not distributions of unencumbered securities in case of insolvency; and 2) there are no cases directly in point. A Hong Kong case decided under British common law adopts a view between Position (i) and Position (ii) above, permitting ownership in a mass, but requiring some level of tracing under common-law tracing rules. Recent British cases as to fungible property generally cling to fairly strict tracing requirements, but some recent U.K. securities cases have permitted pro rata claims on a mass of securities of a single issuer.
d) As to choice of law, British choice-of-law rules traditionally call out one of two territorial rules for determining the law applicable to a dispute over a property interest in shares: the situs of the share certificate or the situs of the issuer’s registry of shares (typically its country of incorporation, but not necessarily so). However, with regard to shares held in “street name,” what Article 8 calls a “securities entitlement,” the U.K. experts mentioned above are nearly unanimous in arguing that the rule should be, and under recent cases will come to be, that the law of the broker’s jurisdiction should be applied. Of course, the final answer will come in future case law or adoption of a statute by Parliament.
e) Bermuda courts would follow established British law, but might be more hesitant to break new ground.
f) As to choice of forum, forum non conveniens, deference, comity, or international abstention (pick your doctrine from the menu of management of multiple international proceedings), British courts generally consider the place of incorporation of a company the “natural forum” for its primary insolvency proceeding, but in one case did defer to an Argentinean bankruptcy (more or less on the ground of forum non conveniens) where the company was incorporated in the U.K., but had its offices, assets and operations in Argentina and nothing in the U.K.
g) GSI was a registered U.S. stockbroker, but none of the other Galactic companies were registered with the SEC.
Materials:
In the materials, look at Article 8, especially section 8-503 and the commentary thereto. Review generally the official introduction to the Article 8 revision, especially sections I, IIC, IIIA, IIIC-3. Then study Subchapter III, sections 741-752, of the Bankruptcy Code, which is the section devoted to stockbroker bankruptcies. Note that only Chapter 7 is open to a stockbroker bankruptcy. Note also that the “insurance” provided by the Securities Investors Protection Act (“SIPA”) may or may not apply in this case. If applicable, recent reports suggest it may not be worth much. Look at the Michigan article, especially 2276-82, 2288-92, as well as the excerpt from the ALI’s Principles of Cooperation, pp. 31-42. The LoPucki excerpt (pp.2216-17) gives you a flavor of a very different view. If we have time, we can discuss the Michigan colloquy a bit and the other views expressed.
Starting Places:
A few points to get you going:
Where does a choice-of-law analysis start? How does an international choice-of-law analysis differ from an interstate analysis (a question too rarely asked in the U.S. literature and cases)? From a policy perspective, why would a court ever apply the law of another country? How does the context of bankruptcy (that is, general, global default) affect the usual choice-of-law analysis in commercial cases?
How does a choice-of-forum analysis start? Why would a court ever defer to another court, as a matter of policy? Is that question different in international bankruptcy cases and, if so, why?
How do law and forum choices interact? Is that interaction different in international bankruptcy cases and, if so, why?
One specific point: Is there any argument that GSBER and GSUK are not stockbrokers for this purpose? Where in the process of a choice-of-law analysis does that characterization fit?