Two US Decisions Remind Investors to "Know Thy Foreign Borrower"

US investors and offshore fund managers have long pursued international investments in order to both obtain higher yields and augment portfolio diversity. With those benefits, of course, come the potential risks of local laws and even political action. Two particular cases, In re Vitro and Anglo Irish Bank, illustrate the significant effect that these issues can have on recoveries, enforcement rights, and participation in the restructuring process. And while both cases are lessons for US investors, they should also inform international investors in general as they assess the benefits and risks of investing in another country.

In re Vitro: Insolvency Risk

In re Vitro was a multi-jurisdictional (and multi-year) litigation regarding the restructuring of Vitro SAB de CV and some of its Mexican subsidiaries. By way of background, between 2003 and 2007, in a series of transactions, Vitro issued approximately $1.2 billion in notes. The notes were guaranteed by substantially all of Vitro’s subsidiaries, including certain US guarantors.

In late 2008, precipitated by the global financial crisis, Vitro’s revenues decreased, which affected its ability to make scheduled payments on the notes. After announcing its intention to restructure the notes, but before commencing formal proceedings (described in more detail below), Vitro entered into a complex sale and leaseback transaction which resulted in substantial intercompany debt owing by Vitro parent to various Vitro subsidiaries (the intercompany claims).

In December 2010, Vitro and some of its Mexican subsidiaries commenced insolvency proceedings in Mexico under the Bankruptcy Act. Vitro did not include the US guarantors in the filing, nor did those subsidiaries commence contemporaneous parallel proceedings under US law. Vitro filed a plan of reorganisation that proposed to release creditor claims against non-debtor parties, including the claims held by the holders of the notes (noteholders) against the US guarantors (the non-debtor releases). Additionally, the reorganisation plan provided that noteholders would only recover 40 per cent on account of their claims, but that Vitro shareholders were retaining equity interests valued at $500 million. Noteholders objected to the reorganisation plan and voted against it. However, Vitro obtained the required 50 per cent creditor approval of this controversial plan because it counted the affirmative votes of the intercompany claims held by Vitro subsidiaries and affiliates. While “insider” votes are not counted in the US to determine whether there is a creditor class that has accepted a plan, such votes can be counted in Mexico.

Thus, from a cynic’s perspective, Vitro created unnecessary and questionable intercompany debt precisely for the purpose of voting through its own reorganisation plan even though its primary pre-existing creditors, the noteholders, adamantly opposed the plan. From the perspective of the Mexican insolvency system, this was perfectly legal and the court had no concern in approving the plan based on the affirmative creditor vote. Again from a Mexican perspective, the non-debtor releases of the US guarantors were also lawful and approved.

Vitro then filed a Chapter 15 petition in the Bankruptcy Court for the Southern District of New York in April 2011. After various trial proceedings, the Fifth Circuit Court of Appeals considered the situation.

As an initial matter, the Fifth Circuit determined that enforcement of the reorganisation plan was not of the type automatically granted upon recognition. Instead, Vitro needed to demonstrate that it qualified for the “appropriate relief” or “additional assistance” that the Court could grant under Sections 1520(a) and 1507(a). The Court was not particularly troubled by the application of Mexican law to count insider votes for purposes of approval of a Mexican plan for Mexican companies. What did concern the Court greatly, however, was whether Vitro could meet the “rigorous” test to justify “extraordinary” nature of the non-debtor releases for the benefit of the US Guarantors. The Court concluded that Vitro did not satisfy that test.

Subsequently, all relevant Vitro parties and noteholders entered into a settlement agreement, resulting in – among other things – noteholder recovery improving from approximately 40 cents on the dollar to 82 cents on the dollar.

The lesson from In re Vitro is simple. While courts everywhere stress the importance of international understanding and cooperation, there are limits. The noteholders should have assumed that Mexican insolvency law would apply to the Mexican debtors and that a US court would not ignore Mexican law permitting insider creditors to dominate a voting class. At the same time, Vitro should have known how unlikely it would be for a US court to enforce a Mexican release as to non-debtor US subsidiaries. If your issuer is in Mexico, expect Mexican law to be respected. And if your subsidiaries are in the US, expect US law to govern. When in Rome…

Anglo Irish Bank: Nationalisation Risk

In 2005, Anglo Irish Bank issued $200 million in private placement notes (notes) to a group of US institutional investors (noteholders). The notes were payable in New York, the note purchase agreement (NPA) was governed by New York law, and the bank submitted to the irrevocable jurisdiction of New York courts. Although the bank was a foreign issuer, all the indices of the investment pointed to US remedies in the event of default, including standard enforceability representations and legal opinions.

But then, in 2009, Ireland nationalised Anglo Irish in the wake of the global financial crisis. The bank then began to sell off significant assets in preparation for a government-compelled merger. Of particular concern to the noteholders was the bank’s efforts to sell off its US-based loan portfolio at a discount, thus potentially leaving the noteholders with no US recovery sources in the event of default.

In February 2011, the noteholders commenced a lawsuit in the United States District Court for the Southern District of New York seeking declaratory and injunctive relief as a result of Anglo Irish’s intended asset sales. Although there was no payment default at the time, the noteholders argued that the merger and US asset sales would, if consummated, breach various covenants of the NPA. By then, however, the US assets would have already been disposed of, leaving the noteholders with no effective remedy for the covenant defaults.

Anglo Irish moved to dismiss the litigation on several grounds, the most significant of which was that Anglo Irish was a sovereign entity and could not be sued in the US. Specifically, Anglo Irish claimed it was entitled to the protection of the Foreign Sovereign Immunity Act (FSIA) and that the noteholders could not overcome the presumption of immunity afforded to Anglo Irish under the FSIA. The noteholders’ two primary responses were self-evident. First, the bank was clearly not a government-owned entity when the notes were issued, and therefore could not seek retroactively to assert sovereign status because it had affirmatively consented to US jurisdiction in the NPA and waived any challenges to such jurisdiction. Second, even if the bank could now assert sovereign status, the issuance of the notes was clearly “commercial activity” of the type that was excluded from the immunity protections of the FSIA.

As to the first response, the Court then considered the key question: when a foreign state takes over a private enterprise, is the state bound by the consents and waivers previously made by the private enterprise? In this particular case, the NPA expressly submitted Anglo Irish to US jurisdiction for litigation concerning the NPA. The Court sided with Anglo Irish and held that only the state entity can waive its own immunity and it cannot be bound by a waiver of a private company even when the private company was subsequently nationalised by the state.

Rejecting the waiver arguments, the Court then turned its attention to the “commercial activity exception” to the FSIA. The Court agreed with the plaintiffs that the issuance of the notes constituted commercial activity in the US. However, the Court concluded that the activity by the private predecessor could not be imputed to the foreign state and that only activity by the foreign state could be used to establish the commercial activity exception. While perhaps logical in a vacuum, as discussed below, it has frightening implications.

In other words, the Court was faced with two choices. The Court could respect that the noteholders had purchased notes issued by a private company in a US-law transaction, or the Court could respect the sovereign nature of a nationalised bank even as to transactions entered into prior to the nationalisation. The Court chose door number two and the noteholders appealed to the Second Circuit Court of Appeals. However, unfortunately for those hoping for definitive guidance from the Second Circuit, the case was settled shortly after oral arguments but before a decision was issued, thus rendering the appeal moot.

While Anglo Irish is a US decision about an Irish nationalised bank, there is nothing to suggest either that courts in other countries would not adopt a similar logic or that the decision would not apply equally to any nationalised company in any industry. The lesson, therefore, is to consider the nature of the foreign issuer or borrower. In a time of crisis, is it in the type of industry – banking, telecommunications, power, infrastructure, commodities, energy production, etc – that a government might seek to nationalise? If so, are there extra protections that can be obtained, such as securitised receivables or other special collateral that can be structurally isolated even if the issuer itself is nationalised? Anglo Irish is a fascinating decision with potential implications well beyond the US and the banking industry, and investors (and their counsel) worldwide would be well advised to understand the decision very carefully.

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This is not an article intending to warn US investors to “be aware” of non-US jurisdictions; nor does it intend to warn foreign issuers and investors to “be aware” of US jurisprudence. It merely warns: “Be informed.” In re Vitro and Anglo Irish clearly illustrate the risks that investors and issuers face in the market today. Nationalisation risks and different procedures, such as pari passu voting of intercompany claims and the availability or non-availability of non-debtor releases, can significantly affect an investor’s ability to enforce its original negotiated-for contractual rights as well as an issuer’s ability to obtain relief for its foreign subsidiaries in addition to its domestic operations.