Shortly after the U.S. Court of Appeals for the Fifth Circuit refused to enforce Vitro SAB’s Mexican plan of reorganization in the United States (covered here), Judge Harlin D. Hale of the U.S. Bankruptcy Court for the Northern District of Texas dealt another major blow to the embattled Mexican glassmaker by placing ten of its U.S.-based guarantor subsidiaries into involuntary bankruptcy at Vitro’s noteholders’ request. At a hearing on the involuntary petitions, the Vitro subsidiaries argued that a “savings clause” in the indenture governing the notes created a bona fide dispute as to the amount of the noteholders’ claims, and that creditors with disputed claims are not permitted to file involuntary petitions under Bankruptcy Code section 303. However, Judge Hale held that the savings clause at issue was designed to protect noteholders from attempts to void the subsidiaries’ guarantees as fraudulent transfers and could not be used to manufacture a disputed claim and invalidate an involuntary bankruptcy petition. This decision helps ensure that savings clauses, which appear in many indentures and credit agreements, serve their intended purpose—to protect lenders, rather than serve as a defense to involuntary bankruptcy or other creditor remedies. In re Vitro Asset Corp., et al., No. 11-32600-hdh-11 (Bankr. N.D. Tex. Dec. 4, 2012).
Savings clauses are common in indentures governing bonds issued by parent holding companies that lack substantial assets of their own and must rely on “upstream” guarantees from asset-rich operating subsidiaries to make their bonds attractive to investors. Because such guarantees may be extended by subsidiaries on financial terms that would not be present in an arms-length deal with a third party, they are susceptible to challenge as a fraudulent transfer. Under section 548 of the Bankruptcy Code, an upstream guarantee may be deemed constructively fraudulent if (i) the subsidiary received less than reasonably equivalent value in exchange for the guarantee, and (ii) the subsidiary was insolvent at the time it granted the guarantee or became insolvent as a result of the guarantee. The purpose of a standard “savings clause” is to save an upstream guarantee from avoidance as a fraudulent transfer by limiting the guarantor’s liability on the guarantee to an amount insufficient to render the subsidiary insolvent, thus destroying the second element of the constructive fraudulent transfer test. Although savings clauses are common in indentures, their utility in defeating a fraudulent transfer challenge has rarely been tested in court. Indeed, one of the few major cases to address the issue held that savings clauses are generally unenforceable. See In re TOUSA, Inc., 422 B.R. 783, 863-65 (Bankr. S.D. Fla. 2009).
Vitro S.A.B. de C.V. (“Vitro”) is a large glass manufacturer organized under the laws of Mexico. In 2008, Vitro defaulted on several notes it had issued in 2003 and 2007, which had been guaranteed by all of Vitro’s wholly-owned direct and indirect subsidiaries. On November 17, 2010, several U.S.-based hedge funds holding certain of the defaulted notes filed involuntary chapter 11 petitions against fifteen of Vitro’s U.S. subsidiaries in the Bankruptcy Court for the Northern District of Texas.
Some of Vitro’s subsidiaries ultimately consented to chapter 11 relief, but the remaining Vitro subsidiaries asserted affirmative defenses based on a savings clause and various other provisions in the indenture governing the notes. With regard to the savings clause, the subsidiaries argued that it created a bona fide dispute as to the amount of the noteholders’ claims, rendering involuntary bankruptcy unavailable.
On March 31, 2011, the Bankruptcy Court preliminarily rejected the subsidiaries’ savings-clause defense. However, the Bankruptcy Court subsequently ruled in the subsidiaries’ favor on two other defenses and dismissed the involuntary petitions. The noteholders appealed these rulings to the District Court for the Northern District of Texas. As previously covered here, the District Court reversed the Bankruptcy Court’s rulings on the two other defenses and remanded the case to the Bankruptcy Court.
While the appeal was pending, the noteholders also sought to enforce the subsidiaries’ guarantees in New York state actions. In response to the noteholders’ summary judgment requests, the Vitro subsidiaries argued that the savings clause created a triable issue of material fact as to the amount of the subsidiaries’ liability and that summary judgment was therefore inappropriate. On December 16, 2011, Judge Bernard Fried of the New York State Supreme Court granted summary judgment to the noteholders in one of the state actions, holding that the savings clause did not affect the amount of the subsidiaries’ liability to the noteholders because the clause was not triggered unless the guarantees were actually challenged as fraudulent transfers. Judge Fried subsequently reiterated this holding in two other actions, and the New York Appellate Division affirmed Judge Fried’s reading of the savings clause on appeal. See Elliot Intl. L.P. v. Vitro, S.A.B. de C.V., 95 A.D.3d 565, 565 (1st Dept. 2012).
Following the District Court’s decision rejecting certain of the subsidiaries’ defenses to involuntary bankruptcy, the Texas Bankruptcy Court held a status conference to determine what issues remained to be decided on remand. The Bankruptcy Court concluded that the only remaining issue was the viability of the subsidiaries’ savings-clause defense—the same issue recently decided by the New York courts.
Section 10.07 of the Vitro indenture, which contains the savings clause at issue, reads, in relevant part:
the . . . Guarantors hereby irrevocably agree that the obligations of each Guarantor under its Note Guarantee are limited to the maximum amount that would not render the Guarantor’s obligations subject to avoidance under applicable fraudulent conveyance provisions of the United States Bankruptcy Code . . . .
The subsidiaries argued that, even in the absence of any allegations of a fraudulent transfer, this clause required the Bankruptcy Court to determine the maximum amount the subsidiaries could pay without becoming insolvent. The subsidiaries further contended that, until such a determination had been made, a bona fide dispute existed as to the amount of the noteholders’ claims, rendering involuntary bankruptcy unavailable.
The noteholders, by contrast, read Section 10.07 as a standard savings clause designed only to protect the noteholders against the possibility that subsidiary guarantees could be avoided. Accordingly, the noteholders reasoned that Section 10.07 should apply only in instances where a guarantee had actually been attacked as an allegedly fraudulent transfer. Because no such attack had occurred in this case, the noteholders contended that the clause had no effect on the amount of their claims.
The Bankruptcy Court ultimately accepted the noteholders’ reading of the clause and rejected the reading proposed by the Vitro subsidiaries. In arriving at this holding, the Bankruptcy Court did not independently interpret Section 10.07, but instead adopted the conclusions in Judge Fried’s December 16, 2011 opinion and the subsequent New York state court opinions, all of which held that Section 10.07 only became operative in the event a subsidiary guarantee was alleged to be a fraudulent transfer. The Bankruptcy Court expressly held that, although the amounts of bankruptcy claims are generally to be determined as of the petition date, and although the New York state court judgments were entered after the date the involuntary petitions were filed, it was proper for a court to consider state court judgments rendered subsequent to the petition date when determining whether a bona fide dispute exists as to the amount of the petitioning creditors’ claims. Consequently, the Bankruptcy Court followed the New York courts in holding that Section 10.07 constituted a savings clause rather than a limitation on liability and thus concluded that the provision did not create a bona fide dispute as to the amount of the petitioning noteholders’ claims.
In addition, the Bankruptcy Court took note of questionable conduct on the part of the Vitro subsidiaries that had recently been brought to its attention. Specifically, beginning in 2009, several of the Vitro subsidiaries had taken steps to transfer assets from the U.S. to Mexico in an apparent effort to evade the noteholders’ collection efforts. Furthermore, while the noteholders’ appeal of the dismissal of their involuntary bankruptcy petitions was pending, five of the Vitro subsidiaries had reincorporated in the Bahamas in a possible attempt to elude the jurisdiction of the U.S. courts. In light of these questionable actions by the subsidiaries, the Bankruptcy Court invoked a common law “special circumstances” exception that excuses strict compliance with the involuntary bankruptcy requirements where an alleged debtor has engaged in a “fraud, trick, artifice, or scam.” The Court expressed some uncertainty as to whether this special circumstances exception was still a viable legal doctrine, but to the extent it still existed, the Court held that it constituted an additional basis for rejecting the Vitro subsidiaries’ arguments regarding a “bona fide dispute.”
Savings clauses have rarely been enforced even for their intended purpose of “saving” upstream guarantees from avoidance as fraudulent transfers. Thus, the Vitro subsidiaries’ attempt to rely on such a clause as a defense to involuntary bankruptcy was a daring, but ultimately ill-fated maneuver. The Bankruptcy Court’s rejection of Vitro’s creative reading of the clause was a clear win for bondholders and other lenders, because a court ruling accepting Vitro’s interpretation could have created a significant new obstacle to the enforcement of many subsidiary guarantees. In addition to eliminating a possible defense under existing indentures, the Bankruptcy Court’s ruling also simplified future debt issuances, as lenders may now continue to demand the inclusion of savings clauses in indentures and credit agreements without creating a risk that these clauses will later be used against them. The Bankruptcy Court’s decision also may have prevented a rise in holding company borrowing costs, as a win for Vitro would have made holding company debt riskier by reducing the enforceability of subsidiary guarantees. The Bankruptcy Court’s decision was also the latest rebuke to the Vitro corporate family, which has struggled to keep its assets out of the hands of U.S. creditors through the use of ethically questionable tactics. The vigilance of the Bankruptcy Court and other U.S. courts in thwarting such potential abuses is a testament to the quality and fairness of the U.S. insolvency system.