Chapter 11, Not In A Courtroom Near You

Today, I want to talk about chapter 11 venue reform. Wait . . . don’t touch that dial. This piece of legal arcana may be affecting you more than you realize.

For example, consider the local Champaign company, Hobbico, which is currently in chapter 11. The company’s headquarters are in Champaign along with more than 330 of its employees who also own the company through an employee stock ownership plan (known as an ESOP). In addition to its Illinois headquarters, Hobbico has facilities in the Chicago suburbs as well as in Nevada, Colorado, and California. Hobbico is incorporated in the state of Illinois.

But, if Hobbico’s employees and local creditors want to protect their rights, they will need to do so in ... wait for it ... Delaware, because that is where Hobbico has filed bankruptcy. The company’s only connection to Delaware is that one of its six subsidiaries is incorporated in the state.

A corporation filing bankruptcy can choose to file where it is incorporated, where it has its principal place of business, or where most of its assets are located. Those choices already would leave open many places, but yet there is more. A corporation also can file bankruptcy where any of its affiliates, such as a subsidiary, have filed.

Bankruptcy lawyers have used these rules to develop a neat trick. A subsidiary of a corporation files bankruptcy, and then the parent corporation follows. That is exactly what has happened in the Hobbico bankruptcy. The practical effect of these rules is that larger corporate organizations can choose to file bankruptcy most anywhere in the United States.

The two places that corporations choose are Manhattan and Delaware, and have been doing so for decades. Eastern Airlines followed its small frequent flyer club subsidiary into bankruptcy in Manhattan. Enron similarly followed a small metals trading subsidiary into Manhattan bankruptcy court although that subsidiary represented less than one-half of one percent of Enron’s total assets.

The venue rules have raised claims about unseemly forum shopping that undermines respect for the rule of law. Because a corporate debtor’s management essentially can decide where the company files, some have argued that what attracts companies to Manhattan and Delaware are court decisions friendly to the salaries of corporate managers and the fees of the attorneys who represent the corporations. It is not uncommon now to see rates of more than $1,500/hour for the attorneys representing corporations in chapter 11.

Also, a body of case law has developed out of the Manhattan and Delaware courts that has become especially favorable to large financial interests in chapter 11 cases. The U.S. Supreme Court recently reversed some of this case law that had blatantly ignored the priority rules for paying creditors in a chapter 11. Unlike other areas of federal law, the bankruptcy venue rules have stymied a more balanced chapter 11 law developed from courts and judges across the country.

Indeed, large chapter 11 cases have all but disappeared from the Illinois federal courts because of an appellate court ruling over a decade ago in the Kmart bankruptcy. Viewed as unfavorable to corporate debtors, this court ruling became yet another reason to file in Manhattan and Delaware.

Because of the perceived abuses, legal academics and law reform groups have proposed changing the bankruptcy venue rules for decades, but New York and Delaware senators were able to successfully block any attempt at reform. That may be about to change. A remarkable bipartisan bill from Republican Senator John Cornyn of Texas and Democratic Senator Elizabeth Warren of Massachusetts would limit corporations to filing bankruptcy only where they have their principal place of business. The bankruptcy cases of local companies would return to local federal courts. If you think this change would be a good idea, our congressional representatives would benefit from hearing that.