The perils of cross-border bankruptcies

Globe and Mail Update

Ontario Superior Court judge Mr. Justice Geoffrey Morawetz and Delaware Bankruptcy Judge Kevin Gross hoped to make a bit of legal history this summer when they joined forces to oversee the auction of Nortel Networks Corp.'s coveted wireless assets.

Instead, what the two judges got was an awkward lesson in the increasingly tricky legal minefield of global bankruptcies. With failures of big global giants such as Nortel on the rise, courts, creditors and lawyers are becoming entangled in cross-border power struggles that are further complicating the already fractious process of salvaging broken companies.

The Nortel court session was called in July to co-ordinate a rare joint cross-border hearing to rule on guidelines for the Toronto-based company's planned sale of its wireless division. The simultaneous court hearings reflected the division of Nortel's core assets in Canada and the United States.

Judge Morawetz and Judge Gross had agreed to follow a simple script for the late July hearing. They would walk into their respective courts in Toronto and Wilmington, and video cameras would track the proceedings so that lawyers and creditors in both countries could make submissions about the planned auction of Nortel's division.

But shortly after Nortel's U.S. lawyer finished explaining the planned auction guidelines in Delaware, however, Judge Gross jumped the gun by approving the auction plan and ending the hearings.

Left slack-jawed in Toronto were Judge Morawetz and more than two dozen Canadian lawyers, creditors and prospective bidders armed with arguments and briefs that were sidelined by the U.S. judge's ruling.

"There was a shocked silence in Toronto," said Craig Thorburn, a partner with Blake Cassels & Graydon LLP, who planned to ask the courts for a longer auction timetable on behalf of his client and Nortel suitor MatlinPatterson Global Advisers LLC.

A visibly startled Judge Morawetz rescued the day by calling for an intermission - during which sources said he had a private telephone discussion with Judge Gross. Shortly afterward, the joint hearing was resumed and Judge Morawetz ultimately granted his approval of the Nortel auction plan.

Judicial peace was restored and an important lesson learned by the Toronto players. Canadian courts and creditors have to fight harder than ever to defend their rights when multiple jurisdictions are involved.

"It was embarrassing what happened that day," said Ashley Taylor, a specialist in cross-border restructurings with Stikeman Elliott LLP. He blames myopic lawyers in dominant financial centres such as the United States who view Canada "as a complete afterthought."

Mr. Thorburn, however, says the cross-border tensions are more a reflection of the difficult restructuring climate. Money for reviving ailing companies is so scarce that creditors from different corners of the world are becoming much more assertive about their rights to cash, assets and other collateral from insolvent companies. At the same time, foreign courts are still taking only baby steps to navigate protocols for the conflicting legal rights of pushy creditors in multiple countries.

"There is a need for more co-operation. We are seeing a lot more issues and challenges," he said.

No one knows this more than Judge Morawetz. The respected restructuring specialist has waded into a number of thorny cross-border workouts that have threatened the rights of Canadian creditors.

At the heart of most of these battles is cash. Any subsidiary or division of a struggling company that is fortunate enough to be sitting on a nest egg in these cash-strapped times inevitably finds itself in the middle of a global shoving match over who can lay claim tocash and other assets.

In Nortel's case, most of the company's cash is located in its U.S. division, which helps to explain why the Delaware court has so much clout in the company's bankruptcy proceedings.

Before U.S. electronics retailer Circuit City Stores Inc. bit the dust earlier this year, the ample cash reserves at its Canadian subsidiary became the object of a messy battle between U.S. and Canadian creditors.

In exchange for a life-saving restructuring loan, known as a debtor-in-possession - or DIP - loan, a syndicate of banks lead by Bank of America demanded such powers as the right to "sweep the cash" from Circuit City's stable of 772 stores known as The Source after a mere five days' notice.

Judge Morawetz succeeded in blocking most of the outrageous demands, but that did not stop other creditors from taking a run at plum Canadian assets. After Judge Morawetz earlier this year approved less controversial terms for the DIP lifeline at Circuit City, the bank syndicate and unsecured creditors of the more troubled U.S. retail chain added an amendment to the loan. The amendment effectively gave the U.S. creditors a stronger claim to Canadian assets in the event the company failed.

The move triggered protests from a court-appointed Canadian monitor and retail landlords who protested that U.S. creditors were trampling over local jurisdiction and threatening their claims against local assets.

Edward Sellers, an Osler Hoskin & Harcourt LLP restructuring specialist who represents Circuit City's Canadian chain, criticized the U.S. loan amendment as an "extra-judicial" and "unhelpful" manoeuvre that was "engineered" to strengthen U.S. creditor claims against the Canadian operations.

Judge Morawetz never ruled on the amendment because the U.S. company was ultimately liquidated and its DIP lenders were repaid. But for Canadian creditors and lawyers, the near miss exposed new vulnerabilities in global workouts. Cross-border raids by foreign creditors not only reveal cracks in the legal framework for global corporate rescues, but they risk poisoning the international creditor co-operation that is essential for successful restructurings.