December 2003

The Metropolitan Corporate Counsel

Page 5

WorldCom, MCI And The Second Circuits Substantive Consolidation Doctrine: Asserting Creditors Rights In The Largest Bankruptcy Case In History Part I
The Editor interviews Thomas Moers Mayer and Philip Bentley, Kramer Levin Naftalis & Frankel LLP. Part II of this interview, which will appear in the January issue, will examine the events leading up to the nal settlement of the case, together with its implications for the rights of creditors.
Editor: Will each of you gentlemen give our readers something of your background and experience? Mayer: I got interested in bankruptcies as a business reporter covering old chapter XIs for a small paper in Easton, Pennsylvania, so I may have been the rst person to go to Harvard Law School knowing that he wanted to be a bankruptcy lawyer. After a clerkship with Judge Lumbard of the Second Circuit and a rigorous bankruptcy education at Wachtell, Lipton, I became head of the bankruptcy group at Robinson, Silverman, Pearce, Aronsohn & Berman and then went to Kramer Levin to work with Ken Eckstein. Bentley: I came to bankruptcy with a background in commercial litigation. I started out at Paul,Weiss and came to Kramer Levin as a commercial litigator. Then in the late 80s I discovered that I was doing more and more bankruptcy work. Bankruptcy was very much an expanding area of the law in those days, and that trend has continued. As a result, for the last fteen years I have devoted almost all of my time to litigation in the bankruptcy arena. Editor: To set the stage, it would be helpful if you gave us the background of the WorldCom case. Mayer: WorldComs basic story is well known: unsustainable expansion and debt hidden by a major accounting fraud. Less well known is the ght inside WorldCom, between creditors of the parent company WorldCom and creditors of its subsidiary, MCI, which WorldCom acquired in 1998. WorldCom owed $24 billion to bond holders and banks, and was set up to act primarily as a holding company. MCI, by contrast, had operating subsidiaries comprising at least 90% of WorldComs operating value, and only about $6 billion in total debt to bondholders and trade creditors. WorldCom led for bankruptcy in June of 2002 and, from the rst day of the case, MCI creditors fought with WorldCom creditors. The MCI creditors argued they were entitled to be paid in full before their shareholder, WorldCom, could receive any value to pay to its creditors. The WorldCom creditors wanted to recover their claims from MCIs assets by substantively consolidating WorldCom with MCI. Editor: Would you give some background on substantive consolidation? Bentley: The doctrine as outlined by the Second Circuit Court of Appeals is quite clear, a good deal clearer than it is in many other circuits. When you have a number of intertwined corporate debtors, the doctrine of substantive consolidation says you can combine their assets and debts and treat them as if they belonged to one company in very limited circumstances. The Second Circuit says you can do so in just two circumstances. The rst is if all the creditors dealt with the different business units as a single consolidated entity that is, When we nally settled, on the rst day of trial, the settlement gave the class of QUIPS holders about 45 cents on the dollar. Editor: Why was the market so pessimistic about the QUIPS prospects? Bentley: The market thought we would lose because the Debtors and virtually every other party in the case were arguing that Worldcom and MCI were hopelessly entangled. WorldCom owned more than four hundred direct and indirect subsidiaries. Their nancial reporting has always been on a consolidated basis. They always conducted their operations and nancial affairs on an integrated basis. They funneled all their cash into a central cash management system. The Debtors said the poor quality of their accounting staff prior to the bankruptcy, as well as the incompatibility of the various software systems that were used to track intercompany transactions, made it impossible to disentangle the trillion dollars of intercompany claims. Editor: How did you go about building a case against WorldComs plan of reorganization? Bentley: Challenging the Debtors plan was a massive undertaking. We were fortunate to be working closely with a number of outstanding lawyers, including Dan Webb of Winston & Strawn and Ed Weisfelner of Brown Rudnick. We also were able to assemble an extraordinary group of experts to advise us and, eventually, to testify at trial. These included Roman Weil, one of the countrys leading accounting scholars, and Art Siegel, who headed Price Waterhouses audit practice for many years and was Executive Director of the Independent Standards Board. My partner Greg Horowitz did an amazing job of working with our team of experts to build a case that would have posed a very serious challenge to WorldComs plan. Editor: The press has cited the testimony of Joseph DAmico, who inspected the books of MCI, as of particular importance in these proceedings. Can you describe that testimony? Why was it so critical? Bentley: Joe DAmico was the lead forensic accountant representing the creditors committee. WorldCom early on delegated to him the job of looking at the intercompany claims to see whether the nances of the various entities could be disentangled. Joe and his team spent more than six months intensively studying literally a trillion dollars of transactions. He concluded that it was not possible to accurately disentangle the nances of the four hundred WorldCom entities in part because data was missing as to $328 billion in intercompany transactions. We argued that Joe had addressed the wrong question. He may very well be right that its not possible to disentangle the nances of the four hundred entities that make up WorldCom, but that shouldnt matter. Instead, what matters is that the nances of MCI as a whole MCI and all of its subsidiaries could be disentangled from the nances of all of the other WorldCom entities, again looked at as a whole. We and our experts including Roman Weil, who had taught DAmico in school developed what we thought was a formidable array of ways to prove that the finances of MCI as a whole can be disentangled from those of the rest of WorldCom. Once this has been done, its relatively easy to see that MCI is solvent by a large margin.

Thomas Moers Mayer

if all creditors relied on the creditworthiness of the enterprise as a whole, rather than on the creditworthiness of any of the individual companies. We were in a particularly strong position to defeat that basis for substantive consolidation. MCI had two types of publicly traded debt that pre-dated its acquisition by WorldCom: $2.6 billion of senior debt and $750 million of subordinated debt known as QUIPS, or Qualified Income Preferred Securities. There is no question that people who bought this debt when it was issued relied only on MCIs creditworthiness, not WorldComs. So the ght in our case was over the second prong of the test, which permitted WorldCom to substantively consolidate MCI only if the nancial affairs of MCI and WorldCom were found to be hopelessly entangled. To satisfy this test, WorldCom would have had to prove that it was impossible to tell which assets or liabilities were MCIs and which were WorldComs or at least that it would be so difcult and expensive to disentangle MCIs nancial affairs from WorldComs that everybody would wind up worse off. Editor: Will you describe the proceedings before U.S. Bankruptcy Judge Arthur Gonzalez on WorldComs reorganization plan under Chapter 11? Bentley: The case was originally led in July of 2002. WorldCom hired a new CEO, Michael Capellas, in December. Understandably, Capellas wanted WorldCom out of chapter 11 as fast as possible. He announced that the Debtors would le a reorganization plan within a hundred days, and they met that deadline with the April 14th plan ling. The Debtors got their disclosure statement approved at the end of May and raced toward a conrmation hearing in early September. We had only three months to hire experts, to plunge into WorldComs extremely complex books and records and try to make sense of them, and to take an enormous amount of discovery. Editor: How long would something of this magnitude normally take? Mayer: At the time Phil and I rst got involved in WorldCom, another team of Kramer Levin attorneys was litigating the same issue substantive consolidation in the Owens Corning bankruptcy. Discovery and other pre-trial proceedings in that case took about nine months, and the trial of substantive consolidation took four weeks. In our case, Judge Gonzalez compressed the

Philip Bentley
timetable both for litigating substantive consolidation and for conrming the Debtors plan of reorganization into a three-and-a-halfmonth time frame. In light of the size and complexity of the case, this was an extraordinarily short timetable. Editor: How did you happen to get involved in the case? Mayer: Kramer Levin got involved for the MCI QUIPS only in March of 2003. Originally, we expected to play a very minor role as supporting cheerleader for the MCI senior bondholders. There was an informal committee of large institutions holding over $1 billion in MCI senior debt. They had hired counsel and some very impressive experts. It looked like they were leading the charge for all MCI creditors. In mid-April, however, the MCI seniors cut their own deal. They agreed to substantively consolidate MCI with WorldCom so long as they got 80 cents on the dollar. The deal gave the MCI QUIPS zero zip, nothing. WorldCom announced the deal on April 14th with a plan and disclosure statement that disclosed for the rst time the existence of a trillion dollars of inter-company transactions between WorldCom and its non-MCI subsidiaries, on the one hand, and MCI and its operating subsidiaries on the other. WorldCom argued that those intercompany claims justied consolidating WorldCom with MCI. WorldCom also argued that, because the MCI senior bondholders had agreed to take 80 cents less than full payment in settlement of their claims, the subordinated MCI QUIPS were entitled to nothing. WorldCom also made a lot of the fact that over 95% of its debt supported the plan that is, everyone was on board except the MCI QUIPS and a few dissident MCI trade creditors who were getting 36 cents on the dollar. We and the dissident trade group spent the rest of the spring and all of the summer ghting WorldComs plan of reorganization against the combined opposition of WorldCom, its creditors committee and virtually every other group in the case. Bentley: Although the QUIPS were widely held by small investors, a few institutions had managed to acquire about $200 million of QUIPS. They retained us. Starting in late May 2003, they decided to invest a signicant amount of money to fund the ght against substantive consolidation. The market didnt think we would win the MCI QUIPS were then trading at about eight cents on the dollar.

Please e-mail the authors at tmayer@kramerlevin.com or pbentley@kramerlevin.com with questions about this article.