United States: At The Mercy Of Debtors - High Court Narrows Creditor’s Ability To Prevent Preferential Transfers

In a case of great interest to financiers of all stripes, the U.S. Supreme Court has ruled against a group of U.S.-based financiers seeking injunctive relief to prevent a Mexican borrower from depleting its assets (by paying its local creditors first), pending final outcome of their suit for defaulted financing payments. The case is noteworthy as a reminder that unsecured creditors are very much at the mercy of their debtors when it comes to favoring payments to some rather than others (putting aside how bankruptcy courts treat preferential payments).

In Group Mexicano De Desarrollo v. Alliance Bond Fund Inc., No. 98-231 (June 17), the Court held that, in an action for money damages, a U.S. district court does not have "the power to issue a preliminary injunction preventing a defendant from transferring assets in which no lien or equitable interest is claimed."

The plaintiffs, U.S. investment funds, purchased unsecured notes from Grupo Mexicano de Desarollo (GMD), a consortium of Mexican construction companies. The Court maintained that the plaintiffs could not prevent the financially troubled Mexican company from allocating its most valuable assets to local Mexican creditors while a judgment for damages brought by the plaintiffs was pending in a U.S. district court.

In 1994, GMD was involved in a government-sponsored toll road construction program in Mexico. However, by 1997, because of the serious downturn in the Mexican economy, GMD was in financial distress. As a result, GMD and its subsidiaries were unable to make interest payments for August 1997 to the plaintiffs and other noteholders. The Mexican government attempted to assist GMD and other companies involved in the construction of the toll road, by issuing guaranteed "toll road notes" in exchange for ownership of the toll roads.

In October 1997, GMD announced its would use part of its right to receive toll road notes to pay its employees and pay back taxes to the Mexican government. When negotiations for restructuring GMD’s debt failed, the plaintiffs accelerated the principal amount on their loan notes and, in December 1997, filed suit for the amounts due in the U.S. District Court for the Southern District of New York. The noteholders also requested a preliminary injunction restraining GMD from transferring its assets, alleging that GMD was likely to become insolvent and was preferring its Mexican creditors in the disbursement of its most significant assets, the toll road notes. The plaintiffs feared that GMD’s planned allocation of the toll road notes would render any ultimate judgment in their favor meaningless.

The district court issued the preliminary injunction, leading to GMD’s appeal of that decision. On appeal, the U.S. Court of Appeals for the Second Circuit affirmed the district court’s decision. However, on a subsequent appeal, the Supreme Court reversed the Second Circuit and remanded the case, holding that a district court does not have the authority to issue such an injunction.

Justice Antonin Scalia, writing for a 5-4 majority, first disposed of the issue of whether the case had been rendered moot because the district court had granted summary judgment in favor of the noteholders subsequent to the granting of the preliminary injunction, clearly establishing their right to the owed amounts. The court found that GMD’s cause of action for wrongful injunction was sufficiently independent of its defenses against the money judgment on the merits.

After a detailed analysis of the history of the powers held by English courts of law and equity, the Court then found that the district court lacked the authority to issue the preliminary injunction, because such a remedy was historically unavailable from an English court of equity (and on which the U.S. legal system was modeled). The Court supports its conclusion by stressing that a contrary finding could lead to "creditors engag[ing] in a ‘race to the courthouse’…which might prove financially fatal to the struggling debtor." The Court conceded that there were various policy considerations, such as preventing "inequitable conduct" by the defendants, "avoiding the necessity for plaintiffs to locate a forum in which the defendant has substantial assets, and … preserving the attractiveness of the United States as a center for financial transactions," for creating such an equitable remedy. However, it went on to say that any further fix would have to come from Congress rather than the Court.

Justice Ruth Bader Ginsberg and the other three dissenters found that the district court had properly granted the preliminary injunction. Historically, federal courts had the authority to exercise equity jurisdiction when, as here, "the remedy in equity alone could furnish relief, and … the ends of justice required[d] the injunction to be issued … [p]articularly … to preserve the situation pending the outcome of a case lodged in court." According to the dissent, flexibility is the hallmark of equity, and the majority’s adherence to "the specific practices and remedies of the pre-Revolutionary Chancellor" was too narrow, limited and static.

The dissent also pointed out that the Court of Chancery might never had issued such an injunction in the past because it was unnecessary "to secure a just result in an age of slow-moving capital and comparatively immobile wealth." However, in this case, had the district court not issued the preliminary injunction, "[the creditor] would have been left with a multimillion dollar judgment on which it could collect not a penny." The dissent was concerned that "increasingly sophisticated foreign-haven judgment proofing strategies, coupled with technology that permits the nearly instantaneous transfer of assets abroad, suggests that defendants may succeed in avoiding meritorious claims in ways unimaginable before the merger of law and equity."

The Court’s opinion hints that the outcome might have been different if the plaintiff creditors had alleged some form of equitable lien against the transferred assets, so that the injunctive relief would have been easier to support in the context of the particular assets in question. Lastly, it is interesting to note that the Court’s all-too-familiar response that Congress needed to address the question may have been a reaction to its knowing that English courts can now issue such injunctions, following a passage of an authorizing statute in that country.