Courts Reject Nortel Bankruptcy Allocation
posted Jun 15, 2015 by Paul Oliveira, CPA
A U.S. bankruptcy court in Delaware ruled that $7.3 billion in proceeds from the bankruptcy sales of Nortel Networks Inc. should be divided on a modified pro rata basis. The Superior Court of Justice in Ontario reached the same conclusion in parallel proceedings linked by video.
Both courts rejected the argument raised by some creditors that the proceeds should be divided under the terms of a research and development (R&D) transfer pricing agreement. The proceeds in question were generated from the sales of the company’s multiple lines of business and the separate sales of its intellectual property (IP) assets.
The U.S. bankruptcy court considered, and rejected, several suggested methods of allocation, including:
- The fair market approach, based on the relative value of the assets each debtor transferred or relinquished in the sales,
- The relative contributions approach, under which each party’s share of the proceeds is determined based on relative contribution to creating the value of what was sold,
- The legal entitlement approach, which looks to the value of property rights transferred or surrendered in connection with the sales, and
- A pro rata model.
Nortel Networks was a highly integrated multinational tech enterprise that in 2000 had a market capitalization of $260 billion and 100,000 employees. Two years later, its market capitalization had plummeted to $2 billion and the company had laid off 60,000 employees. On January 14, 2009, Nortel filed for bankruptcy proceedings under Chapter 11 of the U.S. Bankruptcy Code.
In the years leading up to that, Nortel had in place a number of transfer pricing arrangements, advance pricing agreements (APAs) and cost sharing arrangements (CSAs).
At one point, one of the arrangements was nearing expiration and the IRS and other tax authorities didn’t want to renew it. They encouraged Nortel to adopt a residual profit sharing method (RPSM). Nortel’s tax advisors crafted one that was intended to be submitted to three tax authorities: the IRS, the Canada Revenue Agency (CRA) and the British tax authority.
One objective of the RPSM was to minimize tax payments globally by, among other things, shifting taxable income among subsidiaries to avoid U.S. tax. Over the next eight years, as APA negotiations continued, billions of dollars in transfer pricing payments were made under that system. In the end, neither the IRS nor the CRA approved the RPSM. They directed an income adjustment of $2 billion to a U.S. subsidiary that performed a significant amount of the enterprise’s R&D.
In 2004, a master R&D agreement (MRDA) was circulated to several companies within Nortel and was signed with an effective date of January 1, 2001. The MRDA provided for legal title in IP created by each company to vest in a Canadian subsidiary in consideration for an exclusive license.
In June 2009, several of Nortel’s debtors entered into an interim funding and settlement agreement (IFSA) to address financing of the Canadian subsidiary and the principles to guide the sales of Nortel’s businesses and assets.
The IFSA provided for a $157 million payment by the U.S. subsidiary to the Canadian subsidiary to settle any transfer pricing and other claims. The U.S. and Canadian courts approved the deal. Under a subsequent agreement, the U.S. subsidiary agreed to pay the Canadian subsidiary nearly $191 million to settle all claims.
Nortel’s various lines of business were then sold off, generating $3.29 billion. Of that amount, $2.85 billion was available to be divided. Some of Nortel’s patents were part of those sales, but the company retained any patent that was not predominantly used in a business line. The purchaser was generally granted a nonexclusive right for limited use.
In 2011, it was announced that Nortel’s remaining patent portfolio and related assets (IP assets) would be sold for $900 million, subject to higher or better offers. The sale of the IP assets, which included thousands of patents, ultimately drew a price of $4.6 billion.
The central issue in the case was the basis on which $7.3 billion in combined proceeds from the sales of the IP assets and the lines of business should be allocated. The parties involved included subsidiaries in different countries, bondholders and pension claimants. They couldn’t agree on that issue or on what effect — if any — the MRDA should have on the allocation. Consequently, the U.S. and Canadian courts were left to decide.
Modified pro rata allocation
The two courts ruled that the appropriate allocation method was a modified pro rata under which the amount each regional business received to pay its creditors would be calculated on the basis of the amount of claims against it as a percentage of the worldwide claims.
The U.S. court said the modified pro rata allocation was “appropriate by default.” The court also stated that pro rata distribution “would result in substantial prejudice to creditors who have bargained for separate contractual rights.” It emphasized that the flexibility in its approach comports with the IFSA, which doesn’t require or suggest any allocation method.
The bankruptcy court noted that it and its Canadian counterpart “conducted the cases independently, while cooperatively,” and that “their approaches to the complex issues differ.” However, it said they “agree on the result.” The courts had different interpretations of the MRDA, but agreed that it doesn’t apply to or control the allocation of the proceeds.
In response to the parties’ arguments against pro rata allocation, namely, that it cannot be administered due to uncertain treatment of claims, timing, and creditor recoveries, the court stated that:
- Claims that are not resolved by a certain date wouldn’t be recognized,
- The court would resolve any disputed claims to prevent claim inflation,
- Claims would be recognized only once, and
- Court-approved intercompany claims and settlements would be included in calculating the allocation.
What’s ahead: Given the amount of money in dispute and the extent of disagreement among the parties, it seems certain that this decision will be appealed.