What’s Wrong with Chapter 11?

By Charles J. Tabb (University of Illinois College of Law)

The time has come to cast a discerning eye at chapter 11, the United States corporate bankruptcy reorganization statute, and examine how it is currently broken and what fixes can be made to improve it.

This Article first identifies five core normative goals that chapter 11 should promote: (1) maximize the value of the debtor firm; (2) distribute the maximized value of the firm fairly and equitably; (3) save jobs; (4) minimize the ripple effect of the firm’s failure; and (5) ensure that in pursuing those normative goals, the cure is not worse than the disease.

The Article then examines five critical ways in which chapter 11 in practice fails to achieve the normative ideals: (1) traditional chapter 11 restructurings are largely a thing of the past, and have given way to quick all-asset sales of the company; (2) secured lenders control everything and get a disproportionate share of the firm’s value; (3) a small number of other creditors are able to apply leverage to obtain unfair and inequitable payments on their claims compared to other creditors; (4) venue forum shopping has triggered a race to the bottom; and (5) bankruptcy judges routinely ignore the statute as written and legislate judicially.

The Article concludes by identifying seven possible reforms that could help transform chapter 11 from the current nightmare to the normative ideal dream: (1) making sales once again just sales; (2) resurrecting the “perishability” or “emergency” test for sales; (3) limiting secured creditors to foreclosure value; (4) opening up DIP financing terms and eliminating draconian terms; (5) eliminating all preferential priority-altering payments; (6) curtailing venue choice and forum shopping; and (7) eradicating judicial legislation.

The full article is available here.

Disagreement and Capital Structure Complexity

By Kenneth Ayotte (University of California, Berkeley School of Law)

Complex capital structures are prevalent in many recent high-profile Chapter 11 bankruptcy cases.  One recent example is Toys ‘R’ Us, whose debt structure included dozens of subsidiary entities, with separate debt facilities against entities owning the intellectual property, the real estate, and international operations, among other asset groups.  Why do capital structures become fragmented and complex in this way, and what are the implications for bankruptcy law?

In my working paper, I suggest one reason why a firm’s owners may have the incentive to engineer fragmented capital structures, using the idea that investors may disagree about the values of the various assets that make up the firm.  Fragmenting the capital structure horizontally—that is, pledging different assets and asset groups to different creditor classes—allows the firm to sell asset-based claims that are targeted to the investors who value those assets most highly. This targeting is good for the firm’s owners, because it minimizes the firm’s overall cost of capital.

This complexity can become costly, however, when firms encounter financial distress.  The same disagreement-driven fragmentation that allows the company to borrow more cheaply up front can lead to costly valuation disputes in and around bankruptcy, since creditors place a higher valuation on their own collateral than do the other creditors.  This can lead to valuation disputes that are socially costly in terms of professional fees, delays, and lost opportunities.  An example of this is the Energy Future Holdings case.  Following it’s 2007 leveraged buyout, the capital structure was divided into two silos, with one silo of entities (called the “E” side) holding regulated power assets, and a separate silo of entities holding the non-regulated power assets (the “T” side), with separate creditor groups on each side.  The initial plan to avoid bankruptcy by converting E- and T-side debt into parent-level equity failed after more than a year of negotiations, as the two sides could not come to agreement about the relative value of the two sides.  The resulting bankruptcy took over four years to reach plan confirmation and generated over $500 million in professional fees, to the detriment of creditor recoveries.

The theory has several implications.  One is that disagreement about valuation can lead to inefficient liquidation of viable firms, as creditors may prefer to walk away with the collateral they value highly, rather than fight for that value in a reorganization where the other creditors (from their perspective) are clinging to inflated valuations of their own collateral.  These kinds of forces may have been at play in the Toys ‘R’ Us case.  The B-4 term lenders, including the hedge fund Solus Alternative Asset Management, believed they were better off monetizing their intellectual property collateral in a liquidation of Toys ‘R’ Us than backing a deal to keep existing stores open.  The recent cancellation of the auction of this collateral suggests that these lenders may have held optimistic beliefs than the marketplace about the value of these assets.

From an academic standpoint, the theory provides a new answer to a long-standing question in the literature: why do we need a corporate reorganization mechanism in the first place? Traditional answers to this question revolve around the need to solve illiquidity problems.  In the presence of disagreement, I suggest an alternative benefit.  A traditional Chapter 11 reorganization allows parties to walk away with securities backed by the assets they financed before bankruptcy, about which the creditors are likely to be more optimistic.  Thus, the creditors can continue “agreeing to disagree” about the values of their respective pieces, thus promoting settlement and avoiding socially costly valuation disputes.  This is not possible when the firm is sold as a going concern for cash, since cash has a commonly known value.

Finally, my model emphasizes that when capital structures are fragmented, bankruptcy costs can be driven by haggling and litigation over the value of the parties’ entitlements, even when the parties agree about what to do with the bankrupt firm.  This suggests that the time may be ripe for rethinking and improving the resolution of valuation disputes in bankruptcy.  In a related paper, published in University of Pennsylvania Law Review, Edward Morrison and I review valuation opinions in bankruptcy cases.

The full article is available here.

The Dark Side of Bank Resolution: Counterparty Risk through Bail-in

By Wolf-Georg Ringe and Jatine Patel (University of Hamburg – Institute of Law & Economics, University of Oxford)

Bail-in and its supplementary capital requirements have much touted potential. Beyond their promise to reign in financial institutions’ bail-out moral hazard, bail-in intends to stem systemic risk whilst maintaining “critical” banking functions. It seeks to do this by allocating responsibility for recapitalization of banks to their individual creditors, immediately upon resolution, and in a pre-defined manner, for each financial institution individually. Counterparties to banking capital are therefore intrinsic to the current regulatory framework.

In our recent paper, we show, however, that bail-in legislation may have had counterproductive effects. Our key finding is that the introduction of bail-in has led to increased interconnectedness among banks, which involves more rather than less systemic risk. Worse still, increased interconnectedness between banks may jeopardize the effectiveness of the bail-in regime altogether since resolution authorities may be reluctant to exercise bail-in powers in the face of highly interconnected and contagious banks.

Using a difference-in-differences methodology, we provide evidence for this from the introduction of bail-in powers at the Eurozone level on January 1, 2016 when it entered into force under the European legislation known as the Bank Recovery and Resolution Directive, and the corresponding Single Resolution Mechanism (as part of the Banking Union) became effective. Using data from the European Central Bank’s Securities Holdings Statistics, we demonstrate that beginning in early 2016, financial institutions’ investments in securities issued by other financial institutions has been following a markedly increasing rate. What is more, at the same time non-banks have continued to decrease their investments in the same issuances. Put differently, banks’ holdings of securities in each other increased following the introduction of bail-in legislation, while non-banks continued to divest their holdings of bank securities.

We interpret these findings as evidence of a relative cost advantage that financial institutions have in comparison with other investors when investing in banks’ securities. We know from prior literature that increased interconnectedness may stabilize the banking sector for small external shocks (Acemoglu et al. 2015). For large, systemic shocks, in contrast, bank interconnectedness may frustrate any bail-in decision due to the systemic risk it creates (Bernard, Capponi, and Stiglitz 2017).

We subsequently discuss the challenges in regulating this problem, noting that in addition to the incentive problems mentioned above, there are also extensive knowledge and incentive challenges. Those challenges are symptomatic of the same legal and economic difficulties expressed in the literature and evident in recent bail-in cases.

Whilst some aspects of the current regulatory framework, including the Basel III and the TLAC framework, and standardized information disclosure under IFRS 9, indirectly affect those knowledge and incentive issues, they insufficiently address the bail-in counterparty problem especially because those measures address pre-resolution systemic risk perceptions, and not post-resolution systemic risk. More crucially perhaps, they do not facilitate optimization, or the who should hold corollary.

Finally, we explore some potential regulatory supplements to the current framework that may assist in reducing the challenge of knowing who should hold banking issuances, particularly ensuring that markets are better informed and able to allocate banking securities to optimal holders in accordance with principles of portfolio management, as opposed to attempting to prescribe ideal holders. More analysis and further holistic research are required to understand better what combination of regulatory instruments would be appropriate.

The full article is available here.

Financially Distressed Companies, Restructuring and Creditors’ Interests: What is a Director to Do?

By Andrew Keay (University of Leeds)

Out of court restructuring is a popular and, according to many, optimal way of resolving the circumstances of insolvent companies in the UK, and probably more so since the advent in the UK of the Enterprises Act 2002. One concern that some commentators have raised is the fact that the opportunities to engage in such restructuring are likely to be reduced given the way that the courts have approached claims that directors who have initiated restructuring strategies are liable for breach of duty in failing to take into account the interests of company creditors when their company is insolvent or near to it (as applied by section 172(3) of the Companies Act 2006 in the UK). Allied to this is the concern that if directors are not granted freedom to use their discretion in entering into a restructuring process companies might be placed into administration or liquidation when they have some prospect of continuing to trade and to do so profitably, because directors may choose to be risk averse in placing a company into administration or liquidation rather than take the risk of being held liable for breach of the duty if they attempt restructuring. This paper examines whether the aforementioned concerns are realistic, given the law, and, if they are, what directors should be doing to ensure that they do not breach the obligation in relation to creditors. These are important issues as little consideration has been given in the UK to the issue of liability of directors for breach of duty in the wake of a restructuring. The issues are considered in light of section 172(3) of the Companies Act 2006 which makes the director’s duty to promote the success of the company for the benefit of the shareholders (as under section 172(1) and providing for what is known as ‘enlightened shareholder value’) subject to any rule of law that requires directors to consider the interests of creditors. It is a rule of law in the UK (and in many Commonwealth countries and Ireland) that when their company is insolvent or in dire financial distress directors must take into account the interests of creditors.

The paper finds that while directors might be subject to liability in entering into restructuring attempts, this is only going to occur in limited cases and so there should not be particular concern over liability. This is because first of all courts will not hold directors liable if they acted in good faith and took into account the interests of creditors, and regarded these interests as paramount in their considerations. Even if the directors failed to take into account the interests of creditors or failed to make them paramount, they will not be liable where the court finds that the honest and intelligent director, taking into account creditors’ interests, would have entered into the restructuring in any event on the basis that it would benefit creditors. Obviously if directors restructure in such a way as to benefit themselves or specific creditors, or they have improper motives, then liability is more likely to ensue. But, where the directors have acted reasonably then they should be safe from challenge.

The full article is available here.

Disruption and Credit Markets

By Bo Becker (Stockholm School of Economics) and Victoria Ivashina (Harvard Business School)

Corporate bond defaults have been on a long and powerful upward trajectory in the past few decades. The default rate of U.S. corporate bonds rose from 0.12 percent to 0.46 percent between the first and second halves of the period from 1970 to 2016—an increase of almost four times. The rating agency Moody’s reports that, of the ten years with the highest default rates since 1960, six occurred in the new millennium and none before 1990. In a recent working paper, we investigate the role of disruption in explaining this trend.

By disruption, we refer to the process whereby new firms replace old firms using innovations in their business models, operations, or new technology. This process causes incumbent firms to lose market share, suffer reduced profitability, and, as we demonstrate, default on debt obligations. Just to name a few of the many recent examples: single-location bookstores were disrupted by chain stores, which were in turn disrupted by online bookstores, and off-line travel agents were disrupted by online services.

In our study, we compare industries with high rates of arrival of new firms, measured as either venture capital investments in the sector over the last five years or as the fraction of public firms in the industry with an IPO date in the past five years. The two variables capture different stages of disruptors’ ascent. While one can easily think of several broad forces that have increased innovation and disruption over the past few decades, different industries have been affected at different speed and different depth. We exploit this variation to draw the connection between disruption and defaults.

Our measures of disruption positively predict future defaults on corporate bonds, controlling for a host of other factors (including time, industry, bond characteristics such as seniority and callability, and issuer characteristics such as credit rating). These bonds are largely issued by mature firms (startups rarely access the bond market). Not only are future defaults higher in industries with high rates of disruption, but the bond market prices this in: newly issued bonds in high-disruption industries have higher yields. These findings are surprising, as a reasonable expectation might be that firms in the same industry would generally suffer similar fates. We would then expect to see high rates of new firm creation coupled with low defaults on the debt (of incumbents). Instead, we find the opposite.

An active IPO market and elevated venture capital investment may help the inception and advancement of potential disruptors, but underlying causes may be found in technological shifts (information technology, mobile, and ,in an earlier era, perhaps electricity), deregulation (think airlines), and globalization (in our data, industries directly exposed to off-shoring are no more likely to see defaults; however, global markets may have an important role in scaling up the opportunities available for disruptive businesses).

The importance of disruption probably extends beyond creditors to other stakeholders of incumbent firms. The corporate bond market is useful for studying disruption because bonds are liquid securities with detailed, high-quality data. Furthermore, losses on corporate bonds are important because bonds are widely held. This is in contrast with the gains from disruption, which tend to be concentrated with entrepreneurs and venture capital investors.

Disrupting Secured Transactions: Should UCC Article 9 Be Revised to Reflect the Rise of the Internet of Things?

By Christopher G. Bradley (University of Kentucky College of Law)

The “Internet of Things” (IoT) refers to the networks formed by interconnected devices that can communicate, and be communicated with, remotely. The IoT has already affected our daily lives, as a crucial part of our smart phones, Fitbits, smart watches, car navigation units, and so on.  But even more, it has profoundly affected businesses of every sort.  Manufacturing, transportation, and utilities firms alone are estimated to have spent more than $347 billion on IoT technology in 2018. Companies have deployed IoT tools in order to automate operations, streamline supply chains, ease regulatory compliance, and facilitate safer and more reliable production.

The IoT also affects secured creditors’ ability to monitor their collateral. For instance, individual tags can be placed on objects as they are checked in and out of a facility; cameras and temperature sensors can assess warehouse or field conditions to protect against loss or theft; vehicles can be tracked at all times and even remotely disabled upon default.

I argue that just as the rise of the IoT represents a revolution in business practice, it should bring a similar one to UCC Article 9. The article argues that Article 9 should allow–and in fact require–creditors to stake their claims in tangible collateral directly rather than through the now-antiquated means of a filing system routed through the debtor’s name/identity.

The proposed system would require creditors to tag items as collateral, or to use an interactive map administered by the state filing office over the Internet, in order to perfect security interests in tangible collateral. After sketching the proposed system, the article considers some of its major costs and benefits.

The full article is available here.

Absolute Priority Redux: First-Day Orders and Pre-Plan Settlements in Chapter 11 Post-Jevic

By Bruce Grohsgal (Delaware Law School Widener University)

Bankruptcy’s absolute priority rule arose 150 years ago to prevent insiders from using their control over an enterprise – often coupled with hypothetical valuations, contrived sales, and collusion with other parties – to obtain a greater distribution or “control premium” from estate assets.  This premium came at the expense of parties who had a higher distributional priority but were not “in on the deal.”  The Supreme Court again considered this issue in Jevic in 2017, when it held that a chapter 11 case-ending settlement called a “structured dismissal” must comply with the same absolute priority rule that applies to the similarly case-ending confirmation of a chapter 11 cramdown plan.  The Court emphasized that insider control and collusion can endanger bankruptcy’s core principle of an orderly distribution in accordance with statutory priorities.

The Jevic Court explicitly left open, though, the extent to which a pre-plan settlement or court-ordered “first-day” distribution in chapter 11 may deviate from the absolute priority rule.  It suggested only that a court approving these pre-plan distributions must show some respect for – or a “proper solicitude” to – the statutory distributional priorities.

I propose in this paper that, for a proposed pre-plan, priority-skipping settlement with an insider, secured lender or other party who exercises some control over the debtor, the absolute priority rule is sufficiently respected when a bankruptcy court subjects to an auction the claim proposed to be settled.  If at the auction, a third party bids the same or a higher price for the claim absent the priority-skipping, then it will be clear that the initially proposed transaction included a control premium.  If instead a higher third-party bid is not obtained, it will be clear that the settling insider is not paying a discounted settlement price based on its control and that the priority-skipping has a legitimate basis that does not implicate the problem of insider control.  The auction, by displacing suspect hypothetical valuations, can address the precise mischief sought to be remedied by the absolute priority rule.

I further contend that a market test for a “first-day” distribution to a critical vendor, employee or other creditor that is challenged as priority-skipping will be limited to whether the debtor sought and failed to obtain in the market the same good, service, or credit from an alternative supplier on the same or better terms than those proposed in the first-day motion.  The reason for this is simple – a bankruptcy court will not be able in most cases to obtain, at the time of the first-day hearing, a market determination of case-ending distributions to creditors.  Any hypothetical valuation at a first-day hearing of the end-of-case distributions to creditors will be highly unreliable.  Because of these obstacles, I suggest that the question of whether a first-day payment will comport with end-of-case distributional priorities should be replaced with the question of whether the debtor sought and failed to obtain an alternative supply in the market on the same or better terms, and by a rebuttable presumption that preserving the going concern value of the chapter 11 debtor likely will benefit even the disfavored creditors.  This approach – which essentially adopts the occasionally maligned “doctrine of necessity” and rejects the Seventh Circuit’s Kmart rule – recognizes the disturbing weakness of a hypothetical determination, made at the first day hearing, of end-of-case distributions in a chapter 11 case.

The full article is available here.

Make-Whole Claims in Bankruptcy

By Sam Lawand (White & Case LLP)

The well-established “perfect tender in time rule” dictates that debt must be repaid only upon maturity, and no earlier. Under this rule, early repayments of debt are prohibited absent a contrary provision under the debt instrument. Debt instruments bar early repayments altogether through a “nocall” provision or permit early repayments through a “make-whole” provision. By modifying the “perfect tender in time rule,” make-whole provisions allow debtors to repay debt in advance of stated maturity, in exchange for a predetermined premium, usually based on the discounted value of the stream of future scheduled interest payments.

To determine whether make-whole claims are allowed in bankruptcy, courts undertake a two-pronged analysis. Because make-whole provisions are contractual, courts rely on contract construction principles to determine whether the debt instrument contains a make-whole provision, and, if so, the circumstances in which such provision is triggered. If a make-whole provision is triggered, courts then proceed to determine whether such provision is enforceable under state law.

If the make-whole provision is enforceable under state law, courts proceed to determine whether such provision is enforceable under bankruptcy law. Section 101(5)(A) of the Bankruptcy Code defines “claim” as a “right to payment,” which encompasses make-whole claims. Section 502(a) provides that “claims” are allowed, except to the extent disallowed under section 502(b). In turn, section 502(b)(1) disallows “claims” that are “unenforceable . . . under any agreement or applicable law,” and section 502(b)(2) disallows “claims” on account of “unmatured interest.” In certain circumstances, section 506(b) allows “secured claims” to include “interest” and “any reasonable fees, costs, or charges provided for under an agreement or State statute.” The confluence of these Bankruptcy Code provisions is murky.

Given that make-whole provisions, in essence, liquidate damages arising out of the loss of future scheduled “interest” payments, which by definition are “unmatured,” the allowance of make-whole claims in bankruptcy compels a demanding analysis.

In resolving whether make-whole claims are allowed in bankruptcy, this article examines the application of contract construction principles, reconciles conflicting precedent on such  principles, and construes applicable Bankruptcy Code provisions. This article recognizes that, in applying the provisions of the Bankruptcy Code, bankruptcy courts are courts of equity and that considerations of bankruptcy and commercial policies, including practicality and predictability, bear on the application of such provisions. This article concludes that make-whole claims are generally not allowed in bankruptcy, unless (1) the default or “early repayment” by the debtor is “voluntary”; or (2) the debt instrument contains a “clear and unambiguous” provision calling for a make-whole payment in all circumstances of early repayment.

In accordance with this two-pronged analysis, the first-half of this article covers the state-law analysis, and the second-half of this article covers the bankruptcy-law analysis.

The complete article is available for download here.

Triangular Setoff Impermissible Under Section 553: No Contracting or Theorizing Around It, Section 553 Requires Mutuality

By Ronit J. Berkovich, Andriana Georgallas and Aarti Gupta (Weil, Gotshal & Manges LLP).

In a recent decision, In re Orexigen Therapeutics, Inc., No. 18-10518 (KG) (Bankr. D. Del. Nov. 13, 2018), Judge Kevin Gross of the United States Bankruptcy Court for the District of Delaware analyzed setoff under section 553 of the Bankruptcy Code.  Setoff is a contractual or equitable right that allows entities that owe each other money to apply their mutual debts against each other.  Whether a party has a setoff right is a twofold inquiry.  First, the party seeking setoff must acquire such right prepetition under applicable nonbankruptcy law.  Second, once the party establishes its setoff right, the party must meet the requirements of section 553(a) of the Bankruptcy Code, namely: (1) the party seeking setoff must be a “creditor” and (2) that party must have a “mutual debt” where that party’s debt to the debtor arose prepetition and that party’s claim against the same debtor arose prepetition.

In In re Orexigen Therapeutics, Inc., Judge Gross held that the mutuality requirement must be strictly construed, declining to find mutuality in a triangular setoff between the debtor, a parent entity that owed the debtor money, and that entity’s subsidiary, which was a creditor.  Specifically, Judge Gross held that there is no contractual exception to the mutuality requirement and that mutuality may not be satisfied under a third-party beneficiary theory.

The full article is available here.

Second Circuit Backs Foreign Clawback Claims in Madoff Bankruptcy Action

By Adam J. Goldberg, Christopher Harris, Robert J. Malionek, Kevin L. Mallen (Latham & Watkins)

In In re Picard, Tr. for Liquidation of Bernard L. Madoff Inv. Sec. LLC, No. 17-2992(L), 2019 WL 903978 (2d Cir. Feb. 25, 2019), the Second Circuit held that the trustee administering Bernie Madoff’s insolvent estate could use Section 550(a) of the Bankruptcy Code to claw back purely foreign transactions between foreign entities. The money at issue had been initially transferred by Madoff to foreign funds, then subsequently transferred by the foreign funds to the foreign defendants. The defendants argued that the Madoff trustee’s clawback claims were barred by the presumption against extraterritoriality and the principles of international comity.

While the Southern District of New York had focused its analysis on the subsequent transfers by the foreign funds to the foreign defendants, the Second Circuit focused on the initial transfer from Madoff to the foreign funds when determining whether the subsequent transfers could be recovered. The Second Circuit reasoned that since the initial transfers were from New York-based Madoff, the presumption against extraterritoriality and the principles of international comity did not bar the Madoff trustee’s attempts to recover these foreign subsequent transfers.  In so holding, the Second Circuit reversed the Southern District of New York’s prior ruling that such foreign transfers could not be recovered, and removed a protection for foreign investors who may not have anticipated that their investments — and their returns — could otherwise be subject to clawback under US law.

The full article is available here.

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