By Howell E. Jackson (Harvard Law School) & Stephanie Massman (Davis Polk & Wardwell LLP)
One of the most elegant legal innovations to emerge from the Dodd-Frank Act is the FDIC’s Single Point of Entry (SPOE) initiative for resolving the failure of large financial conglomerates (corporate groups with regulated financial entities as subsidiaries), whereby regulators would seize only the top-tier holding company, down-stream holding-company resources to distressed subsidiaries, and wipe out holding-company shareholders while simultaneously imposing additional losses on holding-company creditors. The SPOE strategy is designed to resolve the entire group without disrupting the business of operating subsidiaries (even those operating overseas) or risking systemic consequences for the broader economy.
Although SPOE’s underlying creativity is admirable, the approach’s design raises several novel and challenging questions of implementation, explored in this chapter. For example, the automatic down-streaming of resources raises the so-called pre-positioning dilemma. If too much support is positioned at subsidiaries in advance, there may be inadequate holding-company reserves to support a severely distressed subsidiary. Alternatively, without such pre-positioning, commitments of subsidiary support may not be credible (especially to foreign authorities), and it may become difficult legally and practically to deploy resources in times of distress.
It is easiest to envision SPOE operating in conjunction with the FDIC’s Orderly Liquidation Authority (OLA), established in the Dodd-Frank Act; however, Dodd-Frank’s preferred regime for resolving failed financial conglomerates remains the U.S. Bankruptcy Code, and several complexities could arise if a bankruptcy court had to implement an SPOE resolution today. While many experts are working on legislative proposals to amend the Bankruptcy Code to facilitate SPOE resolutions, this chapter examines some legal levers that federal authorities could deploy under current law to increase the likelihood of a successful SPOE bankruptcy. For example, with appropriate pre-failure planning, section 365(o) of the Bankruptcy Code—which requires the debtor to assume and cure immediately any deficiency under an obligation to federal regulators to maintain the capital of an insured depository institution—could be used to prioritize holding-company commitments to all material operating subsidiaries, including affiliates that are not insured depository institutions. Such priority status would shield the down-streaming of value to operating subsidiaries from possible legal challenges, thereby alleviating some of the difficulty of the pre-positioning dilemma. Additionally, broad-based credit facilities under section 13(3) of the Federal Reserve Act or targeted lending under the Federal Deposit Insurance Act’s systemic risk exception may be available to provide government-sponsored debtor-in-possession financing where no private or other public alternative (like that provided under OLA) is available.
Implementing these strategies would be challenging and would require considerable planning. However, it is important to take steps now to increase the likelihood that bankruptcy represents a viable and credible alternative for effecting SPOE transactions outside of OLA.
The full chapter is available here.
The Roundtable has covered bank resolution and the SPOE strategy previously. For example, see Lubben & Wilmarth, “Too Big and Unable to Fail“; Crawford, “Establishing ‘Credible Losers’“; Roundtable Update, “Bankruptcy Code Amendments Pass the House in Appropriations Bill.”
By Philipp Paech (London School of Economics)
“Safe harbor” privileges in insolvency are typically afforded to financial institutions. They are remotely comparable to security interests as they provide a financial institution with a considerably better position as compared to other creditors should one of its counterparties fail or become insolvent. Safe harbors have been and continue to be introduced widely in financial markets. The common rationale for such safe harbors is that the protection they offer against the fallout from the counterparty’s insolvency contributes to systemic stability, as the dreaded “domino effect” of insolvencies is not triggered from the outset. However, safe harbors also come in for criticism, being accused of accelerating contagion in the financial market in times of crisis and making the market riskier. In this article, I submit that the more important argument for the existence of safe harbors is liquidity in the financial market. Safe harbor rules do away with a number of legal concepts, notably those attached to traditional security, and thereby allow for exponentially increased market liquidity. Normative decisions by legislators sanction safe harbors, as modern markets could not exist without these high levels of liquidity. To the extent that safe harbors accelerate contagion in terms of crisis, which in principle is a valid argument, specific regulation is well suited to correct this situation, whereas to repeal or significantly restrict the safe harbors would be counterproductive.
The full article may be found here.
For previous Roundtable posts on the safe harbors, see Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“; Janger & Pottow, “Implementing Symmetric Treatment of Financial Contracts in Bankruptcy and Bank Resolution“; and Lubben, “Lehman’s Derivatives Portfolio.”
By Ronald J. Mann (Columbia Law School)
The continuing struggle of the United States to emerge from the Great Recession gives policy responses to financial distress an immediacy they have lacked for 75 years. The Constitution directly grants Congress a broadly worded Bankruptcy Power, which Congress exercised with vigor in its 1978 enactment of the Bankruptcy Code. But the Code has played little or no role in mitigating the dislocation of the Great Recession. The slight rise in filings under the Code during the early years of financial distress contrasts markedly with the unprecedented rise in foreclosures, to say nothing of the more general social and economic turmoil of the last decade.
My forthcoming book, Bankruptcy and the U.S. Supreme Court, considers the role that the Supreme Court has played in the relatively anemic bankruptcy regime of the 21st century. The book’s main point is that the Supreme Court’s 82 decisions evaluating the Code systematically have taken a narrow interpretive approach that has left the Code much less effective than it might have been. The book includes some quantitative analysis. It is interesting, for example, that only 32 of the 82 decisions (39%) have come down in favor of a broad application of the Code. If you look at close cases (those with three or more dissenting votes), the results are even more stark, with only 5 of the 19 decisions (26%) applying the Code expansively.
But the bulk of the book is a series of case studies of nine of the close cases in the early days of the Code. Because the case studies focus much more on the process of the Court’s decision making than on the doctrinal results, they rely heavily on the internal papers of the Justices. Probably the single most important thing that the case studies demonstrate is the Justices’ attention to these cases. Many readers doubtless think of the bankruptcy cases as the “dogs” that the Justices turn to only after they’ve devoted their attention to the exciting constitutional and civil rights cases. But what you find when you go back to look the Justices’ papers is a great deal of back and forth in the crafting of opinions. In one case (Midlantic v. New Jersey Dep’t of Environmental Protection), Justice Powell’s majority opinion originally was crafted as a dissent; it became a majority when Justice Stevens switched his vote. Similarly, in Bildisco v. NLRB, Justice Rehnquist managed to get a court for his opinion only after months of negotiation that eventually led to the removal and rewriting of a large portion of the original opinion.
If you want to know more about how the Court goes about deciding these cases, then I encourage you to look at the book when it comes out from Cambridge University Press this spring.
By Bruce A. Markell (Northwestern University Law School)
Cramdown is the confirmation of a plan of reorganization over the dissent of an entire class of creditors. Bankruptcy’s absolute priority rule permits such confirmation only if the dissenting class is paid in full, or if no junior class receives anything. “Paid in full,” however, does not require payment in cash. It can consist of intangible promises to pay money that banks, investors, and markets regularly value.
Whether this market value can precisely be transferred to cramdown has vexed many. This Article, “Fair Equivalents and Market Prices,” surveys the doctrinal background of such valuations and devises three short apothegms that can synthesize the history and doctrine under these phrases: “don’t pay too little”; “don’t pay too much”; and “don’t expect precision.”
Against this background, debates arose recently when a New York bankruptcy court applied a chapter 13 case, Till v. SCS Credit Corp., to a large corporate cramdown in In re MPM Silicones, LLC (“Momentive”). Given the legislative history and precedents in the cramdown area, the Article takes the position that Momentive was correct, that it is compatible with the doctrinal roots of cramdown, and that in the future, courts should resist using pure market-based valuations in cramdown calculations.
This article recently appeared in the Emory Bankruptcy Developments Journal (2016). The Roundtable has also recently posted Anthony Casey’s related article from the same issue, “Bankruptcy’s Endowment Effect.”
By Craig A. Barbarosh, Karen B. Dine, Jerry L. Hall, and Margaret J. McQuade (Katten Muchin Rosenman LLP)
In November 2016, the Third Circuit rendered a decision in Delaware Trust Co. v. Energy Future Intermediate Holding Co., LLC, finding that the defendants, who voluntarily filed for bankruptcy, were still obligated to pay over $800M in expected interest owed to lenders. The case stemmed from the defendants’ attempt to refinance, during bankruptcy, certain first lien and second lien notes in the wake of declining interest rates. The defendants filed for bankruptcy to render the notes immediately due and payable pursuant to the indentures’ acceleration provision. The defendants assumed acceleration would allow them to avoid the “make-whole” obligation to noteholders that otherwise would be due upon an optional redemption (i.e., the net present value of future payments not yet accrued at the time of prepayment).
In holding that the defendants’ actions effectively constituted an “optional redemption” triggering their obligation to pay future interest to noteholders under the make-whole provision, the Third Circuit clarified the often-muddy interplay between indenture acceleration provisions and “make-whole” redemption provisions. Specifically, the Third Circuit held that: (1) an acceleration provision that is silent as to “make-whole” does not annul a make-whole provision; (2) in order to sever “make-whole” obligations, acceleration provisions must specifically reference “make-whole” obligations; (3) “redemption” does not equal “prepayment;” and (4) issuers have the burden to insist on clear language if they intend to sever make-whole obligations through acceleration.
The full article is available here.
By Anthony J. Casey (University of Chicago Law School)
The notion of endowments and entitlements has a powerful effect on corporate bankruptcy policy. Scholars and lawyers generally assume a creditor endowed with a right outside the bankruptcy system must receive the equivalent of that right when its debtor is within the bankruptcy system. Proponents of this idea often assert that the result is required by the foundational theory of bankruptcy.
In a forthcoming essay, “Bankruptcy’s Endowment Effect,” I demonstrate that this is false. The idea of sacred creditor endowments is an untenable position that misunderstands the fundamental principles of bankruptcy. Corporate bankruptcy is, at its core, a system that alters nonbankruptcy endowments according to a hypothetical bargain that all creditors of a firm would have entered if bargaining were costless. The entire point of that hypothetical bargain is to suspend and alter some nonbankruptcy endowments to maximize the value of the bankruptcy estate and the firm as a whole. Indeed, if every stakeholder retained all of its nonbankruptcy endowments, the Bankruptcy Code would have no provisions at all.
Of course, altering nonbankruptcy endowments can impose costs. Foremost among those costs is the risk of opportunistic behavior that is costly for the estate as a whole. Bankruptcy policy will, therefore, be designed to maximize estate value while minimizing opportunistic bankruptcy behavior. Thus, the guiding principle for optimal bankruptcy design should be not the preservation of nonbankruptcy rights but rather the minimization of opportunistic behavior that reduces the net value of a firm.
With that principle in hand, we can resolve many difficult questions of bankruptcy policy. In the essay, I focus on applying the principle to the debate over what interest rate a senior creditor should get in a chapter 11 cramdown. In particular, I analyze the dispute in In re MPM Silicones, LLC (“Momentive”), where the bankruptcy court mistakenly reached its final decision by importing a creditor-endowment framework from consumer bankruptcy law (where the framework might make more sense). I show that an optimal rule for corporate bankruptcy supports a cramdown interest rate based on the prevailing market rates for similar loans, which reduces the risk of opportunistic behavior by both debtor and creditor.
Last week, the Second Circuit decided Marblegate Asset Management, LLC v. Education Management Corp., holding that § 316(b) of the Trust Indenture Act (“TIA”) protects only bondholders’ formal, legal right to repayment, not their practical ability to recover. The Second Circuit’s 2–1 decision thus resolves uncertainty surrounding out-of-court bond workouts and returns to the pre-Marblegate practice.
The majority viewed the statute’s text as ambiguous and consulted the legislative history; it emphasized legislative history supporting the idea that § 316(b) protects only against the formality of a bondholder vote altering payment terms and discarded legislative history to the contrary as shards. The dissent concluded that the transaction “annihilated” a bondholder’s right to payment and, hence, ran afoul of statute’s plain language — which requires that a bondholder’s right to payment cannot be affected or impaired without the affected bondholder’s consent.
Law firms reacted rapidly to the decision. Wachtell Lipton, which represented the winning appellant, and Weil Gotshal both extoll the opinion. Paul, Weiss and Morgan Lewis see in the decision a clear rule that bars only express changes to core terms. Several firms, such as Shearman & Sterling and White & Case, emphasized that the decision will facilitate out-of-bankruptcy restructurings.
Squire Patton Boggs highlights limitations, arguing that the law remains “neither clear nor predictable” on when an out-of-court restructuring goes so far as to impair bondholders’ right to repayment. They caution against assuming that any action short of a direct alteration of core repayment terms is now permissible.
In his American Bankruptcy Institute column, Bill Rochelle notes that the decision’s focus on legislative history, including views contemporaneous with the statute’s passage, was unusual and, by implication, indicates that the dissent’s textual decision-making mode fits better with current Code interpretation. Seyfarth Shaw notes the decision’s limited practical effect because of the widespread use of binding votes in pre-packaged Code restructurings, which avoid § 316(b)’s restrictions.
The Roundtable has posted previously on Marblegate and § 316(b). In one post, Mark Roe argued that bondholders should not be barred by statute from choosing in their indenture whether to be allowed to reposition their bonds via a fair vote. Other posts include a summary of the National Bankruptcy Conference’s proposed amendments to the Bankruptcy Code to facilitate bond restructuring; a 28-law firm legal opinion white paper on transactional complications arising from the Marblegate district court decision; and an international perspective on the TIA’s prohibition on collective action clauses.
By Jennifer Payne (University of Oxford – Faculty of Law)
In the UK, a number of different mechanisms exist which can be used to restructure the debt of viable but financially distressed companies. This paper assesses the debt restructuring mechanisms currently available to companies in English law and considers whether reform is needed. In particular, the paper analyses the reform proposals put forward by the UK Insolvency Service in July 2016, which recommended: (i) the introduction of an option to cramdown whole classes of creditors using a single restructuring mechanism (something which can only be accessed at present using a scheme of arrangement combined with administration); (ii) the introduction of a restructuring moratorium akin to that which is attached to administration at present, together with a new ability for companies to prevent creditors with “essential contracts” from terminating them on the basis of insolvency alone; and (iii) the introduction of provisions designed to facilitate debtor-in-possession financing, something notably absent from the current UK regime. These reforms will need to be introduced with skill and care in order to ensure that the potential benefit they can bring to financially distressed businesses is balanced appropriately with the constraints that they impose on existing creditors’ rights. The aim of the Insolvency Service’s proposals is laudable, and it is argued that reform of the UK regime is needed. In particular, the introduction of a restructuring moratorium and a cramdown facility would be beneficial. Making these changes would provide English law with a stronger and more effective debt restructuring procedure. Furthermore, such changes are required if the UK wants to remain competitive in a global market.
The full article is available here.
By John Wood (Lancashire Law School, University of Central Lancashire)
In the UK, pre-packaged administrations (“pre-packs”), while few in number, receive widespread attention due to the controversial outcomes that they often produce. The pre-pack process seems to have gained much exposure in recent years, but it is by no means a new concept. The negative reputation that pre-packs have resides with the lack of transparency that surrounds the process, in addition to connected parties purchasing the old company. Such an outcome leaves many creditors frustrated with both the lack of information received and the diminutive monies recovered for what they are owed.
Due to the sustained criticism of pre-packs, the British government reviewed the process to detect weaknesses in the UK’s company law framework and to ensure that the UK remained a competitive and attractive place to conduct business. This led to the Graham Review (“Review”), which made six recommendations that have since become somewhat essential to the survival of pre-packs as a non-legislative procedure. Ministerial pronouncements have put the profession on notice that, unless they take proper steps to produce substantial compliance with the Review’s findings, then legislative power will be exercised. While no further action has been taken, the Review appears to have attracted widespread support. The Review proposes non-legislative action, but the article examines whether, over time, legislation will become inevitable. What is therefore required is a balanced evaluation and critique of the Graham proposals—one that is capable of providing some form of yardstick against which to test the quality of any legislative initiatives which may be taken in the future.
The full article, published in 67 Northern Ireland Legal Quarterly 173 (2016), is available here.
By Gabrielle Glemann (Hughes Hubbard & Reed)
In an unpublished opinion in August, In re Province Grande Old Liberty, LLC, Case No. 15-1669, 2016 WL 4254917 (4th Cir. Aug. 12, 2016), the Fourth Circuit Court of Appeals shed some light on the circumstances under which a court may recharacterize debt as an equity investment, effectively subordinating the claim. The issue before the Fourth Circuit was not one of first impression — the Fourth Circuit had long recognized that a bankruptcy court’s equitable powers include “the ability to look beyond form to substance,” and had previously articulated the factors to consider in evaluating a request for recharacterization. See Fairchild Dornier GMBH v. Official Comm. of Unsecured Creditors (In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc.), 453 F.3d 225 (4th Cir. 2006). The Fourth Circuit decision is notable however, because the court looked beyond the facts giving rise to the underlying claim at issue and ultimately to the economic substance of the entire context of the transaction. In Province, the creditor whose claim was at issue was a company owned by insiders of the debtor. The creditors’ claim was based on a loan that was used by the debtor to settle other obligations. The court held that the settlement agreement was the “substance of the transaction” and a basis for recharacterization, notwithstanding the fact that the creditor was not a party to the settlement agreement.
The full memo is available here.