By Samir D. Parikh (Lewis and Clark Law School) and Zhaochen He (Lewis and Clark College)
Cities and counties are failing. Unfunded liabilities for retirees’ healthcare benefits aggregate to more than $1 trillion. Pension systems are underfunded by as much as $4.4 trillion. Many local government capital structures ensure rising costs and declining revenues, the precursors to service-delivery insolvency. These governments are experiencing the Red Queen phenomenon. They have tried a dizzying number of remedies but their dire situation persists unchanged. Structural changes are necessary, but state legislatures have failed to respond. More specifically, many states have refused to implement meaningful debt restructuring mechanisms for local governments. They argue that giving cities and counties the power to potentially impair bond obligations will lead to a doomsday scenario: credit markets will respond by dramatically raising interest rates on new municipal and state bond issuances. This argument – which we term the paralysis justification – has been employed widely to support state inaction. But the paralysis justification is anecdotal and untested.
This article attempts to fill a significant gap in the literature by reporting the results of an unprecedented empirical study. Our study aggregates data for every general obligation, fixed-rate municipal bond issued in the U.S. from January 1, 2004 to December 31, 2014, over 800,000 issuances in total. By employing multivariate regression analysis, we are able to conclude that the paralysis justification is a false narrative. Municipalities located in states that offer meaningful debt restructuring options enjoy the lowest borrowing costs, all other things equal. This article removes one of the largest obstacles to financial relief for many cities and counties. We hope to encourage recalcitrant state legislatures to enact the structural changes their local governments need desperately.
The full article is available here.
By Pengjie Gao (University of Notre Dame), Chang Lee (University of Illinois at Chicago), and Dermot Murphy (University of Illinois at Chicago)
Recent high-profile municipal default cases in Detroit, Puerto Rico, and various cities in California have underscored the importance of state laws for dealing with default proceedings, or even preventing default from occurring in the first place. However, the effects of these laws, or lack thereof, on municipal borrowing costs remain unclear. Does unconditional state support for distressed local municipalities lead to lower local borrowing costs? If so, are there tradeoffs?
The authors address these questions by examining differences in distress-related laws and statutes across states. Some states have proactive policies in place that activate when their local municipality is exhibiting signs of fiscal distress (“Proactive states”). Meanwhile, other states allow unconditional access to the Chapter 9 bankruptcy procedure, with no laws in place for dealing with distressed municipalities (“Chapter 9 states”).
The authors find that these differences significantly affect local borrowing costs. In particular, Proactive states have lower borrowing costs and significantly lower yield reactions following default. Furthermore, Proactive state yields are less sensitive to economic conditions because of the implicit insurance that becomes particularly valuable when economic conditions are weak. There is also a significant contagion effect in Chapter 9 states that does not exist in Proactive states, in that a default in a Chapter 9 state is more likely to lead to higher yields for other bonds located in that state. However, the authors also provide evidence that borrowing costs at the state level are somewhat higher in Proactive states because of the partial transfer of local credit risk to the state.
The full article is available here.
By Jayanth Krishnan (Indiana—Bloomington)
In 2009, as markets from the United States to Europe to the Global South shook, one country—the United Arab Emirates—found itself on the brink of economic collapse. The U.A.E’s Emirate of Dubai was contemplating defaulting on $60 billion of debt it had amassed. Recognizing that such a default would have cataclysmic reverberations across the globe, the government of Dubai turned to a small group of foreign consultants for assistance. The resulting legal experiment demonstrates how aspects of American corporate bankruptcy law can be imported into and prove useful in the context of a foreign legal tradition. During the crisis, insolvency lawyers from the U.S. law firm of Latham & Watkins, analysts from the New York-based investment bank Moelis, and accountants from PwC – together with local domestic counterparts and experts from the U.K.– devised a highly sophisticated plan that helped the Emirate address the economic crisis in which it found itself. As part of this plan, Chapter 11 and Chapter 15 principles from the U.S. Bankruptcy code, the 2/3 cram down technique on hold-out creditors, and an Anglo-American insolvency tribunal were introduced into Dubai in order to bring about economic stability and handle the highly complex cases that arose during the financial crisis. By respecting and interpreting U.A.E. law, the tribunal has maintained its legitimacy in the eyes of the Dubai government even as it has drawn on Anglo-American insolvency concepts.
On December 13, this study will be formally presented at a public event in Dubai by Indiana-Bloomington’s Center on the Global Legal Profession, where insolvency experts and policymakers from the U.S., Dubai, and the U.K. will be present.
The full article can be found here.
The Seventh Circuit held last July in FTI Consulting, Inc. v. Merit Management Group, LP, 2016 BL 243677 (7th Cir. July 28, 2016), that § 546(e) of the Bankruptcy Code is not a safe harbor for “transfers that are simply conducted through financial institutions.” This decision deepens a circuit split on this issue. While the Second, Third, Sixth, Eighth, and Tenth Circuits have held that the plain language of § 546(e) protects transfers through financial institutions as settlement payments, the Seventh Circuit’s interpretation agrees with the Eleventh Circuit’s older decision in In re Munford, 98 F.3d 604, 610 (11th Cir. 1996). The legislative purpose of § 546(e) was to prevent the insolvency of one financial institution from causing systemic harm to the market as a whole. However, its text also has deep implications for leveraged buyouts that might render target corporations insolvent because payments to selling shareholders almost invariably pass through brokers and clearinghouses that are covered by the safe harbor.
Several law firms have now written memos on the FTI decision. Schiff Harden postulates that debtors will be more likely to forum shop when filing for bankruptcy when they have recently undergone a leveraged buyout. Jones Day makes clear that shareholders selling into a leveraged buyout face differing levels of risk depending on which forums the corporation could legally avail itself of in a bankruptcy proceeding. And Dechert argues that FTI Consulting will result in different treatment for parties selling identical securities in leveraged buyouts: financial institutions, stockbrokers, and the like will remain protected by the safe harbor when they are beneficial owners of stock, but other shareholders will be subject to avoidance action.
By Colleen Honigsberg (Stanford Law School) and Frederick Tung (Boston University School of Law)
For many firms, obtaining debtor-in-possession (DIP) financing is crucial for a successful reorganization. Such financing can be hard to find, however, as lenders are understandably hesitant to lend to firms in severe financial distress. The Bankruptcy Code solves this potential dilemma by authorizing debtors to provide DIP lenders with various sweeteners to induce lending. But because these sweeteners are thought to come at the expense of other stakeholders, the Code permits these inducements only if the judge determines that no less generous a package would have been sufficient to obtain the loan.
Certain types of lending inducements, frequently described as “extraordinary provisions,” have become the subject of growing concern. Anecdotal evidence suggests the use of these provisions has skyrocketed in recent years, leading important bankruptcy courts and the American Bankruptcy Institute to question whether these provisions are really necessary for a robust DIP market—or whether DIP lenders are extracting excessively generous terms. Defenders of DIP lenders, however, have pointed to a plausible external explanation for the popularity of extraordinary provisions in recent years: The Financial Crisis. When credit is tight, lenders demand more inducements. Indeed, judges have explicitly cited credit conditions in approving controversial inducement packages.
In this article, we provide the first evidence on the relationship between credit availability and DIP loan terms. Using a hand-collected dataset reflecting contract terms from DIP loans issued between 2004 and 2012, we study the relationship between DIP loan terms and broader market conditions. As predicted, we find a statistically significant relationship between credit availability and ordinary loan provisions like pricing and reporting covenants. By contrast, we find no evidence that “extraordinary” provisions like roll-ups and case milestones are related to credit availability. We hope that our findings will inform judges and policymakers struggling to evaluate whether the sweeteners extracted by DIP lenders are really necessary to induce lending.
The full article is available here.
By Maurice Horwitz (Weil, Gotshal & Manges)
Recently, the United States Bankruptcy Court for the Western District of Louisiana considered whether a bankruptcy termination provision in a forward contract continues to be safe harbored under section 556 if its enforcement is conditioned on other factors – in this case, the debtor’s failure to perform under the contract. Consistent with prior case law, the court held that termination is only safe harbored if it is based solely on a condition specified in 365(e)(1) (i.e., the financial condition of the debtor, bankruptcy, or the appointment of a trustee).
The contract in Louisiana Pellets contained a standard ipso facto provision that permitted either party to terminate the agreement upon commencement of a bankruptcy case by the other party. But the debtor’s counterparty could only invoke the provision if the debtor was also in breach of its obligations under the agreement. The counterparty alleged that both requirements of the ipso facto provision – bankruptcy and breach – had been satisfied, and sought to terminate.
The court held that because the ipso facto provision contained an additional condition to enforcement (the debtor’s breach), it no longer fell within the 556 safe harbor. Thus, even if both conditions were satisfied (bankruptcy and breach), the automatic stay applied and the termination clause could not be exercised absent relief from the automatic stay.
The lesson of Louisiana Pellets is that ipso facto provisions in financial contracts should be drafted carefully so that their enforcement depends solely on one of the conditions specified in Section 365(e)(1) of the Bankruptcy Code.
The full article is available here.
By Edward J. Janger (Brooklyn Law School) and John A.E. Pottow (University of Michigan Law School)
Financial contracts, such as swaps, repos, and options, are excepted from the Bankruptcy Code’s automatic stay by so-called “derivative safe harbors.” The Lehman Brothers bankruptcy provides a graphic illustration of how this device makes it almost impossible for non-bank financial firms, or other firms with significant derivative exposure, to restructure in chapter 11. Without a stay, non-debtor counterparties may run for the exits by exercising early termination rights, demanding payment, and offsetting obligations, thereby draining assets from the struggling debtor in a destructive rush.
The resolution regime for banks takes a different approach. It imposes a short stay on financial contract termination to permit the orderly transfer of a failed bank’s derivative portfolio intact to a solvent bank. This approach has been used for decades to preserve the value of financial contracts and to minimize the systemic disruption occasioned by bank failures. It has been extended contractually to cover many non-bank SIFIs through the relatively recent ISDA Resolution Stay Protocol. There are, however, significant gaps in the contractual regime. Non-SIFI financial institutions are not covered, and neither are non-financial firms that may have significant derivatives exposure, and may also be systemically important.
Our article offers a road-map for translating and generalizing the “short-stay” regime used for banks into chapter 11. The key to this synthesis is the bankruptcy concept of “adequate assurance of future performance,” provided through a commonplace bankruptcy device—debtor-in-possession financing. This financing can backstop the debtor’s timely performance of its financial obligations. We note that our approach would facilitate use of the “Single Point of Entry” strategy for restructuring financial firms in bankruptcy. Our approach also would, we contend, bring greater stability to financial markets, preserve otherwise evaporating value for insolvent debtors with a significant book of derivatives, and ultimately make it possible for many more firms to restructure in bankruptcy.
The full article, published in 10 Brooklyn Journal of Corporate, Financial and Commercial Law 155 (2015), is available here.
This article was recently published in the Brooklyn Journal of Corporate, Financial and Commercial Law as part of a symposium volume entitled: The Treatment of Financial Contracts in Bankruptcy and Bank Resolution. The volume includes papers by Riz Mokal, Anna Gelpern and Eric Gerding, Adam Levitin, and Irit Mevorach.
The Roundtable has also posted on this topic previously. See Morrison, Roe, and Sontchi, “Rolling Back the Repo Safe Harbors” and Murphy and Smith, “Bankruptcy Code with No Repo Safe Harbor—An Evaluation.”
By Lee C. Buchheit (Cleary Gottlieb Steen & Hamilton) and Mitu Gulati (Duke University School of Law)
The decade and a half of litigation that followed Argentina’s sovereign bond default in 2001 ended with a great disturbance in the Force. A new creditor weapon had been uncloaked: The prospect of a court injunction requiring the sovereign borrower to pay those creditors that decline to participate in a debt restructuring ratably with any payments made to those creditors that do provide the country with debt relief. For the first time holdouts succeeded in fashioning a weapon that could be used to injure their erstwhile fellow bondholders, not just the sovereign issuer. Is the availability of this new weapon limited to the aggravated facts of the Argentine default or has it now moved permanently into the creditors’ arsenal? Only time (and future judicial decisions) will tell. In the meantime, however, sovereigns will occasionally find themselves in financial distress and their debts will occasionally need to be restructured. Venezuela already casts this chilly shadow over the sovereign debt market. If, in a galaxy not too far away, sovereign debt workouts are to have any chance of an orderly completion, a method must be found to neutralize this new weapon. Judging by the secondary market prices of different series of Venezuelan sovereign bonds, large amounts of money are being wagered that this cannot be done.
Argentina’s holdouts argued that they must be paid in full if Argentina wanted to make any payments to the creditors that accepted the country’s restructuring offers in 2005 and 2010. Those creditors had accepted a roughly 75 percent haircut in the value of their claims. But the holdouts were not offering to share with those old creditors any portion of a preferential recovery that the holdouts might be able to extract from Argentina. Why? Because the bonds that had been tendered in the restructurings of 2005 and 2010 had been canceled. The clause in those instruments that the holdouts now pointed to as the basis for their demand for a “ratable” payment whenever Argentina made a payment to its restructured lenders had been extinguished in the bonds previously held by those old lenders. So no contractual basis existed for the old creditors to assert a reciprocal claim against the holdouts.
It didn’t have to be this way. A future workout of New York law-governed sovereign bonds could be structured so that any bonds tendered by participating creditors are kept alive in a kind of deep freeze, available to assert a reciprocal claim against any holdouts who subsequently extract a preferential recovery from the sovereign issuer. The sauce that is flavorful for the goose thus becomes an equally suitable condiment for the gander.
The full article may be found here.
By Kenneth Ayotte (University of California – Berkeley School of Law), Anthony J. Casey (University of Chicago Law School), David A. Skeel, Jr. (University of Pennsylvania Law School)
Side agreements—such as intercreditor and “bad boy” agreements—are increasingly at the center of major bankruptcy disputes. Litigation around these disputes can be costly and the results of that litigation can dramatically alter the landscape within which the stakeholders bargain over reorganization.
These agreements commonly include a promise by one party to remain silent by waiving some procedural right they would otherwise have under the Bankruptcy Code. Those waivers are invoked at crucial points in the reorganization process, including the approval of debtor-in-possession financing and plan confirmation.
In our new paper, Bankruptcy on the Side, we show that while side agreements have beneficial potential, the parties entering them often impose negative externalities on outsiders. A promise not to extend new financing, for example, can affect the debtor’s reorganization prospects. Similarly, a promise not to object to a reorganization plan can rob the court of information that might benefit the other classes of creditors.
The paper presents a simple model to derive a proposal that is consistent with the intent of the parties to the side agreement but also limits negative externalities. The core of the proposal is that where there is a nontrivial potential for value-destroying externalities, the court should limit a nonbreaching party’s remedy to its expectation damages. On the other hand, if the agreement is unlikely to cause externalities, a court should enforce the agreement according to its terms. Our proposal is different and superior to the approach taken by most courts, which invokes a narrow interpretative standard to invalidate side agreements. We focus instead on enforcing the provisions under normal interpretative doctrines while limiting the use of special remedies like specific performance and stipulated damages.
The insights of our paper also provide a new answer to thorny questions involved in choosing which courts should resolve disputes over intercreditor agreements, and in deciding whether forum selection clauses should be enforced. Specifically, the bankruptcy courts have no specialized expertise for cases where the plaintiff seeks expectation damages. In those cases, the court should defer to default venue rules and forum selection clauses. Where specific performance or stipulated damages are at issue, by contrast, our model suggests that the dispute should be resolved exclusively in bankruptcy proceedings.
The Supreme Court is scheduled to hear oral arguments in Czyzewski v. Jevic Holding Corp. on November 28. In this week’s posts, Bruce Grohsgal argues in favor of structured dismissals in his forthcoming article, and Melissa Jacoby and Jonathan Lipson, in an amicus brief signed by several law professors, argue that the Court should reject the structured dismissal in this case as a violation of absolute priority.