Douglas G. Baird, University of Chicago School of Law
Over the last few years, reorganization practice has undergone a massive change. A new device—the restructuring support agreement—has transformed Chapter 11 negotiations. This puts reorganization law at a crossroads. Chapter 11’s commitment to a nonmarket restructuring with a rigid priority system requires bankruptcy judges to police bargaining in bankruptcy, but the Bankruptcy Code gives relatively little explicit guidance about how they should do this policing.
In the past, the debtor initiated multiple rounds of negotiations in which everyone participated. Each party would push back against the claims of the other, and a consensus eventually emerged that left things roughly in equipoise. This has now changed. Instead of bargaining in which everyone participates, there is now a sequence of two-party bargains, beginning with the key players.
Changing the structure of negotiations in this fashion would not matter much if there were not much to bargain over. If bankruptcy’s substantive rules allowed for little variation in what each party received or if the debtor had an incentive to limit what each creditor group received, changing the rules would not change outcomes. But neither is the case, at least not any more.
Priority rights in bankruptcy are sufficiently uncertain that there are a broad range of confirmable plans in any case, each with radically different distributional consequences for the various creditor groups. And modern debtors are interested in a speedy and successful exit from Chapter 11. They are relatively indifferent to how rights in the firm are divided among competing creditors.
These changes have become manifest only in the last few years, and there is little wisdom about how the bankruptcy judge should respond. This essay suggests that long-established principles inform how bankruptcy judges should go about this task. In assessing whether a plan is “fair and equitable” and whether it has been filed in “good faith,” judges should focus not on how the plan apportions rights in the reorganized firm, but whether the process that has led to the plan ensures that everyone’s cards are on the table.
In particular, judges should ensure that restructuring support agreements do not interfere with the flow of information to the judge. Negotiations that lead to a confirmable plan should be problematic to the extent, but only to the extent, that they keep the judge in the dark and limit her ability to ensure that the plan complies with the terms of the Bankruptcy Code.
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Timothy C.G. Fisher, University of Sydney
Ilanit Gavious, Ben-Gurion University of the Negev
Jocelyn Martel, ESSEC Business School & THEMA
Earnings management occurs when managers deliberately manipulate the company’s earnings either to mislead stakeholders about the underlying economic performance of the company or to influence contractual outcomes. We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11.
Using the UCLA-LoPucki Bankruptcy Research Database, we merge a sample of 261 U.S. public firms that filed for Chapter 11 between 1995 and 2009 with firm-level financial information. We construct three measures of earnings management, two of which are accounting (accrual) manipulation measures (discretionary accruals and abnormal working capital accruals) and one a real activities manipulation measure (abnormal operating cash flows).
We find that upward earnings management (more positive or less negative abnormal accruals/operating cash flows) prior to filing significantly reduces the likelihood of confirmation, while downward earnings management significantly increases the likelihood of confirmation. We also find that the likelihood of emerging from Chapter 11 is significantly lower with upward earnings management. The impacts on confirmation and emergence are primarily due to the influence of earnings management values that are one- and two-standard deviations above or below the mean. Thus, our findings are consistent with creditors rewarding unduly conservative earnings reports while punishing overly optimistic earnings reports. We also find that auditor choice (Big 4 vs. non-Big 4) directly affects the probability of confirmation and of emergence from bankruptcy.
Overall, we find that upward management of earnings destroys economic value by making the survival of the firm less likely, an effect that has not previously been uncovered in the literature.
To access the full article, please click here.
Vedran Capkun, Associate Professor, Accounting and Management Control, HEC Paris
Lawrence Weiss, Professor of International Accounting, The Fletcher School, Tufts University
We present new evidence on the violation of priority of claims in bankruptcy and recovery rates for secured creditors, unsecured creditors, equity holders using a sample of firms that filed for Chapter 11 bankruptcy between 1993 and 2004. Our study reveals a number of new insights: First, we find a significant reduction in the violations of priority of claims compared to research on prior periods, with equity holders appearing to have lost their ability to extract concessions in violation to priority of claims. Second, the results are consistent with the hypothesis that unsecured creditors accept a violation to priority of their claims in order to obtain a faster resolution. Third, the results suggest that secured creditors are less likely, and unsecured creditors are more likely, to experience a violation to priority of their claims when secured creditors exercise increased control over the debtor (as proxied by debtor in possession financing). Finally, violations to secured creditors’ priority of claims are more likely when filings occur in Delaware and the Southern District of New York than elsewhere.
The full article is available here.
By Filiberto Agusti, Caroline H.B. Gaudet, and Steven Reed, Steptoe & Johnson LLP
The expansion of North American petroleum production in the past 15 years triggered the construction of many pipelines. Construction was financed largely through long-term Transportation Services Agreements (TSAs) whereby shippers committed to transport minimum volumes on the pipelines at specified tariff rates or make shortfall payments. The recent sharp drop in the world price of crude oil has led to bankruptcies. This article reviews whether, in shipper reorganizations, bankruptcy courts have jurisdiction to approve the rejection of TSAs for which the Federal Energy Regulatory Commission (“FERC”) has approved the tariff rate structure.
No court has yet addressed this question, but there is guidance from cases addressing rejection of FERC-jurisdictional electric power agreements. The Fifth Circuit found that bankruptcy courts have jurisdiction to approve rejection where the reorganized debtor’s business purpose is to abandon the FERC-approved service altogether. In dicta, however, the Court noted that the bankruptcy court would have lacked jurisdiction to approve assumption of a modified contract without prior FERC approval of the modification. And in In re Calpine, the Bankruptcy Court for the Southern District of New York held that it lacked jurisdiction to approve rejection of a FERC-jurisdictional electric power agreement if the business purpose of the rejection was to obtain more favorable pricing for the estate. From a FERC standpoint, it is unclear whether a pipeline and a debtor shipper can modify a TSA to reduce pricing as a requirement for assumption.
The linchpin of FERC’s acceptance of specified TSA rates is that those rates must be offered through an “open season” to all potential shippers. A FERC proceeding may be necessary to clarify whether a pipeline has discretion to modify the TSA of a debtor shipper or if a post-open season modification reducing the shipper’s specified TSA rates would violate FERC’s non-discrimination requirements.
The full article is available here.
Stephanie Massman, J.D. 2015, Harvard Law School
In the wake of the 2007-2008 financial crisis, criticism surrounded not only the government bailouts, but also the decision to not bail out Lehman Brothers, which led to its lengthy and value-destructive chapter 11 bankruptcy. In response to this criticism, Congress enacted the Orderly Liquidation Authority (“OLA”), a regulatory alternative to bankruptcy for systemically important financial institutions (“SIFIs”), included as Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The OLA, although perceived to be a radical departure from traditional bankruptcy, incorporates many familiar resolution principles. The most significant departures from the Bankruptcy Code are those designed to ensure financial stability in the national and global economies in the event of a SIFI failure; because the Bankruptcy Code does not currently specifically provide for a SIFI failure, it does not address financial stability concerns at all. Furthermore, by banning future government bailouts and imposing new stays on qualified financial contracts, the OLA also seeks to correct skewed market discipline incentives surrounding SIFIs—including those arising due to the “Too Big To Fail” subsidy—which may have caused the “moral hazard” problems that were a contributing factor in the financial crisis. Unfortunately, the prescribed tactics for accomplishing a resolution under the OLA may in fact implicate new moral hazard concerns, which have yet to be addressed by regulators. What further remains to be seen is both the extent to which the regulatory agencies will assume their new statutorily ordained authority to regulate these SIFIs and the extent to which the market will find their regulations credible.
This article examines the current state of development of a resolution process for SIFIs under the OLA and evaluates how effective the OLA is likely to be in preserving financial stability and minimizing moral hazard.
To view the full article, click here.
By Andrea Pawliczek, Leeds School of Business, University of Colorado – Boulder
The structure of executive compensation will influence an executive’s behavior. For debt holders, this influence becomes especially important when a firm nears bankruptcy because this is when the debt holders’ value is at risk.
Consider the actions of an executive of a financially distressed firm depending on his compensation. As bankruptcy becomes likely, an executive with only equity compensation (i.e. stock and options) is likely to gamble for solvency as his wealth is entirely dependent on the firm’s stock price. For example, RadioShack, whose CEO had no debt-like compensation, undertook such a strategy, purchasing a 2014 Super Bowl ad for $4 million when the company was already in significant financial distress. Although the ad was popular and resulted in a 12% jump in the firm’s stock price the next morning, it did not help the fortunes of the company, which declared bankruptcy just over a year later on February 15, 2015. Alternatively, an executive with debt-like compensation (e.g., pensions and deferred compensation) does not lose everything in the case of bankruptcy. This executive would have incentives to preserve firm value (i.e. assets that have value in liquidation or more value to the reorganized firm) to generate higher recoveries for himself and other debt holders in the event of bankruptcy.
While this prediction is established theoretically, there is no prior empirical evidence supporting this idea. Using a sample of 104 Chapter 11 bankruptcies of large public firms, I find that debt-like compensation – specifically Supplemental Executive Retirement Plans (SERPs) – is associated with higher recoveries to unsecured debt in bankruptcy. (SERPs are in almost all cases a form of unsecured debt that is at risk in bankruptcy. The only exception is if SERP assets are held in a secular trusts. Secular trusts are rarely used in compensation of executives at large public firms, however, because they result in the loss of tax deferral.) Recoveries to unsecured debt are 22% higher for a firm whose CEO holds sample mean levels of debt-like compensation compared to a firm whose CEO holds no debt-like compensation. I also document that debt-like compensation is associated with efforts to preserve more liquid assets prior to bankruptcy (e.g., cuts to research and development expenses).
The complete paper can be downloaded here.
Recently, in In re Tribune Co. Fraudulent Conveyance Litig., 2016 WL 1226871 (March 29, 2016), the Second Circuit held that 11 U.S.C. § 546(e) preempts state law constructive fraudulent conveyance claims brought by creditors even though the text of § 546(e) mentions only trustees. The court thought it unwise to focus exclusively on § 546(e)’s limitation to trustees in ignorance of its context and legislative history. Using those indicia of meaning, the court concluded that the statute’s purpose is to insulate securities markets from avoidance proceedings, and that allowing creditors to assert state law constructive fraudulent conveyance claims would frustrate that purpose. Accordingly, it held such claims preempted.
Weil Gotshal, Shearman & Sterling and Mintz Levin believe the decision properly forecloses creditors from circumventing § 546(e) by either suing individually under state fraudulent conveyance laws or assigning their claims to the trustee. According to these firms, the decision thus reinforces equitable distributions because it prevents creditors from enhancing their individual recoveries.
Latham & Watkins, on the other hand, believes the decision’s “sweeping” language leaves creditors “stranded at sea” and doubts other circuits will join the Second Circuit’s expansive interpretation. Caplin & Drysdale agrees that the court went too far. “Any untoward consequences threatened by the simultaneous prosecution of claims by a trustee and creditors,” the firm explains, “could be prevented by a Section 105(a) injunction.”
Meanwhile, according to Freshfields, Schulte Roth, and Paul, Weiss, the decision merely reaffirms the Second Circuit’s commitment––announced in Enron and Quebecor––to expansive interpretations of the Bankruptcy Code’s safe harbors.
By David A. Brittenham, Matthew E. Kaplan, M. Natasha Labovitz, Peter J. Loughran, Jeffrey E. Ross, and My Chi To of Debevoise & Plimpton LLP
On April 25, 2016, 28 leading U.S. law firms published a legal opinion white paper (the “Opinion White Paper”) addressing recent decisions of the United States District Court for the Southern District of New York interpreting Section 316(b) of the Trust Indenture Act of 1939 (the “TIA”) in the Marblegate and Caesars Entertainment cases. These decisions contain language that suggests a significant departure from the widely understood meaning of TIA § 316(b) that had prevailed for decades among practitioners. They have introduced interpretive issues that have disrupted established legal opinion practice and created new obstacles for out-of-court debt restructurings.
Section 316(b) of the TIA generally provides that the right of any holder of an indenture security to receive payment of principal and interest when due may not be impaired or affected without the consent of that holder. These recent decisions suggest that TIA § 316(b) protects more than the legal right to receive payment of principal and interest in the context of a debt restructuring.
The Opinion White Paper presents general principles that can guide opinion givers until the interpretive questions raised by these recent cases are resolved through future judicial opinions or legislative action.
The Opinion White Paper and further discussion of these cases are available here: Opinion White Paper.
The Bankruptcy Roundtable has previously posted on the Trust Indenture Act as well as the Marblegate and Caesars Entertainment cases. Most recently, Mark Roe posted an article on the underlying policy behind 316(b) and suggested regulatory and legislative changes to address the problems of bondholder holdouts and coercive exit consents: The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table. Additionally, the Roundtable posted the National Bankruptcy Conference Proposed Amendments to Bankruptcy Code to Facilitate Restructuring of Bond and Credit Agreement Debt.
By Michael L. Cook, Schulte Roth & Zabel LLP
The Uniform Fraudulent Transfer Act (“UFTA”) (§ 8(a)), like Bankruptcy Code 548(c), provides a complete defense for a “good faith” transferee who gives “reasonably equivalent value” when receiving cash from a fraudulent debtor. Courts have been split as to whether the good faith defense is available to transferees of Ponzi scheme debtors in the fraudulent transfer context. Thus, the Fifth Circuit held an advertising firm in an SEC receiver’s Texas fraudulent transfer suit liable for $5.9 million it had received in good faith from a Ponzi scheme debtor. Janvey v. Golf Channel Inc., 780 F.3d 641, 646-47 (5th Cir. 2015 (advertising services had “no value” to Ponzi scheme creditors although services might be “quite valuable” to creditors of a legitimate business; reversed district court’s holding that defendant “looks more like an innocent trade creditor than a salesman…extending [debtor’s] Ponzi scheme.”)
The Fifth Circuit vacated its decision three months later and certified the question of “what showing of ‘value’ under [the Texas version of the [UFTA]] is sufficient for a transferee to prove…the [good-faith] affirmative defense….” 2016 WL 1268188, at *2. The Texas Supreme Court answered the question on April 1, 2016, after discussing the statutory purpose and reviewing what other federal and state courts have done. According to the court, the UFTA “does not contain separate standards for accessing ‘value’ and ‘reasonably equivalent value’ based on whether the debtor was operating a Ponzi scheme…. Value must be determined objectively at the time of the transfer and in relation to the individual exchange at hand rather than viewed in the context of the debtor’s enterprise.”
The full memo is available here: Texas Supreme Court Resolves Good Faith Defense Issue for Fifth Circuit
Stephen J. Lubben
Harvey Washington Wiley Chair in Corporate Governance & Business Ethics, Seton Hall University School of Law.
Clearinghouses reduce risk by acting as a central hub for trades. Each party to a trade faces only the risk of the clearinghouse’s non-performance, rather than the doubtlessly greater risk that the counterparty to the trade will fail to perform.
But the concentration of derivatives trades into a very small number of clearinghouses or central counterparties (CCPs) makes the clearinghouse’s own failure a matter of systemic concern. As such, the recovery and resolution of CCPs becomes vital in the post-crisis financial system.
Given that important context, I argue in my paper—recently published in the Virginia Law & Business Review—that the lack of any obvious resolution mechanism for clearinghouses represents a major flaw in the Dodd-Frank regulatory fabric.
I explain why Dodd-Frank’s new orderly liquidation authority was probably not intended to apply to clearinghouses and would provide little help in the case of a distressed CCP in any event. The Bankruptcy Code is equally unhelpful, in that clearinghouses are forced into Chapter 7 liquidation proceedings, and the “safe harbors” for derivative contracts would make such a filing an exercise in futility.
I also argue that the CCP’s own, internal resolution mechanisms will be unworkable in times of systemic crisis. Most clearinghouse rules state that upon exhaustion of their default fund and any assessment rights they have against members, all contracts will be closed and member positions netted. Given the concentration of certain trades in one or two clearinghouses, the sudden termination of more than half of the index CDS trades—to take but one example—could not help but have systemic effects.
In the paper, I propose that the government should nationalize the clearinghouses upon failure, and that the intention to do so should be made clear ex ante. That is, the government should expressly state clearinghouses that ultimately fail will be nationalized, with specific consequences to investors, and an expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable. This should provide stakeholders in the clearinghouses with stronger incentives to oversee the clearinghouse’s management, and avoid such a fate.
In essence, what I propose is a system of precommitment or “structured bailouts.” Bailouts of clearinghouses seem inevitable. We must specify what would happen today, both to discourage an avoidable situation, and to facilitate an organized response in the event of an essential bailout.