By Douglas Mintz, Robert Loeb and Monica Perrigino of Orrick, Herrington & Sutcliffe
The Supreme Court recently granted certiorari in Czyzewski v. Jevic Holding Corp. to decide whether a bankruptcy court may authorize the distribution of settlement proceeds through a “structured dismissal” in a way that violates the statutory priority scheme in the Bankruptcy Code. Specifically, the Court must decide whether Section 507 of the Bankruptcy Code, which details the order of payment of certain priority claims, must be followed outside of a plan when distributing proceeds pursuant to a structured settlement of a bankruptcy case.
The Supreme Court’s decision should resolve an important circuit split. There is a strong textual argument to permit such distributions and structured dismissals, given the lack of provisions in the Bankruptcy Code dictating that priorities apply to settlements (as opposed to plans). A ruling in favor of structured dismissals would serve to channel cases away from chapter 11 plans and toward consensual settlements, thereby reducing administrative costs and facilitating quicker bankruptcy resolutions. However, this could also lead to settlements that run counter to the expected results under the absolute priority rule. The Supreme Court’s decision may also indirectly permit “gifting” payments outside the scope of a plan – as courts have generally limited gifts in the plan context.
The full article is available here.
By John Crawford, UC Hastings College of Law
Systemically important bank holding companies (“SIBs”) have always had an abundance of creditors that can legally absorb losses in the event of failure. The SIB bailouts of 2008, however, were driven by regulators’ unwillingness to allow losses to fall on these creditors. The Fed has recently proposed a rule requiring SIBs to issue large quantities of “loss-absorbing” long-term debt (“LTD”) out of their parent holding companies. If, however, regulators were averse to haircuts for SIB creditors before, how will creating a new class of debt help? I attempt to answer this question here. First, regulators fear the consequences of loss or delay for SIBs’ short-term creditors. These consequences include, inter alia, the risk of “contagion by simile,” as short-term creditors of other SIBs “run” to avoid a similar fate. This risk does not extend to long-term debt per se. The challenge of imposing losses on long-term debt while protecting short-term debt goes beyond mere repayment priority, however, as involuntary haircuts typically require a bankruptcy or resolution process that creates the risk of uncertainty or delay for all claims—potentially triggering the very contagion dynamics regulators wish to avoid. I nevertheless argue that the combination of a “single point of entry” resolution strategy for SIBs and a set of proposed “clean holding company” requirements plausibly solves the problem for LTD, so that it can absorb losses without creating these risks. In short, LTD may be the “credible loser” that SIBs previously lacked.
The full article may be found here.
By Michael L. Cook of Schulte, Roth & Zabel LLP
Bankruptcy Code §363(f)(1) empowers a bankruptcy court to order a debtor’s assets sold “free and clear of any interest in such property.” Courts in the business bankruptcy context have been wrestling with successor liability, i.e., whether an asset buyer can be held liable for the debtor-seller’s liabilities. In 2009, the Second Circuit affirmed a bankruptcy court order barring creditors of the selling debtor from pursuing the asset buyer “for product defects in vehicles produced by” the debtor. In re Chrysler LLC, 576 F.3d 108, 123-24 (2d Cir. 2009), vacated as moot, 558 U.S. 1087 (2009) (held, successor liability claims are interests covered by a sale order under Code § 363(f)(1)).
Most recently, on July 13, 2016, the Second Circuit held that the bankruptcy court’s asset sale order in the General Motors reorganization case limiting specific pre-bankruptcy product liability claims required prior “actual or direct mail notice” to claimants when the debtor “knew or reasonably should have known about the claims.” In re Motors Liquidation Co., 2016 U.S. App. LEXIS 12848, *46-47 (2d Cir. July 13, 2016). Although the substance of the sale order may have been enforceable otherwise, “mere publication notice” to known or knowable claimants was insufficient. Had the complaining product liability claimants received adequate notice, reasoned the court, they “could have had some negotiating leverage [regarding the terms of any sale order] . . . and [a meaningful] opportunity to participate in the proceedings.” Id. at *61. The court noted a “trend…toward a more expansive reading of ‘interests in property’ which encompasses other obligations that may flow from ownership of the property.” Id., at 124, citing In re Trans World Airlines, Inc., 322 F. 3d 283, 285-90 (3d Cir. 2003).
The full memo is available here.
By Douglas G. Baird, University of Chicago Law School
Chapter 11 of the Bankruptcy Code is organized around the absolute priority rule. This rule mandates the rank-ordering of claims. If one creditor has priority over another, this creditor must be paid in full before the junior creditor receives anything. Many have suggested various modifications to the absolute priority rule. The reasons vary and range from ensuring proper incentives to protecting nonadjusting creditors. The rule itself, however, remains the common starting place.
This paper uses relative priority, an entirely different priority system that flourished until the late 1930s, to show that using absolute priority even as a point of departure is suspect when firms are being reorganized. The essential difference between absolute and relative priority is the effect of bankruptcy on the exercise date of the call-option component of the junior investment instrument. Under absolute priority, the bankruptcy accelerates the exercise date; a regime of relative priority leaves it untouched.
Absolute priority is naturally suited for regimes in which the financially distressed firm is sold to the highest bidder. It is much less appropriate for a regime that puts a new capital structure in place without a market sale. In the absence of an actual sale, absolute priority requires some nonmarket valuation procedure. Such a valuation is costly and prone to error.
Chapter 11 attempts to minimize these costs by inducing the parties to bargain in the shadow of a judicial valuation, but rules are needed to police the strategic behavior that arises from the ability of parties to exploit information they have, but the judge does not.
Once one decides in favor of a reorganization rather than a market sale, the commitment to absolute priority is suspect. Instead of trying to find a bankruptcy mechanism that best vindicates the absolute priority rule, one is likely better off trying to identify the priority rule that minimizes the costs of bankruptcy itself. Asking which priority rule is most likely to lead to a successful plan at reasonable cost is a better point of departure than a debate over which priority rule provides the best set of ex ante incentives.
Looking at Chapter 11 from this perspective shows that much of the complexity and virtually all of the stress points of modern Chapter 11 arise from the uneasy fit between its priority regime (absolute instead of relative) and its procedure (negotiation in the shadow of a judicial valuation instead of a market sale). These forces are leading to the emergence of a hybrid system of priority that may be more efficient than one centered around absolute priority.
Read the full article here (forthcoming 165 U. Pa. L. Rev.).
By Richard Levin of Jenner & Block
The bankruptcy courts and their appellate courts continue to explore issues of interest to practitioners and academics. This quarterly summary of recent developments in bankruptcy law covers cases reported during the second quarter of 2016.
Cases of note include the Supreme Court’s invalidation of Puerto Rico’s homegrown restructuring statute and its surprising conclusion that an individual debtor’s debt to his corporation’s creditor might be nondischargeable for “obtain[ing] money or property” by “actual fraud” where the corporation transferred away property in an actual fraudulent transfer.
The Second Circuit upset GM’s 2009 bankruptcy sale by granting some ignition switch plaintiffs an exemption from the free and clear ruling because they didn’t have a chance to participate in sale process negotiations. The debate over whether the Code’s financial contracts safe harbor preempts creditors’ claims under state fraudulent transfer laws continues with a Delaware decision ruling against preemption.
A Delaware bankruptcy court (following a recent Illinois decision) invalidated an LLC agreement provision that allowed a creditor to veto a bankruptcy filing. In a boost for litigation funding, a Florida bankruptcy court found that communications with the funder might be subject to the common interest privilege.
And in a decision that should send shudders down the spine of every consumer bankruptcy lawyer, the Ninth Circuit BAP held that a chapter 7 trustee may reject a debtor’s prepaid retainer agreement with his lawyer to defend dischargeability litigation and recover “unused” fees.
The full memo is available here.
We at the Bankruptcy Roundtable will take a break from posting for the next few weeks in August and hope that you too will be able to get away from your desk at work. We’ll be back after Labor Day.
By Richard Lear of Holland & Knight.
The Supreme Court held 7-1 in Husky Int’l Electronics v. Ritz that “actual fraud” under § 523(a)(2)(A) of the Bankruptcy Code does not require a false representation for a debt to be nondischargeable. In so holding, the Court resolved a split among the circuits.
Petitioner Husky International Electronics, Inc., argued that “actual fraud” under § 523(a)(2)(A) does not require a false representation, but instead encompasses other traditional forms of fraud, such as a fraudulent conveyance of property made to evade payment to creditors.
Acknowledging that “fraud” is difficult to define precisely, the Supreme Court nevertheless rejected the need to do so, stating that “[t]here is no need to adopt a definition for all times and all circumstances here because, from the beginning of English bankruptcy practice, courts and legislatures have used the term ‘fraud’ to describe a debtor’s transfer of assets that, like Ritz’s scheme, impairs a creditor’s ability to collect the debt.” The Supreme Court further recognized that the common law indicates that although fraudulent conveyances are “fraud,” fraudulent conveyances do not require a misrepresentation from a debtor to a creditor, because fraudulent conveyances are not “an inducement-based fraud.”
The full memo is available here.
On July 7, the House of Representatives passed an appropriations bill (H.R. 5485) that includes a revised version of H.R. 2947, the Financial Institution Bankruptcy Act (FIBA), which passed the House by voice vote earlier this year. This bill, which the Roundtable has covered previously (here and here), would add to Chapter 11 of the Bankruptcy Code a “Subchapter V” to facilitate the bankruptcy resolution of troubled financial institutions. The inclusion of FIBA in the appropriations bill suggests there could be a substantial effort to pass the bankruptcy bill this year.
The version of FIBA included in the appropriations bill is largely the same as the bill that was introduced in the House last July. Importantly, however, the current version of the bill, which passed the House by voice vote this past spring, no longer allows the Board of Governors of the Federal Reserve System (the Board) to force a financial institution into bankruptcy. The role of federal regulators in the initiation and conduct of bankruptcy proceedings has been a controversial issue in debates about how to adapt the Bankruptcy Code to handle failed financial institutions more effectively. As included in the appropriations bill, FIBA permits only the debtor to file for bankruptcy. At the same time, the current bill would still provide for federal financial regulators, including the Board, to appear and be heard in any case under Subchapter V.
Although the bill aims to make bankruptcy feasible for large financial institutions, Subchapter V has been designed to facilitate a two-day, single-point-of-entry (SPOE) resolution strategy. FIBA’s proposed changes to the Bankruptcy Code would not support financial institutions during a lengthier path through bankruptcy. As the two-day bankruptcy resolution of a large, complex firm has no precedent, it is unclear whether the resolution strategy contemplated by Subchapter V would prove workable in practice. Thus, FIBA may not go as far as its proponents claim in making bankruptcy feasible for systemically important financial institutions (SIFIs).
H.R. 5485 is now in the Senate, which will consider it after the summer recess.
For a link to the full text of H.R. 5485, click here.
(This post was authored by Rebecca Green, J.D. ’17.)
By Lee Harrington of Nixon Peabody.
Recently, in In re Physiotherapy Holdings Inc., the Bankruptcy Court in Delaware held that section 546(e) of the Bankruptcy Code did not preempt various state fraudulent transfer actions because the allegedly fraudulent transfers implicated neither the rationale for that section nor preemption generally. The decision is at odds with recent case law, notably: (i) the Tribune litigation, in which the Second Circuit concluded that state law constructive fraudulent transfer claims involving payments in LBO transactions are prohibited under section 546(e); and (ii) a proceeding in which the Southern District of New York concluded that the interest payment at issue, which did not retire the underlying debt, were not “settlement payments” and was thus outside section 546(e).
Section 546(e) precludes certain bankruptcy avoidance actions involving settlement payments made by or to a financial institution and transfers made by or to a financial institution in connection with a securities contract. It is intended to prevent litigation that might have a destabilizing “ripple effect” on the financial markets and provides a defense to constructive fraudulent transfer actions against shareholders receiving LBO payments.
Physiotherapy found that section 546(e) was not intended to shield “LBO payments to stockholders at the very end of the asset transfer chain, where the stockholders are the ultimate beneficiaries of the constructively fraudulent transfers, and can give the money back . . . with no damage to anyone but themselves” without the attendant destabilizing “ripple effect.”
The full memo is available here.
The Bankruptcy Roundtable has previously covered treatment of 546(e), most recently in our Tribune Fraudulent Conveyance Litigation Roundup.
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.
Click here to view the full article.
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.