The Law and Economics of Investing in Bankruptcy in the United States

By Jared A. Ellias (University of California Hastings College of the Law)

Jared A. Ellias

When commentators describe American bankruptcy law as “the model to which European restructuring laws should aspire,” they are really speaking about an ‘American bankruptcy ecosystem’ of which law is only a significant part. The American bankruptcy ecosystem is best understood as a complex system inhabited by bankruptcy judges, law firms, investment bankers and activist investors. In this Report, I focus on one of the major components of this ecosystem: specialized investors that participate in the ‘bankruptcy claims trade.’ As I discuss, American bankruptcy courts today are best understood not as a place of shame and failure but rather as an integrated part of the capital markets, similar to the private equity firms of New York and the venture capital investors of Palo Alto. As this view of bankruptcy law took hold, investors, typically hedge funds, began to raise a large stock of capital to deploy in it. Importantly, while these investors were born of the bankruptcy bar’s development of institutions that situated bankruptcy courts within the capital markets, they have deployed their capital to accelerate it. This Report chronicles the rise of claims trading and the state of the academic literature on activist investing. In sum, the best interpretation of the available empirical evidence is that claims trading and activist investing have, at the very least, not harmed Chapter 11 or distressed corporations, and may have actually improved the capacity of the American bankruptcy system to reorganize distressed assets.

The Report is available here.

How Cities Fail: Service Delivery Insolvency and Municipal Bankruptcy

By Clayton Gillette (New York University School of Law)

Clayton Gillette

Courts in municipal bankruptcy cases have confronted the inherent vagueness in the statutory tests for municipal “insolvency” by embracing a test of “service delivery insolvency.” That test is typically evaluated in terms of a significant reduction in the availability of city services. Focus on a municipality’s failure to deliver services certainly serves as a plausible proxy for fiscal health, since provision of services is a primary function of local governments and thus a function that a financially healthy municipality would satisfy. Initially, such a test appears to be viable, since it invites both temporal and interlocal comparison service levels as a measure of fiscal health. Nevertheless, this article indicates severe limitations of a service delivery insolvency test. Reductions in service may indicate efforts to recover fiscal health rather than indicating fiscal distress, because that distress was generated by overspending on services. In addition, focus on particular service reductions as a measure of insolvency creates perverse incentives for local officials who desire to obtain debt relief to diminish those services most susceptible to measurement. When determining eligibility for Chapter 9, two potential measures other than service delivery insolvency may serve as alternative or complementary proxies for the need to adjust municipal debt: population outflows and loss of agglomeration benefits.

Population outflows may serve as an alternative indicator of fiscal distress. A city that fails to provide services at a level commensurate with its tax prices may lose mobile residents, and population declines imply that the per capita debt of the municipality is increasing. But that measure does not necessarily distinguish among emigrants. If those who exit consumed more services than they paid for, then exit will not necessarily betoken fiscal distress.

Local fiscal health is often dependent on the capacity of the locality to obtain the benefits of agglomeration. As a result, and notwithstanding measurement difficulties, one promising proxy for fiscal distress entails identifying whether those who have exited would otherwise have contributed agglomeration benefits to the locality. Agglomeration effects are related to the benefits that individuals or firms receive from being located within a network of other individuals or firms, such as sharing of knowledge and information, reducing spatial mismatches between jobs and places of residence, and neighborhood effects which are necessary for the development of social capital. Agglomeration may affect decision making by prompting residents to remain when they might otherwise emigrate because they would lose network benefits in excess of the gains they would obtain from exit. Demonstrable declines in agglomeration benefits could, more than population declines or rough measures of service delivery insolvency alone, inform judgments about the potential sources of fiscal distress and the likelihood that debt adjustment would be appropriate. If population decline is largely attributable to exit by firms that tend to generate local agglomeration benefits, then continued and declining fiscal distress is more likely to occur without intervention than if population decline results from exit that creates less of a reduction of those benefits.

The full article is available here.

Net-short Creditor Activism is an Urban Legend

By Vincent S.J. Buccola (University of Pennsylvania – The Wharton School), Jameson K. Mah (Cyrus Capital Partners), Tai Yi Zhang (University of Pennsylvania – The Wharton School)

Vincent S.J. Buccola
Jameson K. Mah

Bankruptcy scholars have worried about the potential for credit derivatives to frustrate sensible out-of-court reorganizations since such derivatives became widespread in the 2000s. The basic problem they saw was that derivative contracting could complicate dealmaking by disguising investors’ true interests vis-à-vis a distressed company. Most perniciously, derivatives could lead creditors to oppose value-maximizing restructuring plans that offer fair treatment—not just for the familiar purpose of furthering a holdout strategy, but with the very aim of opposing the general welfare. In particular, a creditor with a large derivative position betting against its debtor could actively use its rights as creditor to drive the debtor into a messy and value-destroying default.

Many debt-market observers are sure that a recent episode pitting the hedge fund Aurelius against Windstream was a case in point. That episode has only increased attention on the subject, and issuers are experimenting with contractual devices that purport to muffle the influence of net-short activists at the expense, presumably, of secondary-market liquidity.

Our recent article argues that commotion over net-short creditor activism is misplaced—indeed that such activism is implausible. The nub of our skepticism lies in the incentives and capacities of investors other than a hypothetical net-short activist to foil the activist’s plans. The objective of net-short tactics, according to the story’s logic, is to cause a liquidity crisis that will reduce a targeted company’s value and prompt default. This objective implies, however, as a matter of arithmetic, that others can make money supplying offsetting liquidity.

Our article explores some of the channels through which this responsive liquidity is most likely to flow. We conclude that in the ordinary case one should expect parties other than the would-be saboteur to undermine its plans. If we are right, then it is a puzzle why a sophisticated potential activist would think it could succeed. A net-short activist bets not just on debt prices falling, as all short investors do. It bets rather on its own ability to cause the prices to fall. But in placing such a bet, the activist must know it is daring rival investors to profit by punishing it. The whole approach seems misguided. Which brings us to Windstream. Why did Aurelius think it could prevail at sabotage? As the article explains, we don’t believe it did and don’t believe it tried. We can’t say for sure, because lack access to the fund’s books and records. But so do the many other commentators who have opined on the story.

To us, then, one of the most intriguing features net-short activism is its rhetorical appeal. We suggest that the appeal lies in a kind of mythological function—that net-short sabotage has, in particular, the cautionary form of a good urban legend.

The article is available here.

Where Past is Prologue: Applying Lessons from the Past to Protect ABL Lenders in a World of Future Distress

By Shana A. Elberg, Seth E. Jacobson, & George R. Howard (Skadden)

Shana A. Elberg
Seth E. Jacobson
George R. Howard

Today, U.S. borrowers are more indebted than ever before. Borrowers have become increasingly aggressive in using secured leverage, and in taking advantage of “cov-lite” loan documents to engage in creative (and sometimes controversial) transactions to transfer assets beyond the reach of existing secured lenders by way of distributions to shareholders or contributions to unrestricted subsidiaries and then utilize those assets to raise additional secured financing. While the debt levels and cov-lite structures of leveraged loans may create risks for many stakeholders, lenders under asset-based loan facilities (“ABL facilities”) should be well-positioned to weather any storm. ABL facilities typically offer lenders greater protections in a liquidation scenario. In addition, ABL facilities often are a critical lynchpin of debtor-in-possession financing facilities when borrowers are looking to effectuate comprehensive restructurings through chapter 11. There are several tools available to ABL lenders to protect their credit position in the event that a borrower finds itself in a distressed situation. Lenders should position themselves to understand and use the chapter 11 process to ensure their debt claims retain, and even gain, protections in bankruptcy.

The full article is available here.

Secured Credit Spreads

By Efraim Benmelech (Northwestern University – Kellogg School of Managemen, Nitish Kumar (University of Florida), and Raghuram Rajan (University of Chicago – Booth School of Business)

Efraim Benmelech
Nitish Kumar
Raghuram Rajan

Is collateral at all valuable to creditors in corporate lending? At one level, it is clear why collateral should be important for lenders: it consists of hard assets that are not subject to asymmetric valuations in markets and that the borrower cannot alter easily. Collateral gives comfort to a lender that, even if the lender does little to monitor the borrower’s activity and the borrower’s cash flows prove inadequate to service the debt, the lender’s claim is protected by underlying value.

Yet even if assets are important to lending, why does debt need to be secured by them? After all, in a bankruptcy filing the firm’s assets will all be there to support the lender’s claim. Why protect the lender further through claims on specific collateral? In a related work (The Decline of Secured Debt), we find that firms tend to issue more secured debt when their credit quality is low or at times when average credit spreads across firms are higher or economic growth is slower. These are times when firms may find access to credit more difficult, creditors may fear greater stockholder-debtholder conflicts, and borrowers may need to collateralize debt issuances in order to regain access to funding. Moreover, with new lenders unwilling to lend without the comfort of collateral, existing lenders might rush to secure their claims so as not to be diluted. Indeed, negative pledge clauses (whereby the borrower commits to a lender that it will not issue secured debt to any other lender, failing which the debt payment will be accelerated) allow creditors to large companies to stay unsecured until they sense a greater likelihood of borrower distress, at which point they will move to secure their claims.

If collateral matters to creditors for the enforcement of debt claims, even in the case of large, mature companies but in a more contingent way, we should see it reflected in the pricing of secured claims vis-à-vis unsecured claims, especially in how that pricing moves with the state of the firm and the economy. Security should be of little value to lenders when a firm is far from distress or the economy is healthy, and it should become much more valuable (and hence secured debt should promise lower interest rates than unsecured debt) as a firm nears distress or the economy deteriorates.

The difficulty in identifying the effects of security on debt pricing derives from the circumstances under which it is offered. Since riskier firms will offer security at riskier times, a comparison of rates offered by secured debt issuances against rates offered by unsecured debt issuances across firms, or by the same firm over time, will tend to be biased toward suggesting higher rates for secured debt issuances.

In this paper, we use multiple data sets to get at the true pricing of secured debt, stripped as best as possible of the selection bias. Our identification strategy compares spreads on secured and unsecured credit of the same firm and at the same point in time.

We conclude from all these ways of obtaining the value of security that the selection bias is important, and correcting for it suggests that security is valuable to creditors – creditors typically require a lower spread when their claim is secured. Most important, however, we show that creditors value security differently for different firms and at different times.

For highly rated firms, creditors pay almost nothing for the added protection afforded by security, whereas for low-rated firms, they pay a lot. Yields on bonds issued by investment grade firms (those with an S&P rating of BBB− or better) are 20 basis points lower when secured, whereas this yield differential (unsecured versus secured) jumps to 112 basis points for a firm having a non-investment grade rating. Similarly, implied yields from bond trades in secondary market suggest that investors are willing to give up almost 161 basis points in spread for the added protection of security for non-investment grade issuers, whereas they are not willing to reduce spread at all for the added protection of security in the case of investment grade issuers.

Equally important, as a firm’s credit quality deteriorates, we see the valuation of secured claims improve relative to unsecured claims, suggesting that security becomes more valuable. We also find that secured spreads decline relative to unsecured spreads as the economy’s health – as reflected in GDP growth or the economywide Baa–Aaa spread – deteriorates.

The upshot is that collateral does not seem to matter for debt enforcement in normal times for a healthy firm, since debt linked to specific assets do not seem to enjoy better prices. Indeed, given the negligible pricing benefit, firms may want to avoid any loss in financial slack and operational flexibility at such times by not issuing secured debt. However, in tougher times, creditors do seem to value security, and firms do issue secured debt, either because creditors demand it or because of the better pricing.

The full article is available here.

Want to Take Control of Professional Fees in Large Chapter 11 Bankruptcy Cases? Talking with Your Client’s General Counsel is a Good First Step

By Professor Nancy Rapoport (William S. Boyd School of Law, University of Nevada, Las Vegas)

Nancy Rapoport

As someone who studies professional fees in large chapter 11 cases, I’ve thought a lot about how quickly those professional fees can escalate. Successful chapter 11 bankruptcies are expensive, though, in almost all cases, the end result—a successful reorganization—is a good result. But can the fees be controlled effectively?

I think that they can, although there are all sorts of reasons why, often, fees aren’t monitored very closely. There’s usually a disconnect between who’s paying those fees and who’s monitoring the work. In a non-bankruptcy context, a lawyer might bill a client on a monthly basis and get relatively fast feedback from the client regarding issues of reasonableness. The image that comes to mind is of a lawyer pushing a bill across a table and an experienced client pushing it back to request reductions for potentially unreasonable fees or expenses. But the process is different for fees paid to professionals in chapter 11 cases. Bankruptcy courts are charged with the responsibility of reviewing the fees and expenses for reasonableness, and the Office of the United States Trustee serves as another set of eyes, as would a fee examiner.

For estate-paid professionals, the bankruptcy court must first approve the fee applications, which then get paid either from a carveout of a secured creditor’s collateral or as administrative expenses. Imagine a typical list of estate-paid professionals: the debtor’s counsel (plus conflicts counsel and local counsel), the creditors’ committee counsel (plus conflicts counsel and local counsel), investment banks and financial advisors (often for both the debtor and the committee), along with other, more specialized counsel. All of those professionals are working at warp speed, because large chapter 11 cases are literally bet-the-company actions. The fee applications themselves can run into the thousands of pages, per professional, with the time entries showing who worked on what, and for how long, on a day-by-day basis. There’s also often a lag between the work done and the submission of the fee applications, and few actors—other than the professionals themselves and some large institutional creditors—are repeat players. If the client isn’t familiar with the rhythm of chapter 11 bankruptcies, then that client has to take the professionals’ word for whether the tasks were both reasonable and necessary. Parsing the fee applications is a complicated task.

Let me be clear: I’m not suggesting that bankruptcy professionals try to gouge the estate by performing unnecessary tasks. Far from it. The professionals whose fees I’ve reviewed have genuinely been trying to work within the reasonableness guidelines. But the staffing choices that get made—which level of professional works on which tasks, how long it takes to do the work, how many people review that work, how often all of the professionals touch base on the case’s progress, and how a professional must react to actions taken by a different professional—often don’t have the luxury, on the front end, of data-driven planning to eke out the most efficient workflows. Add to that the fact that all of these professionals worry about missing something important, and it’s not hard to see how fees can mount up.

I’ve written a lot about how to think about fees in chapter 11 cases, including these articles (here, here, and here). Most recently, I’ve been working with a co-author, Joe Tiano of Legal Decoder, to imagine a world in which big data can help professionals perform more efficiently (here and here). (Full disclosure: Legal Decoder helped me review the fees and expenses in the Toys R Us cases.) In a recent piece for the American Bankruptcy Institute Law Review, I’ve taken what we know about how a company’s general counsel works with outside professionals outside bankruptcy and suggested that, in a chapter 11 context, many of those behaviors can help to control the size of the professional fees and expenses: by paying closer attention to staffing and monthly budget-to-actual reconciliations, by using legal analytics to measure efficiency, and by using artificial intelligence for certain types of tasks. The point is that paying attention to efficient behavior on the front end benefits everyone, including the professionals themselves, who won’t have to negotiate reductions of their already billed work. The ABI Law Review article is available here.

For a previous Roundtable post discussing fees in another context, please see Through Jevic’s Mirror: Orders, Fees, and Settlements.

Ultra III: Law Firm Perspectives

By Xiao Ma (Harvard Law School)

Xiao Ma

On November 26, 2019, the Fifth Circuit granted a petition for rehearing en banc and issued a revised opinion in In re Ultra Petroleum Corp., No. 17-20793 (5th Cir. Nov. 26, 2019). The new opinion reaffirmed the court’s prior holding that the alternation of a claim by the Bankruptcy Code does not render a claim impaired under 11 U.S.C. § 1124(1), while withdrew the court’s earlier guidance that make-whole premium was the “economic equivalent of ‘interest’” together with its prior suggestion on setting the appropriate post-petition interest rate via reference to general post-judgment interest statute or bankruptcy court’s equitable discretion.

Noting that issues relating to make-whole premiums is a common dispute in modern bankruptcy, the Fifth Circuit retracted its dicta and emphasized in the revised opinion that specific facts are essential in determining the difficult question of whether any premiums are effectively unmatured interest. The court concluded that “[t]he bankruptcy court is often best equipped to understand these individual dynamics – at least in the first instance.”

Firms took notice of the issues remain unsolved and offered perspectives on implications of this case. Morgan Lewis specifically notes that the revised opinion did not alter the original opinion’s reversal of the bankruptcy court’s ruling that creditors who are unimpaired in a bankruptcy plan pursuant to section 1124(a)(1) must receive the full amount of their claim under state law. Weil finds the opinion “does not answer the question of whether, or when, a make-whole may be payable in the Fifth Circuit”, but acknowledges that the ruling is “viewed by some as a victory” for certain creditors. Cleary highlights that the court’s revised opinion “withdrew essentially all of the guidance it had offered in its prior opinion” which had cast doubt on the enforceability of make-whole claims in bankruptcy. “Given the legal and economic significance of the questions left to be resolved”, debtors and creditors alike are likely to watch closely how the questions will proceed at the bankruptcy court, says Mayer Brown.

An earlier post on the Roundtable, Fifth Circuit’s Ultra Petroleum Decision Suggests Make-Wholes are Unenforceable in Bankruptcy, Questions Collectability of Contract Rate Postpetition Interest, discussed the original opinion on Ultra by the Fifth Circuit dated Jan. 17, 2019.

INSOL Europe/LexisNexis coronavirus (COVID-19) Tracker of Insolvency Reforms—China

By Xiahong Chen (China University of Political Science and Law)

Xiahong Chen

The modification of Enterprise Bankruptcy Law of the People’s Republic of China in 2006 had been announced to be in legislative organ’s amendment procedure for years. As there is no further progress in 2020, the slow process must not catch the urgent needs of economic community for corporate rescue after breakout of coronavirus epidemic. Consequently, the Supreme People’s Court of P.R.China was playing an active role in policy-making from judicial perspective concerning civil disputes resolution. From April to June 2020, the Supreme People’s Court of P.R.China had issued 3 judicial guidance in series to direct judicial hearing of civil case in all level of courts during and after the epidemic, with purpose to guide judicial hearing of civil cases relating to disputes caused by coronavirus. Among them, the second one, published on 19 May 2020, contains 7 important guidelines for judicial hearing of bankruptcy cases relating to COVID-19, aiming to improve possibility of corporate rescue and enhance viability of those financial-distressed companies further.

Changes of bankruptcy policy in above-mentioned guidance include: (1) Court-supervised negotiation between the insolvent debtor and those creditors before the opening of bankruptcy proceeding; (2) Distinguishing real causes of insolvency when examining bankruptcy criteria; (3) Further promoting the link between civil execution proceedings and bankruptcy proceedings; (4) Extending the reorganization period from maximum of 9 months according to EBL 2006 by another 6 months; (5 ) Highlights of effective protection of creditors’ substantive rights and procedural rights in bankruptcy proceedings;(6) Maximizing the debtor’s ability to continue operations and the value of property disposal; (7) Promoting the efficient hearing of bankruptcy cases.

In this short note, the author Xiahong Chen, fellow of Bankruptcy Law and Enterprise Restructuring Research Center of CUPL, was invited by the INSOL Europe, introduces the main points of adjustments of bankruptcy policies relating to epidemic in detail. According to his observation, like the global legal and policy changing trends in bankruptcy area all over the world recently, the changes concerning judicial hearing of bankruptcy cases in China is expected to be helpful for survival of those financial struggling companies.

The full article is available here.

Bankruptcy Claim Dischargeability and Public Externalities: Evidence from a Natural Experiment

By Michael Ohlrogge (New York University School of Law)

Michael Ohlrogge

In 2009, the Seventh Circuit ruled in U.S. v. Apex Oil that certain types of injunctions requiring firms to clean up previously released toxic chemicals were not dischargeable in bankruptcy.  The result of this was to expose lenders, even those with security interests, to larger losses in the event a firm they extended credit to entered bankruptcy with significant outstanding environmental cleanup obligations. I document that lenders tightened the covenants on loans they extended to firms impacted the decision. In particular, lenders added new requirements that borrowers’ facilities and operations be inspected by outside environmental engineering firms in order to assess the safety with which they handle toxic chemicals.

Using an array of statistical tests and data from federal environmental agencies, I show that firms impacted by the decision responded to these new pressures from lenders by taking meaningful steps to reduce their risks of causing catastrophic pollution spills. In particular, firms reduced volume of toxic chemicals they release on-site by approximately 15%. In place of these releases, firms substituted off-site treatment by specialized facilities generally considered to be safer for the environment.  These results point to important ways in which bankruptcy law and other legal rules that impact recovery for firms’ creditors can work to shape the positive or negative externalities those firms generate.

The full article is available here.

Venezuela’s Potential Debt Restructuring and Economic Recovery Efforts: Some Key Legal and Policy Challenges

By Steven T. Kargman (Kargman Associates/International Restructuring Advisors)

Steven T. Kargman

The article provides an overview of certain key legal and policy issues that are likely to arise in any eventual Venezuelan debt restructuring.  Specifically, the article focuses on what will likely be some of the central elements of any future debt restructuring, including the possibility of debt-for-equity swaps and oil warrants, and it also reviews various considerations in connection with a possible insolvency filing by Venezuela’s state-owned oil company, PDVSA.  Further, the article discusses legal and policy considerations related to economic recovery efforts that Venezuela may undertake in the future, including matters related to any efforts to revive Venezuela’s oil industry as well as any attempts to diversify Venezuela’s economy so that it is not so reliant on a single commodity, oil.  Finally, the article examines the issue of asset recovery and how a future Venezuelan regime might seek to recover assets that have been misappropriated from Venezuela.

This article recently appeared in the Venezuelan law journal, La Revista Venezolana de Legislación y Jurisprudencia (Venezuelan Journal of Legislation and Jurisprudence).  The full article can be found here.

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