By Jennifer Payne (Oxford University)
This paper examines the intervention of the law, and the role of the court, in debt restructuring, both in terms of imposing constraints on creditors and in seeking to ameliorate the potential abuses that can arise from such constraints. Three potential forms of abuse are examined: the imposition of a restructuring on dissenting creditors, which introduces the potential for wealth transfers between creditors; the imposition of a moratorium while a restructuring is negotiated, which might lead to misuse of the process by managers wishing to prop up companies that are not viable or may allow the managers of a viable business to “shake off” liabilities that the business is capable of servicing; and the imposition of debtor-in-possession arrangements, which raise the potential for new creditors to be preferred at the expense of existing creditors. It is argued that the court’s role in protecting creditors from these three forms of potential abuse is vital, although the nature of that role differs according to the form of abuse. Recent debt restructuring reform proposals in both the UK and the EU, which adopt quite different approaches to the role of the court in this process, are examined in the light of this discussion.
The full paper is available here.
By Aurelio Gurrea-Martínez (Harvard Law School and Ibero-American Institute for Law and Finance)
Most insolvency jurisdictions provide several mechanisms to reverse transactions entered into by a debtor prior to the commencement of the bankruptcy procedure. These mechanisms, generally known as claw-back actions or avoiding powers, fulfill several economic goals. First, they act as an ex post alignment of incentives between factually insolvent debtors and their creditors, since the latter become the residual claimants of an insolvent firm but do not have any formal control over the debtor´s assets while the company is not yet subject to a bankruptcy procedure. Therefore, the existence of these mechanisms allows the prevention or, at least, reversal of opportunistic behaviors by factually insolvent debtors. Second, the existence of avoidance actions may also prevent, at an early stage, a destructive race to collect. Third, these legal devices also minimize the overinvestment problems potentially faced by insolvent debtors. Fourth, the existence of avoidance powers may encourage managers to take corrective actions in a timely manner. Finally, the existence of avoidance actions may also protect the interests of both the debtor and its creditors as a whole when some market participants want to take advantage of a distressed debtor.
However, the use—and even existence—of avoidance actions is not costless. On one hand, such actions bring litigation costs. On the other hand, the existence of these provisions may be harmful for legal certainty, especially in those countries in which bad faith is not required to avoid a transaction and the “twilight period” may be too long.
In a recent paper, I discuss how insolvency legislators should deal with this trade-off. Namely, by providing an economic and comparative analysis of avoidance actions, I discuss the optimal way to design claw-back actions across jurisdictions, taking into account the costs and benefits potentially generated by these provisions.
The full paper is available here.
By Michael Friedman, Simone Tatsch, and Nicholas Whitney (Chapman and Cutler LLP)
As more Companies face liquidity issues and near term debt maturities, they are looking closely to exceptions contained within their indenture/credit agreement covenants in order to achieve an overall or partial restructuring of their capital structure. Investments in “Unrestricted Subsidiaries” are an exception to investment covenants, which have been used in an attempt to provide flexibility in restructuring a Company’s capital structure. Before purchasing debt, distressed investors need to be mindful of what Unrestricted Subsidiaries are and how they impact the overall credit of a Company or debt recovery.
Companies may use Unrestricted Subsidiaries in order to transfer a valuable asset outside of the purview of a Financing Agreement’s covenants. A Company can use the Unrestricted Subsidiary to exchange near term maturing debt junior in the Company’s capital structure for debt issued by the Unrestricted Subsidiary – an exchange that would otherwise not be permitted by the covenants. The exchanged indebtedness could then be supported by the asset which has been transferred to the Unrestricted Subsidiary.
Two recent and well publicized examples of moving value into an Unrestricted Subsidiary are iHeartCommunications (“iHeart”) and J.Crew Group, Inc. (“J.Crew”). In iHeart, the stock of an iHeart subsidiary was moved to an Unrestricted Subsidiary in order to effect a debt exchange, while in J.Crew valuable intellectual property was moved into an Unrestricted Subsidiary for likely the same purpose. Investors must be prepared to determine if there is a way for a Company to utilize its covenants to transfer value to an Unrestricted Subsidiary.
The full client alert is available here.
By Mark J. Roe (Harvard Law School)
During the past century, three decisionmaking systems have arisen to accomplish a bankruptcy restructuring — judicial administration, a deal among the firm’s dominant players, and a sale of the firm’s operations in their entirety. Each is embedded in the Bankruptcy Code today, with all having been in play for more than a century and with each having had its heyday — its dominant age. The shifts, rises, and falls among decisionmaking systems have previously been explained by successful evolution in bankruptcy thinking, by the happenstance of the interests and views of lawyers that designed bankruptcy changes, and by the interests of those who influenced decisionmakers. Here I argue that these broad changes also stem from baseline market capacities, which shifted greatly over the past century; I build the case for shifts underlying market conditions being a major explanation for the shifts in decisionmaking modes. Keeping these three alternative decisionmaking types clearly in mind not only leads to better understanding of what bankruptcy can and cannot do, but also facilitates stronger policy decisions today here and in the world’s differing bankruptcy systems, as some tasks are best left to the market, others are best handled by the courts, and still others can be left to the inside parties to resolve.
The full article is available here.
By Laura N. Coordes (Arizona State University Law School)
In order to gain access to chapter 9 bankruptcy, municipalities must demonstrate that they meet several eligibility requirements. These requirements were put in place to prevent municipalities from making rash decisions about filing for bankruptcy. Too often, however, these requirements impede municipalities from attaining desperately needed relief. This Article demonstrates that as currently utilized, the chapter 9 eligibility rules overemphasize deterrence and are not rationally connected to the reasons the chapter 9 bankruptcy system was developed. This Article, therefore, posits that the chapter 9 eligibility requirements should be relaxed.
To support this claim, the Article conducts a detailed analysis of the history and theory of chapter 9 to determine the primary reasons for the eligibility rules and the core functions of a municipal bankruptcy solution. It then demonstrates how many of the concerns driving the eligibility rules’ existence are addressed in other chapter 9 mechanisms, and it proposes sweeping revisions to the eligibility rules to facilitate appropriate access to chapter 9. Specifically, municipalities in fiscal distress should be able to access bankruptcy when they demonstrate a need for the primary types of assistance that bankruptcy can best provide: nonconsensual debt adjustment, elimination of the holdout creditor problem, and breathing space. Through its analysis, this Article brings needed attention to the broader questions of who should have access to bankruptcy and when that access should be granted.
The full article is available here.
For more Roundtable posts on municipal bankruptcy, see Parikh & He, “Falling Cities and the Red Queen Phenomenon”; Skeel, “From Chrysler and General Motors to Detroit”; and Roundtable updates on Puerto Rico’s debt crisis (covering a call for congressional action and Puerto Rico’s Public Corporation Debt Enforcement and Recovery Act).
By Horst Eidenmueller (Oxford University)
The European Commission has proposed a directive on “preventive restructuring frameworks” for financially distressed firms. If adopted, the directive would force the Member States of the European Union (“EU”) to design restructuring proceedings that conform to the directive’s stipulations.
In a recent paper, I demonstrate that the proposal is flawed because it creates a refuge for failing firms that should be liquidated, because it rules out going-concern sales for viable firms, and because it is, in essence, a twisted and truncated insolvency proceeding. I also demonstrate that the Commission’s harmonization plan is misguided. If implemented, financing costs for firms would rise. The plan would cast in stone an inefficient restructuring framework on a European-wide scale, preventing member states from experimenting with more efficient procedures.
I suggest an alternative regulatory proposal: European firms should have the option to choose a “European Insolvency Regime” in their charter. This regime should be embodied in a European regulation, guaranteeing legal certainty to stakeholders. This proposal would preserve horizontal regulatory competition between the Member States for the best “insolvency product,” and it would introduce vertical regulatory competition between the member states and the EU in the field of insolvency law. Hence, my proposal would strengthen market testing of European insolvency regimes instead of eliminating creative discovery processes through a flawed harmonized framework.
Key design principles of the proposed optional “European Insolvency Regime” are the following: (i) it should be open for restructurings, going concern sales, and liquidations, and firms should be channelled into the appropriate process based on the opinion of a court-appointed supervisor; (ii) it should be a fully specified (complete) and fully collective insolvency proceeding; and (iii) the proceeding should be conducted in DIP form with the mandatory appointment of a supervisor who performs important insolvency-related functions.
The full paper is available here.
By Howell E. Jackson (Harvard Law School) & Stephanie Massman (Harvard Law School, J.D. 2015)
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.”