Solving the Pari Passu Puzzle: The Market Still Knows Best

By Sergio J. Galvis (Sullivan & Cromwell LLP)

As a result of the Argentine sovereign debt crisis and ensuing holdout litigation saga, the pari passu (or ranking) clause became a source of great consternation in the international sovereign bond market. Specifically, Judge Griesa’s holding that Argentina had violated the pari passu clause by refusing to pay creditors who had not participated in the nation’s earlier debt exchanges, and the accompanying requirement that Argentina had to pay those holdout bondholders, led to uncertainty in the market regarding the leverage holdouts could exercise in sovereign debt restructurings going forward. Concern was expressed over the ability of sovereigns to succeed with voluntary exchange offers premised on the threat that the restructuring sovereign would default on payments due to non-participating bondholders. This article evaluates the impact of the court’s decision in the Argentine litigation to date, including subsequent court decisions that have helped reinforce the view that the equitable holding in favor of the holdouts in the Argentine saga is a narrowly prescribed outcome that is unlikely to be repeated absent extraordinary circumstances. It then examines the adoption of improved ranking clauses and collective action voting clauses in recent issuances of sovereign debt in the effort to bring greater certainty to market participants and facilitate efficient restructurings in the future without the need for extra-contractual restructuring mechanisms and remedies.

The full article is available here.


For other recent Roundtable posts related to sovereign debt, see Lubben, “Sovereign Bankruptcy Hydraulics“; Gulati and Rasmussen, “Puerto Rico and the Netherworld of Sovereign Debt Restructuring“; and a Cleary Gottlieb update on Puerto Rico’s bankruptcy.

Pari Passu Undone: Game-Changing Decisions for Sovereigns in Distress

By James Michael Blakemore (Cleary Gottlieb Steen & Hamilton LLP)

In “Pari Passu Undone: Game-Changing Decisions for Sovereigns in Distress,” which appears in Issue No. 3 of the “Cleary Gottlieb Emerging Markets Restructuring Journal,” published by Cleary Gottlieb Steen & Hamilton LLP,[1] Michael Lockman and I examine a recent decision in White Hawthorne, LLC v. Republic of Argentina, No. 16 Civ. 1042 (TPG), 2016 WL 7441699 (S.D.N.Y. Dec. 22, 2016), regarding the hotly litigated pari passu clause.

Following an economic catastrophe in the early 2000s, the Republic of Argentina successfully restructured the vast majority of its more than $80 billion of debt, exchanging new bonds for those on which the crisis had forced default. In February 2012, Judge Thomas P. Griesa of the Southern District of New York, based on a boilerplate provision in the defaulted bonds known as the pari passu clause, enjoined Argentina from servicing its restructured debt without simultaneously making ratable payments to holdout creditors who had refused to participate in the exchange. This interpretation was unprecedented and, given the pari passu clause’s ubiquity in sovereign debt instruments, threatened to reverberate far beyond the specific facts of Argentina’s case. For nearly five years, anxious sovereigns and market participants were left to ponder the scope of these rulings. Most basically, would a sovereign debtor’s decision to pay some but not all of its creditors, taken alone, violate the pari passu clause?

Judge Griesa has now answered this crucial question. Following Argentina’s announcement, in February 2016, of a global proposal to settle its defaulted debt, a group of hedge funds brought suit, arguing in part that Argentina’s settlement with other creditors violated the pari passu clause. In White Hawthorne, Judge Griesa disagreed. The Court’s opinion confirmed that, absent aggravating circumstances—Judge Griesa mentioned specifically the “incendiary statements” and “harmful legislation” of Argentina’s former government—a sovereign debtor may pay some of its creditors and not others without running afoul of the pari passu clause. The decision does much to clarify the limits of the pari passu clause and deals a serious blow to creditors who would interpret the clause broadly to undermine future sovereign restructuring efforts.

The full article is available here.


[1] The firm represented the Republic of Argentina in the matters described in the article. The views expressed here are solely those of the authors and do not necessarily reflect those of the firm or its clients.

Reconciling “Additional Assistance” with “Appropriate Relief” in Ch. 15

By David L. Eaton (Kirkland & Ellis LLP) and Aaron J. David (Paul, Weiss, Rifkind, Wharton & Garrison LLP)*

When faced with a Chapter 15 foreign representative seeking discretionary post-recognition relief on behalf of a foreign debtor, courts have struggled to decide whether the requested relief falls under § 1507(a), referring to “additional assistance” and subject to the factors enumerated in § 1507(b), or under § 1521, affording “appropriate relief” under the balancing test in § 1522.  Because both provisions seem to enable courts to provide discretionary relief, but subject to different standards, courts and commentators have lamented the difficulty of assessing “where section 1521 ends and where section 1507 begins.”

In our view, the problem is illusory.  We revisit Chapter 15 in light of the “language and design of the statute as a whole” to argue that § 1507 has been misinterpreted.  On our reading, §1507 is not, itself, a source of discretionary relief, but rather sets out principles to guide courts in granting any discretionary relief, including under § 1521.  Specifically, § 1507(a) allows courts to employ applicable non-bankruptcy law in fashioning discretionary relief, and § 1507(b) imposes standards that preserve pre-Chapter 15 jurisprudence governing such relief.  Interpreting § 1507 this way clarifies that § 1521 is the true source of discretionary relief, but that it should be employed against the background principles of § 1507.

The full article was published in the ABI Journal and is available here.


*David Eaton is a recently retired partner of Kirkland & Ellis LLP.  Aaron David is an associate at Paul, Weiss, Rifkind, Wharton & Garrison LLP.  The article reflects the views of authors, and does not represent the views of Kirkland & Ellis or Paul, Weiss.

Roundup: Recent Op-Eds on Bankruptcy for Banks

The House of Representatives’ passage first of the Financial Institution Bankruptcy Act (FIBA) and then of the Financial CHOICE Act last Thursday has made bankruptcy for banks and the fate of Dodd-Frank’s Orderly Liquidation Authority (OLA) a live issue again. Both FIBA and the CHOICE Act would add a “subchapter V” to chapter 11 to resolve financial conglomerates in bankruptcy. Unlike FIBA, however, the CHOICE Act would also repeal the OLA, leaving bankruptcy as the only option for handling the failure of a financial conglomerate.

Several academics, former regulators, and practitioners, including several contributors to the Bankruptcy Roundtable, have recently published op-eds weighing arguments for and against replacing the OLA with bankruptcy. Support for adding tools to the Bankruptcy Code is widespread. Commentators differ, however, on whether bankruptcy, by itself, can address the systemic risk concerns that prompted the creation of the OLA and on whether it would be useful to have a bankruptcy procedure more robust than subchapter V.

Stephen Lubben contends that without a mechanism for providing liquidity to financial institutions—the usual providers of funding for companies in chapter 11—the Bankruptcy Code cannot effectively handle a widespread financial crisis. Mark Roe emphasizes that economic stability requires having the OLA and related structures to allow subchapter V to succeed (through regulatory coordination with international authorities and supervision over financial institutions to ensure that they have the capital structures to facilitate a subchapter V resolution). The OLA is also needed in case a subchapter V reorganization fails, as subchapter V is not a general bankruptcy authorization but, instead, a mechanism to use the 48-hour “single-point-of-entry” restructuring strategy in bankruptcy. This point renews some of the arguments Roe and David Skeel expressed earlier on ways subchapter V should be strengthened, such as by the addition of a regulatory trigger and a means to deal with an inability to complete the resolution within 48 hours.

Finally, Sheila Bair and Paul Volcker argue that having the OLA as a backstop for a failed bankruptcy makes government bailouts less likely, as the OLA provides regulators with the tools to wind down a failed financial institution in an orderly fashion. In contrast, Stephen Hessler argues that the Bankruptcy Code, amended along the lines of subchapter V, would promote both market discipline and financial stability. A bankruptcy judge applying well established precedents and rules in a subchapter V case would combat moral hazard more effectively than the OLA, which grants regulators significant discretion to treat similarly situated creditors differently.

(By Rebecca Green, Harvard Law School, J.D. 2017.)


Recent Roundtable coverage of this subject includes posts on a letter submitted to Congress by academics and the Trump administration’s direction to the Treasury to issue a report on the OLA.

Do the Financial Institution Bankruptcy Act and the CHOICE Act Undermine an Effective Restructuring of a Failing Financial Institution?

By Bruce Grohsgal (Delaware Law School, Widener University)

The House recently passed the Financial Institution Bankruptcy Act of 2017 (FIBA). FIBA’s provisions are incorporated into the Financial CHOICE Act of 2017, passed by the House last week, which would repeal Dodd-Frank’s receiverships for failing financial institutions that pose risk to the financial system. The Senate may soon consider both bills.

FIBA creates a subchapter V of chapter 11 for financial institutions. Only the holding company will file. In the first 48 hours of the case, it will transfer certain assets—consisting primarily of its equity in its subsidiaries and its derivatives—to a newly-formed bridge company. It will leave behind pre-designated “bail-in debt,” mostly unsecured term obligations owed to 401ks and pensions and shorter term unsecured trade debt.

In my view, however, FIBA is unlikely to result in an effective restructuring. First, because of FIBA’s 48-hour deadline, individual determinations likely will not be made with respect to the hundreds of thousands, if not millions of repo, derivatives, and other qualified financial contracts. Instead, the entire book of financial contracts—the “bad” along with the “good”—likely will be transferred to the bridge company. The bankruptcy court’s jurisdiction over the bridge company and its property—and the restructuring—ends on the transfers.

Second, the bridge company must assume 100% of the debt secured by any property transferred—without any write down, even if the property is worth less than the claim—and all liabilities owed on the derivatives and repo transferred. These statutory provisions may weaken the bridge company’s balance sheet and imperil its ability to obtain financing.

Though the Federal Reserve’s total loss-absorbing capacity (TLAC) rule includes “clean holding company” requirements to facilitate restructuring, the rule does not adequately address these balance sheet ills that FIBA creates. The clean holding company requirements apply only to eight U.S. global systemically important banks, and do not reach dozens of $50+ billion banks or nearly 5,000 other FIBA-eligible financial institutions. Moreover, TLAC does not prohibit secured borrowing even by those eight bank holding companies, though undersecured borrowings by those eight banks may be limited by TLAC’s regulatory capital requirements. But at a time of declining asset values and a ramp-up to a subchapter V filing, it is likely that many previously fully secured loans will have become undersecured. FIBA will require the bridge bank to either assume the unsecured portion of the debt or lose the collateral to the lender.

FIBA’s bankruptcy proceeding makes a run by the bridge company’s derivatives and repo counterparties more likely. If the bridge company’s balance sheet is weakened by the wholesale assumption of qualified financial contracts and by the assumption of debt above asset value, then the bridge company’s ability to obtain new financing may be diminished. Actions against the bridge company and its assets are not stayed under FIBA. As a result, when repo lenders and other counterparties require post-transfer haircuts and margin payments, and the bridge company is unable to obtain new funding, the run on repo and derivatives will continue.


The text of FIBA is available here. My testimony on FIBA before the House Judiciary’s subcommittee is available here. The text of The Financial CHOICE Act of 2017 is available here. The “clean holding company” requirements of TLAC are at 12 CFR § 252.64, and the TLAC final rule release is available here.

Creditor Rights and Corporate Debt Structure Around the World

By Kose John (New York University & Temple University), Mahsa S. Kaviani (Temple University), Lawrence Kryzanowski (Concordia University), and Hosein Maleki (Temple University)

In this study, we document that the strength of creditor protection influences corporate debt structures. Using data from 46 countries, we find that managers choose more concentrated debt structures and use more bank debt relative to other debt types in countries with better creditor rights protection. The choice of more concentrated debt structures in the face stronger creditor rights is made for two main reasons.

First, more concentrated debt structures increase the probability that a firm can successfully renegotiate distressed debt with its creditors. Therefore, concentrated debt structures can reduce expected bankruptcy costs.

Second, better creditor protection reduces the creditors’ monitoring incentives. The managers can form more concentrated debt structures to boost the monitoring incentives of creditors when creditor rights are strong. This monitoring is beneficial for the firm, as it results in higher firm value by reducing the problem of risk shifting (investment in high-risk, negative net present value projects by managers when a firm has risky debt outstanding).

We confirm our cross-country findings in a difference-in-difference analysis of corporate debt structure’s response to creditor rights reforms in Brazil, France, Italy, and Spain. The results are robust to various controls, alternative dependent variables, endogeneity concerns, and alternative estimation methods. Our sample consists of 25,700 unique firms and spans from 2001 to 2014.

The full article is available here.

Financial Scholars Submit Letter to Congress Opposing Repeal of Title II

On May 23, bankruptcy and financial scholars submitted a letter to members of Congress opposing the Financial CHOICE Act’s proposed replacement of the Dodd-Frank Act’s Orderly Liquidation Authority (“OLA”) with a new subchapter of the Bankruptcy Code as the exclusive method for resolving failed financial institutions. Like the Financial Institution Bankruptcy Act (“FIBA”), which passed the House earlier this year, the CHOICE Act would add a subchapter V to chapter 11, amending the Bankruptcy Code to facilitate a single point of entry (“SPOE”) resolution strategy for financial institutions. Unlike FIBA, however, the CHOICE Act would also repeal the OLA, making subchapter V the only method for resolving a large, failed financial institution.

The letter noted that a bankruptcy proceeding could provide a useful addition to the financial crisis toolbox but expressed several concerns about FIBA’s capacity to deal effectively with an economy-wide financial crisis. For example, the bankruptcy court’s lack of familiarity with failed institutions could undermine the chances of success for the lightning-fast, 48-hour bankruptcy proceedings envisioned in proposed subchapter V. In contrast, in a proceeding under the OLA, the FDIC would have in-depth knowledge of the financial institution’s operations based on the “living wills” resolution planning process. Moreover, the SPOE resolution strategy at the heart of proposed subchapter V requires a specific kind of capital structure; regulators can verify that this structure is in place in advance, but the bankruptcy courts cannot. In addition, the letter voiced concerns about the lack of international coordination for a subchapter V proceeding, the absence of assured liquidity facilities in bankruptcy, and the general inability of bankruptcy courts to provide a coordinated response to the simultaneous failure of several financial institutions. Based on these weaknesses, the letter emphasized the need to retain the OLA as a backstop for resolving financial institutions in the event of a large-scale economic crisis, as well as the need to plan in advance for a subchapter V SPOE-style bankruptcy.

The letter also enumerated concerns specific to subchapter V itself as included in both FIBA and the Financial CHOICE Act. First, the letter pointed to FIBA’s weakness in giving financial institutions and their executives exclusive control over the initiation of the bankruptcy proceeding. Second, it noted that subchapter V does not provide a backup plan for a resolution that fails to be completed within 48 hours. Finally, it emphasized that existing limits on bankruptcy courts’ legal authority could result in challenges to any proceeding under subchapter V, potentially undermining its efficacy by creating uncertainty.

The full letter is available here.

(By Rebecca F. Green, Harvard Law School, J.D. 2017.)


For previous posts on this topic, see “White House Releases Memorandum on Orderly Liquidation Authority“; Jackson & Massman, “The Resolution of Distressed Financial Conglomerates“; and “Bankruptcy Code Amendments Pass the House in Appropriations Bill.”

Recent Developments in Bankruptcy Law, April 2017

By Richard Levin (Jenner & Block LLP)

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 first quarter of 2017.

Cases of note include the Supreme Court’s decision in Czyzewski v. Jevic Holding Corp., prohibiting a structured dismissal that includes priority-skipping distributions over the objection of holders of claims in the skipped class.

Two bankruptcy courts used various powers to impose harsh sanctions on two different banks for even harsher misbehavior. In re Sundquist imposed actual damages of $1 million and punitive damages of $45 million against Bank of America for a sustained campaign of stay violations, harassment, misinformation, and recalcitrance against homeowners who suffered serious medical and emotional damages as a result. In characterizing the bank’s action, the court began its opinion, “Franz Kafka lives.” Following a new concept in imposing punitive damages, the court directed $40 million of the award to various nonprofit institutions rather than to the homeowners. In In re Kraz, LLC, the court imposed actual and consequential contract damages for a bank’s repeated tendering of a false estoppel certificate (payoff demand) but denied punitive damages for lack of a tort to which to attach them.

In other cases of note, the Ninth Circuit clarified what is included in the section 502(b)(6) landlord damages cap (In re Kupfer) and refused to apply the automatic stay’s police or regulatory power exception to a Private Attorney General Act action (Porter v. Nabors Drilling), the Eleventh Circuit found “related to” jurisdiction in an action against a trustee for conspiracy to obstruct justice by hiring the judge’s fiancé but no appellate jurisdiction over a bankruptcy court’s report and recommendation (Wortley v. Bakst), and the New York district court applied the Rule of Explicitness in a non-bankruptcy priority dispute (U.S. Bank v. TD Bank),

The full memo is available here.

The New Bond Workouts

By William W. Bratton (University of Pennsylvania Law School)

Bond workouts are a dysfunctional method of debt restructuring, ridden with opportunistic and coercive behavior by bondholders and bond issuers. Yet since 2008 bond workouts have quietly started to work. A cognizable portion of the restructuring market has shifted from bankruptcy courts to out-of-court workouts by way of exchange offers made only to large institutional investors. The new workouts feature a battery of strong-arm tactics by bond issuers, and aggrieved bondholders have complained in court. A fracas followed in courts of the Second Circuit, where a new, broad reading of the primary law governing workouts, section 316(b) of the Trust Indenture Act of 1939 (“TIA”), was mooted in the Southern District of New York, only to be rejected by a Second Circuit panel.

In “The New Bond Workouts,” Adam Levitin and I exploit the bond market’s reaction to the recent volatility in the law to reassess the desirability of section 316(b). Section 316(b), which prohibits majority-vote amendments of bond payment terms and forces bond issuers seeking to restructure to resort to untoward exchange offers, has attracted intense criticism, with calls for its amendment or repeal. Yet section 316(b)’s staunch defenders argue that mom-and-pop bondholders need protection against sharp-elbowed issuer tactics.

Many of the empirical assumptions made in the debate no longer hold true. Markets have learned to live with section 316(b)’s limitations. Workouts generally succeed, so there is no serious transaction cost problem stemming from the TIA; when a company goes straight into bankruptcy, there tend to be independent motivations. But workout by majority amendment will not systematically disadvantage bondholders.  Indeed, the recent turn to secured creditor control of bankruptcy proceedings makes workouts all the more attractive to them, as their claims tend to be unsecured. Accordingly, we cautiously argue for the repeal of section 316(b). Section 316(b) no longer does much work, even as it prevents bondholders and bond issuers from realizing their preferences regarding modes of restructuring and voting rules. The contractual particulars are best left to the market. Still, markets are imperfect, and a free-contracting regime may result in abuses. Accordingly, repeal of section 316(b) should be accompanied by the resuscitation of the long forgotten intercreditor good faith duties, which present a more fact-sensitive way to police overreaching in bond workouts than section 316(b).

The full paper is available here.


For previous Roundtable posts on Marblegate, section 316(b), and bond workouts, see “Second Circuit Rules on § 316(b) in Marblegate“; Liu, “Exit Consents in Debt Restructurings“; Roe, “The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table.”

Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond

Lawyers from Davis Polk, Drinker Biddle, and Wilmer Hale recently held a panel discussion entitled “Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond.” Jude Gorman of Reorg Research moderated.

The panelists considered the future of out-of-court restructurings and refinancings in light of the Second Circuit’s recent Marblegate decision, the latest development in the litigation between Marblegate Asset Management and Education Management Corp. The panelists discussed several issues surrounding section 316(b) of the Trust Indenture Act (“TIA”), including its underlying policy rationale, how the statute might serve capital markets most effectively, the practical application of 316(b) after the Second Circuit’s decision, and the likelihood of near-term changes to the legal context for out-of-court restructurings. Of particular note, James Millar, of Drinker Biddle, discussed how guarantees of bonds may be treated independently from the underlying bond under the TIA and, hence, subject to 316(b). George Shuster, of WilmerHale, noted that the decision could lead unhappy bondholders to pursue involuntary chapter 11 cases or fraudulent transfer actions. Byron Rooney, of Davis Polk, discussed how the lower court decision in Marblegate had disrupted opinion practice. Finally, Mark Roe emphasized that the SEC has broad authority to issue exemptions, presumably prospectively and generally, as well as on a case-by-case basis; although the SEC has used this authority only occasionally, in theory, bond market players unhappy with the impact of 316(b) could seek conditional exemptions.

Reorg Research’s summary of the session is available here.

(This post comes from Paavani Garg, J.D. ’18.)

 

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