By Hans Degryse, Vasso Ioannidou, Jose Maria Liberti, and Jason Sturgess
The effect of bankruptcy laws and institutions governing enforcement on firm borrowing, investment, and growth has been studied extensively in the economics and finance literature using mainly country-level data. Due to the lack of micro-level data, the same literature has been silent on the underlying economic channels through which weak laws and institutions affect debt contracting.
In order to fill this gap, we study how laws and legal institutions that shift bargaining power between creditors and debtors in the event of default affect expected recovery rates on assets pledged as collateral in secured lending transactions. In particular, we study empirically the determinants of expected recovery rates on different types of collateral using a detailed loan-level dataset of secured loans made by a single bank across emerging market countries. We are able to pin-point the actual mechanism through which better law and stronger enforcement of secured loans can translate into lending: the effect of creditor rights and asset types on the bank’s expected recovery rates. Our results suggest collateral that is movable (machinery, equipment, inventory, and accounts receivable), more asset specific, more susceptible to agency concerns, or faster to depreciate exhibits lower expected recovery rates since they are more vulnerable to laws and institutions.
For the full article, please click here.
By Jacqueline Marcus of Weil, Gotshal & Manges and Doron Kenter of Robins Kaplan
Sales of a debtor’s assets pursuant to section 363 of the Bankruptcy Code carry significant benefits for buyers and sellers alike. But pursuing a sale process with the overlay of the Bankruptcy Code can also pose challenges and pitfalls, particularly for participants who are unfamiliar with the intricacies of the bankruptcy process and the applicable statutes, rules, and procedures inherent in 363 sales.
Jacqueline Marcus, a partner with Weil, Gotshal & Manges, LLP, and Doron Kenter, Counsel with Robins Kaplan LLP, recently authored an article for Practical Law Bankruptcy, in which they outline the relative advantages and disadvantages of sales in bankruptcy, from both the buyer’s and the seller’s perspective, and offer a practical guide to participating in section 363 sales. The article discusses the various types of section 363 sales, as well as the forms of sale processes that debtors may choose to employ in selling some or substantially all of their assets. The article discusses the benefits and drawbacks of finding, or being, a stalking horse bidder, and provides guidance for the marketing process, credit bidding, conducting auctions, and choosing a winning bid. It then discusses the competing views regarding the circumstances under which the bankruptcy court may call the debtor’s decision into question or reopen an auction that has otherwise been closed. Finally, the article discusses the considerations that should be taken into account in determining an exit strategy after a debtor completes a sale of substantially all of its assets.
The full text of the article is available here.
By Melissa B. Jacoby, University of North Carolina – Chapel Hill, and Edward J. Janger, Brooklyn Law School
Bankruptcy courts have become fora for the sale of entire firms as going concerns, as well as for the liquidation of assets piecemeal. This book chapter teases out the advantages and disadvantages of conducting such sales under federal bankruptcy law as compared to state law. We first describe the forms that bankruptcy sales can take, and the contexts in which they occur. Next, we explore the concept of “bankruptcy created value,” identifying the ways in which the federal bankruptcy process can create value over and above what can be realized through compulsory state processes. We then identify several procedural and governance-based concerns about all-asset sales. We suggest that our recent proposal, the Ice Cube Bond, might address concerns about sales of substantially all assets by withholding a portion of the sale proceeds. To recover the withheld funds, claimants would have to establish that the sale did not harm the bankruptcy estate and that they would be legally entitled to the funds under the normal bankruptcy priority rules or pursuant to an agreement reached after the sale. To conclude, we explore the related issues of credit bidding and the permissible scope of sale orders that declare assets to be “free and clear” of various kinds of claims and property interests.
The full chapter may be found here.
This draft chapter has been accepted for publication by Edward Elgar Publishing in the forthcoming Corporate Bankruptcy Handbook, edited by Barry Adler, due to be published in 2017.
By Michael Simkovic, Seton Hall University School of Law
Valuation, solvency, and adequate capitalization analyses play a crucial role in corporate reorganization. Courts and bankruptcy professionals have often complained about the expense, delay, subjectivity, and unpredictability inherent in traditional approaches to valuation.
However, newer methods based on market prices for equity, debt, or options and derivatives are supplementing, and in some cases supplanting more established approaches. One proposal is that instead of looking to bond or equity prices, courts should look to credit spreads between corporate and treasury bonds. Because investors could eliminate almost all credit risk by selling a corporate bond and purchasing a treasury bond, the difference in yield between a corporate bond and a treasury bond must compensate investors for the additional risks of non-payment of corporate bonds.
Credit spreads offer a clear indicator of market actors’ expectations about the likelihood of default and the likely losses given default. With a single assumption about recovery rates—which can be grounded in historic data or sometimes backed out from contemporaneous market data—one can reconstruct a daily market estimate of a debtors’ probability of default.
Credit-spread based approaches are faster, less expensive, and more objective than current approaches. An example is provided below using data for Caesar’s Entertainment Operating Company:
The traditional financial analysis performed by the Examiner in Caesars required months of work and only looked at a few specific dates. The preliminary market-based analysis above was completed by a law professor in a few days, and indicates capital adequacy on a daily basis.
If market-based approaches to solvency analysis could be used with confidence in many large corporate bankruptcy cases, the collective savings to debtors’ estates over a decade could easily be in the tens of millions of dollars.
By Kandarp Srinivasan
Financial contracts such as repurchase agreements (“repos”) have effective “super-priority” in a bankruptcy situation—they are safe harbored from the automatic stay provision. The common justification for this special treatment is the threat of cascade effects (systemic risk). The 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”) expanded safe harbor provisions for repos collateralized by mortgage-related securities.
This paper highlights an unintended consequence of preferential treatment: Safe harbor exemptions increased incentives for financial institutions to issue complex securitized products. From an economic standpoint, an increase in demand for collateral in repo markets can cause securitized products to become more attractive to issue (Gorton and Metrick (2012)). This theoretical premise has remained untested so far.
Using data from bank holding companies and underwriters of structured mortgage products, this paper finds an increase in mortgage securitization activity in years preceding the financial crisis. Hand-collected data on repo collateral in the tri-party repo market reveals underwriters of securitized products increased use of mortgage-backed repos in the quarters following the law change.
Understanding the securitization “flash flood” is important because regulatory responses during the financial crisis (for example, TARP) were primarily targeted at buying securitized assets. Yet, the Dodd-Frank Act directs little attention to repurchase markets (Acharya (2010)). If safe harbor contributed to the proliferation of securitized products, it renews the debate (Roe (2011), Duffie and Skeel (2012)) on the costs and benefits of preferential treatment of financial contracts in bankruptcy.
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.