Activist Investors, Distressed Companies, and Value Uncertainty

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Authors:  Michelle M. Harner, Jamie Marincic Griffin, and Jennifer Ivey-Crickenberger

Hedge funds and other private investment funds often play a key role in chapter 11 cases.  They may hold the debtor’s prepetition secured debt or provide postpetition financing to the debtor.  They also may buy and trade the debtor’s secured and unsecured debt both before and after a chapter 11 filing.  These activities can provide much-needed liquidity to a debtor and foster a robust secondary market for creditors looking to exit the credit.  A fund’s participation in a case, however, sometimes generates litigation and, arguably, both delays the resolution and increases the cost of the case.  Consequently, many commentators and practitioners debate the utility of funds in restructurings.

In our most recent article on funds in chapter 11, we conduct an original empirical study of funds as purchasers of chapter 11 debtors.  Specifically, the study analyzes cases where a fund (individually or as part of a group) acquires control of a debtor through the chapter 11 process by purchasing either substantially all of the debtor’s assets or a majority interest in the reorganized stock.  In the stock acquisition context, we were concerned only with the investment of new capital.

Overall, the data suggest that funds have the potential to provide value in chapter 11.  But neither the participation of funds nor the chapter 11 process itself is a panacea, and more empirical and traditional case studies are needed to understand fully the impact of funds on corporate restructurings.  We hope our study encourages further research.

The full-length article can be found here.

“Trade Away!”—Bankruptcy Court for the Southern District of New York Decides That Original Issue Discount From Fair Value Exchanges Is Allowable in Bankruptcy

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Authors: Richard L. Wynne and Lance Miller, Jones Day

Debt exchanges have long been utilized by distressed companies to address liquidity concerns and to take advantage of beneficial market conditions.  A company with burdensome debt obligations might seek to exchange existing notes for new notes with the same outstanding principal but with borrower-favorable terms (a “Face Value Exchange”).   Alternatively, the company could attempt to exchange existing notes for new notes with a lower face amount (a “Fair Value Exchange”).  Under either scenario, a debt exchange will create “original issue discount” (“OID”) equal to the difference between the face amount of the new notes and the value generated by the exchange for the company (i.e., the fair market value of the old notes).  For tax and accounting purposes, OID is treated as interest that is amortized over the life of the note, with the face amount scheduled to be paid on maturity.

When a company files for bankruptcy, however, unaccrued OID should arguably be disallowed under section 502(b)(2) of the Bankruptcy Code as “unmatured interest.”  However, to encourage out-of-court restructurings, both the Second and Fifth Circuit Courts of Appeal have ruled that unaccrued OID from Face Value Exchanges should not be disallowed.  In In re Residential Capital , LLC, 501 B.R. 549 (Bankr. S.D.N.Y. 2013), the court expanded that rationale to apply to Fair Value Exchanges.  If interpreted broadly and adopted by other courts, the decision will bring certainty to the markets that OID resulting from a debt-for-debt exchange will be allowed in bankruptcy, regardless of how the exchange is structured.

A more detailed discussion of the ruling is available here.

 

Essential Corporate Bankruptcy Law

Authors:  Oscar Couwenberg & Stephen J. Lubben

In every economy, the question of what to do with financially distressed businesses is a matter of concern.   The United States has a long history of corporate restructuring law, starting with the reorganization of railroads in the nineteenth century and continuing through chapter 11 in its current form.   This naturally leads to a tendency to adopt chapter 11, or something like it.

But why?  In particular, chapter 11 is a rather ornate system of corporate reorganization, and it has been adorned with elements that reflect little more than particular creditors’ ability to lobby Congress.

We reexamine chapter 11 to understand its core.  In short, what, if any, are the essential elements of corporate bankruptcy law?

We point to two facets of chapter 11:  asset stabilization and asset separation.  These two aspects of chapter 11 could not be established other than by statute, and jurisdictions looking to reform their corporate bankruptcy processes should focus there.

Asset stabilization is the ability to temporarily protect assets as a coherent whole.  It includes obvious things like the stay on individual creditor collection, provision of post-bankruptcy liquidity and delays on termination of contracts with the debtor.

Asset separation captures the ability to separate assets from their concomitant liabilities.  This might take the form of a discharge, but is not necessary.  Essential is that the system provides clean title to a new owner of the assets, which may or may not be the post-bankruptcy firm.

As this is the core of any sensible corporate insolvency system, features beyond that are a matter of policy, and politics.

The full article can be found here.

Recent Lessons on Management Compensation at Various States of the Chapter 11

By James H. M. Sprayregen, Christopher T. Greco, and Neal Paul Donnelly, Kirkland & Ellis

Setting compensation for senior management can be among the most contentious issues facing companies reorganizing under Chapter 11 of the US Bankruptcy Code. Corporate debtors argue that such compensation—often in the form of base salary, bonuses, or stock of the reorganized company—helps retain and incentivize management, whose services are believed necessary to achieve a successful reorganization. Creditors, by contrast, may be loath to support compensation packages that they perceive as enriching the very managers who led the company into bankruptcy.

This tension over management compensation, though long present in corporate bankruptcy cases, has been more pronounced since 2005, when the US Congress added Section 503(c) to the Bankruptcy Code. Section 503(c) limits bankrupt companies’ freedom to give management retention bonuses, severance payments, or other ancillary compensation. For instance, under the current regime, a company cannot pay managers retention bonuses unless it proves to a bankruptcy court that the managers both provide essential services to the reorganizing business and that they have alternative job offers in hand. Even then, the Bankruptcy Code caps the amount of the retention bonuses. Severance payments to managers are similarly restricted by Section 503(c).…Read more here.

[This article first appeared in the March 2013 issue of Financier Worldwide magazine. Copyright Financier Worldwide 2014 all rights reserved. Reprinted with publishers permission. www.financierworldwide.com]

The Evolution of European Insolvency Law: Part 1: The Heidelberg/Luxembourg/Vienna Report

Authors: Prof. Burkhard Hess (Luxembourg/Heidelberg), Univ.-Prof. Paul Oberhammer (Vienna/London/St. Gallen) and Prof. Thomas Pfeiffer (Heidelberg), summarized by team member Robert Arts

The first step towards the upcoming amendment of the European Insolvency Regulation was an evaluation of its application since its adoption in 2002. The Regulation itself required the evaluation to make sure that European Insolvency Law keeps up with the constant changes to the multitude of national insolvency regimes. A team from the Max Planck Institute Luxembourg (Hess), Heidelberg University (Pfeiffer), and the University of Vienna (Oberhammer) conducted the research and collected empirical data in all 26 concerned Member States.

The evaluation shows that the defining principle of the Regulation, that of universality (single proceeding and single insolvency statute with universal effect and recognition) has proven to be a great boon for the procedural handling of cross-border insolvencies in Europe. The report consequently proposes to further strengthen universality by reducing the possibility of separate, territorial proceedings.

Moreover, the report finds that widening the scope of application (by inclusion of pre-, hybrid and annex proceedings and by providing – for the first time ever – a framework for collaboration within group of company insolvencies), is necessary to keep the Regulation in line with the ongoing shift from liquidation towards the reorganization of companies.

The report also addresses technical difficulties arising from cross border insolvencies – e.g., the lodging of claims, the need for communication amongst judges and administrators and the information deficit of foreign creditors.

The entire report can be found here. Part 2 will cover the proposal for the amendment of the Regulation by the European Commission, which adopted many of the report’s suggestions.

Second Circuit Limits Availability of Chapter 15

Authors: Jasmine Ball, Richard F. Hahn, M. Natasha Labovitz, George E.B. Maguire, Shannon Rose Selden, My Chi To, Michael E. Wiles, Debevoise & Plimpton LLP

In a recent opinion on an issue of first impression in Drawbridge Special Opportunities Fund LP v Barnet (In re Barnet), 2013 WL 6482499 (2d Cir. Dec 11, 2013), the United States Court of Appeals for the Second Circuit held that foreign entities seeking recognition under Chapter 15 of the Bankruptcy Code must, in addition to satisfying the requirements for recognition set forth in that chapter, have a residence, domicile, place of business or assets in the United States.  The Second Circuit’s decision reversed an earlier Bankruptcy Court ruling that granted recognition under Chapter 15 to an Australian company that had not introduced evidence of any assets or operations in the U.S. and conflicts with a recent ruling of the Bankruptcy Court for the District of Delaware in In re Bemarmara Consulting a.s., Case No. 13-13037 (KG) (Bankr. D. Del. Dec. 17, 2013), holding that a Chapter 15 debtor is not required to have assets in the U.S.  In so doing, the Second Circuit has added an additional barrier to Chapter 15 recognition, which could be problematic for foreign companies looking to benefit from the advantages of the U.S. bankruptcy system.  For additional detail on the Second Circuit’s decision, see Second Circuit Limits Availability of Chapter 15.

Preference Recovery: You May Be More Exposed Than You Think

posted in: Avoidance | 0

Author: Vicki R. Harding, Pepper Hamilton LLP

Imagine a $2 million property that secures a $1.75 million senior loan and a $500,000 junior loan.  The owner files bankruptcy, and during the 90 days prior to bankruptcy the senior lender received payments totaling $250,000.  Does the senior lender have preference exposure?

A typical assessment is that because the senior lender is over-secured, it did not receive a preference because it did not receive more than it would have in a chapter 7.  However, it can be argued that the payments constitute a preference to the junior lender since it will receive more than in a chapter 7 as a result:  Without the payments, only $250,000 would be left after payment of the senior lender, but with the payments, $500,000 is left.  And the senior lender could be liable in a recovery action as the transferee of the preference under Section 550.

But wait, isn’t that a Deprizio argument, and didn’t Congress fix the Code to preclude this result? The answer is no: Deprizio and Section 550(c) address transfers benefitting insiders made between 90 days and a year prior to bankruptcy.  It does not protect a lender for claims based on transfers made during the 90 days prior to bankruptcy.  Unfortunately for senior lenders, this is not a fanciful hypothetical, but rather the approach taken in Gladstone v. Bank of America, N.A. (In re Vassau), 499 B.R. 864 (Bankr. S.D. Cal. 2013), discussed more in Preferences:  Surprise – Being Fully Secured May Not Be A Complete Defense.

 

Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain

posted in: Cramdown and Priority | 0

Post by Frederick Tung, Professor at Boston University School of Law

In “Breaking Bankruptcy Priority:  How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, Mark Roe and I question the stability of bankruptcy’s priority structure and suggest a new conceptualization of bankruptcy reorganization that challenges the long-standing creditors’ bargain view. Bankruptcy scholarship has long conceptualized bankruptcy’s reallocation of value as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of statutory and agreed-to contractual priorities.

In “Breaking Priority,” we propose an alternative view. No hypothetical bargain is ever fully fixed because creditors continually attempt to alter the priority rules, pursuing categorical rule changes to jump ahead of competing creditors. These moves are often successful, so creditors must continually adjust to other creditors’ successful jumps. Because priority is always up for grabs, bankruptcy should be reconceptualized as an ongoing rent-seeking contest, fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps.

We highlight a number of recent and historical priority jumps. We explain how priority jumping interacts with finance theory and how it should lead us to view bankruptcy as a dynamic process. Breaking priority, reestablishing it, and adapting to new priorities is part of the normal science of Chapter 11 reorganization, where bankruptcy lawyers and judges expend a large part of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.

The paper is available here.

Buyer Beware: Courts Put Claims Trades Under a Microscope

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By Rick Antonoff, Mark Pesso, Timothy Bennett and Leah Edelboim, Clifford Chance US LLP

Recent decisions on claims trading in bankruptcy cases further develop the Second Circuit’s seminal ruling in Dish Network Corp. v.  DBSD North America, Inc. that if the primary motive for a secondary market purchase of bankruptcy claims is control of the Chapter 11 process, cause may exist to “designate,” or not count, the votes cast by the purchasers in connection with a Chapter 11 plan.  Read together, these decisions demonstrate the willingness of courts to scrutinize secondary market claim transactions when determining disputes over classification, treatment and, ultimately, the value claims purchasers realize on account of purchased claims.

In our Client Memorandum we discuss four decisions issued in the last year as additional examples of courts examining claims transfers under a microscope.  A Third Circuit Court of Appeals decision affirmed that the purchaser of trade claims is subject to the defenses that a debtor would have against the original creditor.  In another case, the bankruptcy court permitted the debtor to treat a claim differently solely because the claim was assigned to a secondary market purchaser.  A Ninth Circuit appellate panel ruled that insider status does not travel with a claim that is assigned.  And finally, a court sustained a debtor’s objection to an assigned claim because the assignee was unable to produce sufficient evidence of its right to assert the claim.

These cases show that courts increasingly look into relationships between the parties and their respective motives when deciding how purchased claims are treated.  The full Client Memorandum is available for download here.

The Ownership and Trading of Debt Claims in Chapter 11 Restructurings

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By Victoria Ivashina, Ben Iverson, and David C. Smith

The role that active investors play in Chapter 11 reorganization is hotly debated in bankruptcy circles. In our paper, “The Ownership and Trading of Debt Claims in Chapter 11 Restructurings,” we collect comprehensive data on individual claims for 136 large firms that filed for Chapter 11 protection to empirically test how active investors might influence the bankruptcy process. Our data allows us to observe the identities of over 77,000 claimants and precisely measure both ownership concentration as well as claims trading for these cases.

We find evidence that firms with more concentrated capital structures are more likely to enter bankruptcy with pre-negotiated or pre-packaged bankruptcy plans, suggesting that negotiations are easier when creditors are not dispersed. In addition, even if they do not have a pre-packaged plan, firms with more concentrated ownership tend to exit bankruptcy more quickly and are more likely to emerge from Ch. 11 intact rather than being sold or liquidated piecemeal.

In the second half of the paper, we turn to the question of how claims trading in bankruptcy affects the resolution of the case. We find that trading during bankruptcy tends to concentrate ownership even further, and that the bulk of claims purchasing is done by hedge funds and other active investors. Interestingly, as these active investors enter the capital structure the overall recovery rate for the case tends to decrease, suggesting that perhaps active investors shrink the size of the overall “pie” in their efforts to obtain a larger piece of it.

The full-length article can be found here.