The Agglomeration of Bankruptcy

By Efraim Benmelech, Nittai Bergman, Anna Milanez, & Vladimir Mukharlyamov

In “The Agglomeration of Bankruptcy,” Professor Benmelech and his coauthors examine the spread of bankruptcy by analyzing the ways in which bankrupt firms impose costs on nearby non-bankrupt competitors. The authors argue that the normally positive economies of agglomeration created by stores in close proximity to one another can become detrimental during downturns. When a store is in distress, proximity works to amplify the negative effects of distress. The result is that retail stores in distress impose costs, such as decreasing sales, on nearby peers, which can ultimately lead to store closures and ultimately bankruptcy.

The authors use a novel and detailed dataset of all national chain store locations and closures across the United States from 2005 to 2010. The authors show that stores located in proximity to those of national chains that are liquidated are more likely to close themselves. Importantly, this effect is stronger for stores in the same industry as the liquidating national chain as compared to stores in industries different from that of the liquidating chain. Further, the geographical effect of store closures on neighboring stores is more pronounced in financially weaker firms.

For the full article, navigate here.

This summary was drafted by Robert Niles (J.D./M.B.A. ’16)

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The HLS Bankruptcy Roundtable will be off-line for the holidays. We will be back in January.

House Passes Financial Institution Bankruptcy Act

On December 1, 2014, the House of Representatives passed, with bipartisan support, H.R. 5421—the Financial Institution Bankruptcy Act of 2014 (FIBA), a bill that would amend the Bankruptcy Code to better allow for the resolution of systemically important financial institutions (SIFIs). FIBA (previously discussed in Roundtable posts here and here) is similar in many respects to the bankruptcy amendments proposed in another bill introduced in the Senate (previously covered here) and to the “chapter 14” proposal from the Hoover Institution, but there are some key differences among these proposals.

First of all, the Senate version would entirely repeal the Orderly Liquidation Authority (OLA), the current regulatory receivership alternative to traditional bankruptcy (and to some, the only current viable option) to resolve failed SIFIs. Both FIBA and the Hoover Institution’s version, however, would keep the OLA in place as an alternative.

Additionally, each proposal takes a different approach to the issue of federal funding in a SIFI resolution, which is provided in an OLA resolution. The Hoover Institution’s version does not explicitly provide for such federal funding, but it does contemplate it and condition it upon a showing that no private funding is available. FIBA is silent on the matter, and the Senate version explicitly prohibits it.

Lastly, both FIBA and the Senate proposal solely focus on facilitating a single-point-of-entry (SPOE) resolution of a SIFI, whereas the Hoover Institution’s proposal seeks to accommodate both an SPOE recapitalization and a conventional reorganization of a SIFI. An SPOE recapitalization would make debt and equity at the financial holding company take the brunt of losses, while substantially all of the holding company’s assets would be transferred to a new bridge institution and cash would be pushed down into shaky subsidiaries to prevent their bankruptcy. A conventional reorganization (or liquidation) of a SIFI would largely track traditional bankruptcy approaches, with the troubled subsidiaries entering bankruptcy.

These and other differences among the proposals are some of the most debated aspects in the SIFI resolution reform discussion. Moreover, which version (if any) ultimately passes through both houses of Congress and is signed by President Obama may set significant precedent in resolution regimes worldwide.

For previous HLS Bankruptcy Roundtable coverage of the viability and limits of an SPOE approach in bankruptcy, click here and here.

This post was composed by Stephanie Massman (J.D. ’15)

The Duty to Maximize Value of an Insolvent Enterprise

By Brad Eric Scheler, Steven Epstein, Robert C. Schwenkel, and Gail Weinsten of Fried, Frank, Harris, Shriver & Jacobson LLP

In the recent Delaware Chancery Court decision of Quadrant Structured Products Company, Ltd. v. Vertin (October 1, 2014), the Court clarified its approach to breach of fiduciary duty derivative actions brought by creditors against the directors of an insolvent corporation. Importantly, the Court applied business judgment rule deference to the non-independent directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy—even though the creditors bore the full risk of the strategy’s failing, while the corporation’s sole stockholder would benefit if the strategy succeeded. By contrast, the court viewed the directors’ decisions not to exercise their right to defer interest on the notes held by the controller and to pay above-market fees to an affiliate of the controller as having been “transfers of value” from the insolvent corporation to the controller, which were subject to entire fairness review.

This decision appears to stand for the proposition that, under all but the most egregious circumstances, the business judgment rule will apply to directors’ decisions that relate to efforts to maximize the value of an insolvent corporation. Thus, even decisions made by a non-independent board for a high-risk business plan that favors the sole equity holder over the creditors, as in Quadrant, will be subject to business judgment deference. The court also distinguished decisions involving direct transfers of value from the insolvent corporation to the controller, holding that these decisions would be subject to entire fairness review because the controller stood on both sides of such transactions.

See here for a more detailed discussion of this case.