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

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Editor’s Note:  Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain, by Mark Roe and Fred Tung, was selected as one of the ten Best Corporate and Securities Articles of 2014. This “10-best” list reflects the choices of academic teachers in this area from more than 560 articles published last year. The article was the subject of a Bankruptcy Roundtable post on April 8, 2014 at its time of publication. It was the only bankruptcy-based article on the “10-best” list. That list can be found here.

By Mark Roe, Harvard Law School, and Frederick Tung, Boston University School of Law

Roe 124tungprofileIn “Breaking Bankruptcy Priority:  How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, we question the stability of bankruptcy’s priority structure. 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 among creditors is ever fully fixed because creditors continually seek 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.

A Third Way: Examiners As Inquisitors

By Daniel J. Bussel, UCLA School of Law

BusselThere is a buzz concerning bankruptcy examiners. Recently in such cases as ResCap, Dynegy and Tribune, and perhaps now in Caesars, examiners have played a decisive role in resolving major Chapter 11 cases involving avoiding power claims.

“Litigate or settle” is the dispute resolution choice generally available in US bankruptcy courts. But there is another way: An inquisitorial model of justice in which an active and informed neutral investigates the facts and then assesses and applies the law to resolve a legal dispute. Chapter 11 examiners are peculiarly suited to introduce this inquisitorial process into a Chapter 11 case. In particular, Ken Klee, serving as examiner in the Tribune case, and a series of post-Tribune investigations show that inquisitorial methods make sense in certain large bankruptcy cases involving complex legal disputes (rather than financial or operational problems). Indeed Tribune and its progeny suggest that the inquisitorial experiment has already begun.

A Third Way: Examiners As Inquisitors looks at examiner methodologies in Tribune and the few post-Tribune examiner cases. It assesses the method’s comparative advantages (fact-finding accuracy, nonpartisan experts, freedom from artificial evidentiary constraints, transparency and legitimacy) and disadvantages (lack of finality, expense, delay, risks to reorganization efforts, risk of overzealousness, due process concerns) and suggests that in the absence of a countervailing business exigency demanding exclusive focus on reorganization, the Tribune model may offer a superior alternative for resolving contested avoidance claims. Indeed, large Chapter 11 cases may be an ideal proving ground for inquisitorial methods more broadly.

For more see A Third Way: Examiners As Inquisitors, 90 Am. Bankr. L. J. __ (forthcoming 2016), available here.

Bankruptcy Examiners in Chapter 11

By Jonathan C. Lipson, Temple University—Beasley School of Law, and Christopher Fiore Marotta, KPMG

Lipson MarottaBankruptcy examiners have long been a controversial feature of chapter 11—and remain so in recent cases such as Caesars Entertainment. Section 1104 of the Bankruptcy Code requires one if sought in large cases ($5 million+ in debt) or if “in the interests of creditors.” Congress created the position as a check on the reorganization process, since neither the SEC nor trustees typically provide oversight. Yet, system participants grouse about their costs and potential to disrupt negotiations. The ABI’s reform proposal would eliminate them.

In a recent paper, we study their use in a sample of 1225 chapter 11 cases from 1991-2010. We find that, despite the Code’s “mandatory” language, examiners are exceedingly rare, being sought in about 9% and appointed in 4% of cases. About half were very large cases, with far more than $5 million in debt, so most requests should have been granted—but they weren’t. The factors that Congress thought should matter most—such as fraud or incompetence—don’t.

What predicts whether an examiner will be appointed? Timing and location: an early request in a case outside Delaware is nearly twice as likely to be granted than otherwise. Yet, contrary to conventional wisdom, we also find that examiners correlate to better outcomes, including in post-bankruptcy earnings and headcounts.

We explain why examiners are so rare, and suggest a way to use them more frequently and economically.

For the full article see here.

Supreme Court Permits Bankruptcy Courts to Issue Final Judgments with Parties’ Consent

By Harold S. Novikoff, Douglas K. Mayer, Ian Boczko, Emil A. Kleinhaus, and Alexander B. Lees of Wachtell, Lipton, Rosen & Katz

The Supreme Court’s latest decision regarding the power of bankruptcy judges to resolve claims between bankruptcy estates and their creditors is Wellness International Network, Ltd. v. Sharif, handed down on May 26, 2015. In its landmark 2011 ruling in Stern v. Marshall, the Court held that bankruptcy judges have limited authority under Article III of the Constitution to determine claims asserted by an estate against creditors. However, Stern left open the question, which has split lower courts, whether parties can nonetheless consent to bankruptcy court adjudication. In Wellness, the Supreme Court held that bankruptcy litigants may waive Article III rights, and suggested that parties may forfeit untimely objections to a bankruptcy court’s lack of authority.

For a fuller analysis and summary, click here for our memo on Wellness.

Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio

By Mark J. Roe, Harvard Law School, and Stephen D. Adams, Ropes & Gray LLP

adams-stephen-200 Roe 124Lehman Brothers’ failure and bankruptcy led to the deepest part of the 2008 financial crisis. Yet, while Congress reformed financial regulation in hopes of avoiding another crisis, bankruptcy rules, such as those that governed Lehman’s failure, have persisted unchanged. When Lehman failed, it lost perhaps tens of billions of dollars of further value when its contracting counterparties terminated their financial contracts with Lehman.

Bankruptcy must be able to market salable parts of the failed institution’s financial contracts portfolio at other-than-fire-sale prices. Current law prevents this marketing, however. It allows only two polar choices: sell the entire portfolio intact (currently impossible in bankruptcy and only narrowly viable under Dodd-Frank) or allow for the liquidation of each contract, one-by-one (which worked poorly in Lehman). Bankruptcy needs authority, first, to preserve the failed firm’s overall portfolio value, and, second, to break up and sell along product lines a very large portfolio that is too large to sell intact.

Congress and the regulators favor bankruptcy for financial resolution. Yet, bankruptcy law has neither been fixed nor even updated here since the financial crisis. We here outline one critically needed fix: authorizing bankruptcy to break up a large derivatives portfolio by selling its constituent product lines, one-by-one, instead of a Lehman-style close-out of each contract, one-by-one.

This article is forthcoming in 32 Yale Journal on Regulation. A full draft of the article can be found here.

For related pieces discussing safe harbors, see here and here.