Bankruptcy’s Endowment Effect

posted in: Cramdown and Priority | 0

By Anthony J. Casey (University of Chicago Law School)

The notion of endowments and entitlements has a powerful effect on corporate bankruptcy policy. Scholars and lawyers generally assume a creditor endowed with a right outside the bankruptcy system must receive the equivalent of that right when its debtor is within the bankruptcy system. Proponents of this idea often assert that the result is required by the foundational theory of bankruptcy.

In a forthcoming essay, “Bankruptcy’s Endowment Effect,” I demonstrate that this is false. The idea of sacred creditor endowments is an untenable position that misunderstands the fundamental principles of bankruptcy. Corporate bankruptcy is, at its core, a system that alters nonbankruptcy endowments according to a hypothetical bargain that all creditors of a firm would have entered if bargaining were costless. The entire point of that hypothetical bargain is to suspend and alter some nonbankruptcy endowments to maximize the value of the bankruptcy estate and the firm as a whole. Indeed, if every stakeholder retained all of its nonbankruptcy endowments, the Bankruptcy Code would have no provisions at all.

Of course, altering nonbankruptcy endowments can impose costs. Foremost among those costs is the risk of opportunistic behavior that is costly for the estate as a whole. Bankruptcy policy will, therefore, be designed to maximize estate value while minimizing opportunistic bankruptcy behavior. Thus, the guiding principle for optimal bankruptcy design should be not the preservation of nonbankruptcy rights but rather the minimization of opportunistic behavior that reduces the net value of a firm.

With that principle in hand, we can resolve many difficult questions of bankruptcy policy. In the essay, I focus on applying the principle to the debate over what interest rate a senior creditor should get in a chapter 11 cramdown. In particular, I analyze the dispute in In re MPM Silicones, LLC (“Momentive”), where the bankruptcy court mistakenly reached its final decision by importing a creditor-endowment framework from consumer bankruptcy law (where the framework might make more sense). I show that an optimal rule for corporate bankruptcy supports a cramdown interest rate based on the prevailing market rates for similar loans, which reduces the risk of opportunistic behavior by both debtor and creditor.

Second Circuit Rules on § 316(b) in Marblegate

posted in: Workouts and Pre-Packs | 0

Last week, the Second Circuit decided Marblegate Asset Management, LLC v. Education Management Corp., holding that § 316(b) of the Trust Indenture Act (“TIA”) protects only bondholders’ formal, legal right to repayment, not their practical ability to recover. The Second Circuit’s 2–1 decision thus resolves uncertainty surrounding out-of-court bond workouts and returns to the pre-Marblegate practice.

The majority viewed the statute’s text as ambiguous and consulted the legislative history; it emphasized legislative history supporting the idea that § 316(b) protects only against the formality of a bondholder vote altering payment terms and discarded legislative history to the contrary as shards. The dissent concluded that the transaction “annihilated” a bondholder’s right to payment and, hence, ran afoul of statute’s plain language — which requires that a bondholder’s right to payment cannot be affected or impaired without the affected bondholder’s consent.

Law firms reacted rapidly to the decision. Wachtell Lipton, which represented the winning appellant, and Weil Gotshal both extoll the opinion. Paul, Weiss and Morgan Lewis see in the decision a clear rule that bars only express changes to core terms. Several firms, such as Shearman & Sterling and White & Case, emphasized that the decision will facilitate out-of-bankruptcy restructurings.

Squire Patton Boggs highlights limitations, arguing that the law remains “neither clear nor predictable” on when an out-of-court restructuring goes so far as to impair bondholders’ right to repayment. They caution against assuming that any action short of a direct alteration of core repayment terms is now permissible.

In his American Bankruptcy Institute column, Bill Rochelle notes that the decision’s focus on legislative history, including views contemporaneous with the statute’s passage, was unusual and, by implication, indicates that the dissent’s textual decision-making mode fits better with current Code interpretation. Seyfarth Shaw notes the decision’s limited practical effect because of the widespread use of binding votes in pre-packaged Code restructurings, which avoid § 316(b)’s restrictions.


The Roundtable has posted previously on Marblegate and § 316(b). In one post, Mark Roe argued that bondholders should not be barred by statute from choosing in their indenture whether to be allowed to reposition their bonds via a fair vote. Other posts include a summary of the National Bankruptcy Conference’s proposed amendments to the Bankruptcy Code to facilitate bond restructuring; a 28-law firm legal opinion white paper on transactional complications arising from the Marblegate district court decision; and an international perspective on the TIA’s prohibition on collective action clauses.

The Future of UK Debt Restructuring

By Jennifer Payne (University of Oxford – Faculty of Law)

In the UK, a number of different mechanisms exist which can be used to restructure the debt of viable but financially distressed companies. This paper assesses the debt restructuring mechanisms currently available to companies in English law and considers whether reform is needed. In particular, the paper analyses the reform proposals put forward by the UK Insolvency Service in July 2016, which recommended: (i) the introduction of an option to cramdown whole classes of creditors using a single restructuring mechanism (something which can only be accessed at present using a scheme of arrangement combined with administration); (ii) the introduction of a restructuring moratorium akin to that which is attached to administration at present, together with a new ability for companies to prevent creditors with “essential contracts” from terminating them on the basis of insolvency alone; and (iii) the introduction of provisions designed to facilitate debtor-in-possession financing, something notably absent from the current UK regime. These reforms will need to be introduced with skill and care in order to ensure that the potential benefit they can bring to financially distressed businesses is balanced appropriately with the constraints that they impose on existing creditors’ rights. The aim of the Insolvency Service’s proposals is laudable, and it is argued that reform of the UK regime is needed. In particular, the introduction of a restructuring moratorium and a cramdown facility would be beneficial. Making these changes would provide English law with a stronger and more effective debt restructuring procedure. Furthermore, such changes are required if the UK wants to remain competitive in a global market.

The full article is available here.

The Sun Is Setting: Is It Time to Legislate Pre-Packs?

By John Wood (Lancashire Law School, University of Central Lancashire)

In the UK, pre-packaged administrations (“pre-packs”), while few in number, receive widespread attention due to the controversial outcomes that they often produce. The pre-pack process seems to have gained much exposure in recent years, but it is by no means a new concept. The negative reputation that pre-packs have resides with the lack of transparency that surrounds the process, in addition to connected parties purchasing the old company. Such an outcome leaves many creditors frustrated with both the lack of information received and the diminutive monies recovered for what they are owed.

Due to the sustained criticism of pre-packs, the British government reviewed the process to detect weaknesses in the UK’s company law framework and to ensure that the UK remained a competitive and attractive place to conduct business. This led to the Graham Review (“Review”), which made six recommendations that have since become somewhat essential to the survival of pre-packs as a non-legislative procedure. Ministerial pronouncements have put the profession on notice that, unless they take proper steps to produce substantial compliance with the Review’s findings, then legislative power will be exercised. While no further action has been taken, the Review appears to have attracted widespread support. The Review proposes non-legislative action, but the article examines whether, over time, legislation will become inevitable. What is therefore required is a balanced evaluation and critique of the Graham proposals—one that is capable of providing some form of yardstick against which to test the quality of any legislative initiatives which may be taken in the future.

The full article, published in 67 Northern Ireland Legal Quarterly 173 (2016), is available here.

Recharacterization of Debt as Equity in the Fourth Circuit

posted in: Cramdown and Priority | 0

By Gabrielle Glemann (Hughes Hubbard & Reed)

In an unpublished opinion in August, In re Province Grande Old Liberty, LLC, Case No. 15-1669, 2016 WL 4254917 (4th Cir. Aug. 12, 2016), the Fourth Circuit Court of Appeals shed some light on the circumstances under which a court may recharacterize debt as an equity investment, effectively subordinating the claim.  The issue before the Fourth Circuit was not one of first impression — the Fourth Circuit had long recognized that a bankruptcy court’s equitable powers include “the ability to look beyond form to substance,” and had previously articulated the factors to consider in evaluating a request for recharacterization. See Fairchild Dornier GMBH v. Official Comm. of Unsecured Creditors (In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc.), 453 F.3d 225 (4th Cir. 2006). The Fourth Circuit decision is notable however, because the court looked beyond the facts giving rise to the underlying claim at issue and ultimately to the economic substance of the entire context of the transaction.  In Province, the creditor whose claim was at issue was a company owned by insiders of the debtor.  The creditors’ claim was based on a loan that was used by the debtor to settle other obligations.  The court held that the settlement agreement was the “substance of the transaction” and a basis for recharacterization, notwithstanding the fact that the creditor was not a party to the settlement agreement.

The full memo is available here.

Beyond Options

posted in: Cramdown and Priority | 0

By Anthony J. Casey (University of Chicago Law School) and Edward R. Morrison (Columbia Law School)

Scholars and policymakers now debate reforms that would prevent a bankruptcy filing from being a moment that forces valuation of the firm, crystallization of claims against it, and elimination of junior stakeholders’ interest in future appreciation in firm value. These reforms have many names, ranging from Relative Priority to Redemption Option Value. Much of the debate centers on the extent to which reform would protect the non-bankruptcy options of junior stakeholders or harm the non-bankruptcy options of senior lenders. In a new paper, “Beyond Options,” we argue that this focus on options is misplaced. Protecting options is neither necessary nor sufficient for advancing the goal of a well-functioning bankruptcy system. What is needed is a regime that cashes out the rights of junior stakeholders with minimal judicial involvement. To illustrate, we propose an “automatic bankruptcy procedure” that gives senior creditors an option to restructure the firm’s debt or sell its assets at any time after a contractual default. Under this procedure, restructuring occurs in bankruptcy, but sales do not. Sales are either subject to warrants (which give junior stakeholders a claim on future appreciation) or are subject to judicial appraisal (which forces senior lenders to compensate junior stakeholders if the sale price was too low). Our proposal can be seen as an effort to design a formalized restructuring procedure that borrows from traditional state law governing corporate-control transactions. We show that this procedure minimizes core problems of current law—fire sales that harm junior stakeholders, delay that harms senior lenders, and the uncertainties generated by judicial valuation, which are exploited by all parties.

The full paper is available here.