Financially Distressed Companies, Restructuring and Creditors’ Interests: What is a Director to Do?

By Andrew Keay (University of Leeds)

Out of court restructuring is a popular and, according to many, optimal way of resolving the circumstances of insolvent companies in the UK, and probably more so since the advent in the UK of the Enterprises Act 2002. One concern that some commentators have raised is the fact that the opportunities to engage in such restructuring are likely to be reduced given the way that the courts have approached claims that directors who have initiated restructuring strategies are liable for breach of duty in failing to take into account the interests of company creditors when their company is insolvent or near to it (as applied by section 172(3) of the Companies Act 2006 in the UK). Allied to this is the concern that if directors are not granted freedom to use their discretion in entering into a restructuring process companies might be placed into administration or liquidation when they have some prospect of continuing to trade and to do so profitably, because directors may choose to be risk averse in placing a company into administration or liquidation rather than take the risk of being held liable for breach of the duty if they attempt restructuring. This paper examines whether the aforementioned concerns are realistic, given the law, and, if they are, what directors should be doing to ensure that they do not breach the obligation in relation to creditors. These are important issues as little consideration has been given in the UK to the issue of liability of directors for breach of duty in the wake of a restructuring. The issues are considered in light of section 172(3) of the Companies Act 2006 which makes the director’s duty to promote the success of the company for the benefit of the shareholders (as under section 172(1) and providing for what is known as ‘enlightened shareholder value’) subject to any rule of law that requires directors to consider the interests of creditors. It is a rule of law in the UK (and in many Commonwealth countries and Ireland) that when their company is insolvent or in dire financial distress directors must take into account the interests of creditors.

The paper finds that while directors might be subject to liability in entering into restructuring attempts, this is only going to occur in limited cases and so there should not be particular concern over liability. This is because first of all courts will not hold directors liable if they acted in good faith and took into account the interests of creditors, and regarded these interests as paramount in their considerations. Even if the directors failed to take into account the interests of creditors or failed to make them paramount, they will not be liable where the court finds that the honest and intelligent director, taking into account creditors’ interests, would have entered into the restructuring in any event on the basis that it would benefit creditors. Obviously if directors restructure in such a way as to benefit themselves or specific creditors, or they have improper motives, then liability is more likely to ensue. But, where the directors have acted reasonably then they should be safe from challenge.

The full article is available here.

Disruption and Credit Markets

By Bo Becker (Stockholm School of Economics) and Victoria Ivashina (Harvard Business School)

Corporate bond defaults have been on a long and powerful upward trajectory in the past few decades. The default rate of U.S. corporate bonds rose from 0.12 percent to 0.46 percent between the first and second halves of the period from 1970 to 2016—an increase of almost four times. The rating agency Moody’s reports that, of the ten years with the highest default rates since 1960, six occurred in the new millennium and none before 1990. In a recent working paper, we investigate the role of disruption in explaining this trend.

By disruption, we refer to the process whereby new firms replace old firms using innovations in their business models, operations, or new technology. This process causes incumbent firms to lose market share, suffer reduced profitability, and, as we demonstrate, default on debt obligations. Just to name a few of the many recent examples: single-location bookstores were disrupted by chain stores, which were in turn disrupted by online bookstores, and off-line travel agents were disrupted by online services.

In our study, we compare industries with high rates of arrival of new firms, measured as either venture capital investments in the sector over the last five years or as the fraction of public firms in the industry with an IPO date in the past five years. The two variables capture different stages of disruptors’ ascent. While one can easily think of several broad forces that have increased innovation and disruption over the past few decades, different industries have been affected at different speed and different depth. We exploit this variation to draw the connection between disruption and defaults.

Our measures of disruption positively predict future defaults on corporate bonds, controlling for a host of other factors (including time, industry, bond characteristics such as seniority and callability, and issuer characteristics such as credit rating). These bonds are largely issued by mature firms (startups rarely access the bond market). Not only are future defaults higher in industries with high rates of disruption, but the bond market prices this in: newly issued bonds in high-disruption industries have higher yields. These findings are surprising, as a reasonable expectation might be that firms in the same industry would generally suffer similar fates. We would then expect to see high rates of new firm creation coupled with low defaults on the debt (of incumbents). Instead, we find the opposite.

An active IPO market and elevated venture capital investment may help the inception and advancement of potential disruptors, but underlying causes may be found in technological shifts (information technology, mobile, and ,in an earlier era, perhaps electricity), deregulation (think airlines), and globalization (in our data, industries directly exposed to off-shoring are no more likely to see defaults; however, global markets may have an important role in scaling up the opportunities available for disruptive businesses).

The importance of disruption probably extends beyond creditors to other stakeholders of incumbent firms. The corporate bond market is useful for studying disruption because bonds are liquid securities with detailed, high-quality data. Furthermore, losses on corporate bonds are important because bonds are widely held. This is in contrast with the gains from disruption, which tend to be concentrated with entrepreneurs and venture capital investors.

Disrupting Secured Transactions: Should UCC Article 9 Be Revised to Reflect the Rise of the Internet of Things?

By Christopher G. Bradley (University of Kentucky College of Law)

The “Internet of Things” (IoT) refers to the networks formed by interconnected devices that can communicate, and be communicated with, remotely. The IoT has already affected our daily lives, as a crucial part of our smart phones, Fitbits, smart watches, car navigation units, and so on.  But even more, it has profoundly affected businesses of every sort.  Manufacturing, transportation, and utilities firms alone are estimated to have spent more than $347 billion on IoT technology in 2018. Companies have deployed IoT tools in order to automate operations, streamline supply chains, ease regulatory compliance, and facilitate safer and more reliable production.

The IoT also affects secured creditors’ ability to monitor their collateral. For instance, individual tags can be placed on objects as they are checked in and out of a facility; cameras and temperature sensors can assess warehouse or field conditions to protect against loss or theft; vehicles can be tracked at all times and even remotely disabled upon default.

I argue that just as the rise of the IoT represents a revolution in business practice, it should bring a similar one to UCC Article 9. The article argues that Article 9 should allow–and in fact require–creditors to stake their claims in tangible collateral directly rather than through the now-antiquated means of a filing system routed through the debtor’s name/identity.

The proposed system would require creditors to tag items as collateral, or to use an interactive map administered by the state filing office over the Internet, in order to perfect security interests in tangible collateral. After sketching the proposed system, the article considers some of its major costs and benefits.

The full article is available here.

Absolute Priority Redux: First-Day Orders and Pre-Plan Settlements in Chapter 11 Post-Jevic

By Bruce Grohsgal (Delaware Law School Widener University)

Bankruptcy’s absolute priority rule arose 150 years ago to prevent insiders from using their control over an enterprise – often coupled with hypothetical valuations, contrived sales, and collusion with other parties – to obtain a greater distribution or “control premium” from estate assets.  This premium came at the expense of parties who had a higher distributional priority but were not “in on the deal.”  The Supreme Court again considered this issue in Jevic in 2017, when it held that a chapter 11 case-ending settlement called a “structured dismissal” must comply with the same absolute priority rule that applies to the similarly case-ending confirmation of a chapter 11 cramdown plan.  The Court emphasized that insider control and collusion can endanger bankruptcy’s core principle of an orderly distribution in accordance with statutory priorities.

The Jevic Court explicitly left open, though, the extent to which a pre-plan settlement or court-ordered “first-day” distribution in chapter 11 may deviate from the absolute priority rule.  It suggested only that a court approving these pre-plan distributions must show some respect for – or a “proper solicitude” to – the statutory distributional priorities.

I propose in this paper that, for a proposed pre-plan, priority-skipping settlement with an insider, secured lender or other party who exercises some control over the debtor, the absolute priority rule is sufficiently respected when a bankruptcy court subjects to an auction the claim proposed to be settled.  If at the auction, a third party bids the same or a higher price for the claim absent the priority-skipping, then it will be clear that the initially proposed transaction included a control premium.  If instead a higher third-party bid is not obtained, it will be clear that the settling insider is not paying a discounted settlement price based on its control and that the priority-skipping has a legitimate basis that does not implicate the problem of insider control.  The auction, by displacing suspect hypothetical valuations, can address the precise mischief sought to be remedied by the absolute priority rule.

I further contend that a market test for a “first-day” distribution to a critical vendor, employee or other creditor that is challenged as priority-skipping will be limited to whether the debtor sought and failed to obtain in the market the same good, service, or credit from an alternative supplier on the same or better terms than those proposed in the first-day motion.  The reason for this is simple – a bankruptcy court will not be able in most cases to obtain, at the time of the first-day hearing, a market determination of case-ending distributions to creditors.  Any hypothetical valuation at a first-day hearing of the end-of-case distributions to creditors will be highly unreliable.  Because of these obstacles, I suggest that the question of whether a first-day payment will comport with end-of-case distributional priorities should be replaced with the question of whether the debtor sought and failed to obtain an alternative supply in the market on the same or better terms, and by a rebuttable presumption that preserving the going concern value of the chapter 11 debtor likely will benefit even the disfavored creditors.  This approach – which essentially adopts the occasionally maligned “doctrine of necessity” and rejects the Seventh Circuit’s Kmart rule – recognizes the disturbing weakness of a hypothetical determination, made at the first day hearing, of end-of-case distributions in a chapter 11 case.

The full article is available here.