Corporate Governance, Bankruptcy Waivers and Consolidation in Bankruptcy

By Daniel J. Bussel (UCLA School of Law)

Bankruptcy law—once the vanguard of enterprise liability —has increasingly tended to kowtow to formalities of corporate law standing in the way of effective reorganization.

In two areas in particular, corporate law is seen by some courts and commentators as imposing rigid and substantive limitations on bankruptcy rights.

First, although bankruptcy courts have long held that access to bankruptcy relief may not be waived in a contract, recent decisions have enforced state corporate law’s choice to defer to contractual governance arrangements baked into corporate charters that hinder or preclude an entity from filing for bankruptcy relief.

Second, influential appellate decisions have pushed bankruptcy courts to respect the legal boundaries between affiliated entities within a corporate group for substantive insolvency law purposes, even as those boundaries are routinely ignored for operational, financial, tax and regulatory purposes.

Professors Baird and Casey, expanding upon earlier work by Professor LoPucki, have noted and embraced this judicial trend toward respecting corporate law formalities.  They have coined the term “withdrawal rights” to describe the phenomenon of prebankruptcy contractual arrangements enforceable under state corporate law that operate to allow a particular creditor to opt-out of the bankruptcy process by segregating key operating assets in entities that are effectively precluded from obtaining bankruptcy relief without the creditor’s express consent.

In CORPORATE GOVERNANCE, BANKRUPTCY WAIVERS AND CONSOLIDATION IN BANKRUPTCY, I argue that these techniques, however clever, run smack into traditional and still vibrant bankruptcy doctrines that find contractual waivers of access to bankruptcy relief void as against public policy, and that permit consolidation of entities whose formal separateness is inconsistent with the actual and effective operation of the corporate enterprise under reorganization.

Thus “Golden Share” arrangements in which a creditor is issued a special class of equity (the Golden Share) and the debtor’s charter is amended to preclude bankruptcy filing absent the Golden Shareholder’s consent, fail as unenforceable contractual waivers of bankruptcy rights.

Moreover, constituents with claims against affiliated companies in bankruptcy proceedings that effectively operate as a unified enterprise should not be surprised when they are treated as a claimant against that unified enterprise, except to the extent that the bankruptcy equities themselves demand otherwise, and so long as the value of their rights in property are adequately protected, even if the formalities of entity separateness are otherwise respected.  The restrictive approach to substantive consolidation adopted by some appellate courts, notably the Third Circuit in Owens-Corning, that encourages reliance on formal entity separation, should be rejected.

Bankruptcy courts are destined to struggle with the problem of withdrawal rights forever. Powerful creditors have never fully accepted the concept that they can be compelled to participate in a collective proceeding in the event of the common debtor’s insolvency and have sought ways to opt out of those proceedings when it is to their advantage to do so. They show no signs of flagging in efforts to structure bankruptcy-remote relations through statutory exceptions and preferences, the creation of property rights in their favor, and contractual strictures. If they have the political strength to carve out express exemptions in the Bankruptcy Code, courts may have little flexibility to prevent the opt-out.

But absent a federal statutory exemption, to the extent that state law corporate formalities manipulated to the advantage of certain constituencies through special contractual arrangements become impediments to effective bankruptcy reorganizations, those formalities are quite properly overridden by bankruptcy law.  Bankruptcy law limits the efficacy of the “Golden Share” and other contractual arrangements incorporated into company charters, and the entity partition techniques observed by LoPucki, Baird and Casey (among others).  Those limits should be factored into market expectations surrounding asset securitization and other structuring techniques designed to avoid the ordinary operation of bankruptcy law upon a particular creditor’s claim. If they are properly factored in, it is difficult to believe that securitization of core assets of non-financial operating companies will remain a cost-effective alternative to more traditional financing arrangements. The market should place little value on a bankruptcy withdrawal right that is likely to prove illusory when it matters most.

The full article is available here.

Bankruptcy’s Cathedral: Property Rules, Liability Rules, and Distress

By Vincent S.J. Buccola (University of Pennsylvania – The Wharton School)

What good can a corporate bankruptcy regime do in the modern economy? The question bears asking because the environment in which distressed companies find themselves is so markedly different from the environment of just twenty years ago—to say nothing of the days of the equity receiverships, of sections 77 and 77B, of Chapters X and XI. The most important changes are well known: increased depth and liquidity of financial markets and, especially, increased capacity of financial contracting to say ex ante how distress will be resolved ex post. Recent efforts to take stock of contemporary bankruptcy practice, most notably the ABI’s Chapter 11 reform project, grapple implicitly with the significance of a changing environment. But by leaving the matter implicit, they underscore a lacuna about what the law’s marginal contribution to the economic order might be.

In a forthcoming article, Bankruptcy’s Cathedral, I hazard a general answer and elaborate its implications for a few prominent uses of bankruptcy in today’s practice.

The characteristic function of bankruptcy law, I say, is to recharacterize the mode in which an investor’s relationship to a distressed firm is governed. In particular, bankruptcy frequently toggles the protection of an investor’s economic interests from a property rule, in the Calabresi and Melamed sense, to a liability rule. It swaps out the investor’s unilateral right upon default to withdraw her investment, when such a right would ordinarily prevail, in favor of a judicially mediated procedure designed to give her the official value of her right. The automatic stay furnishes an example. It extinguishes a secured creditor’s power to repossess and sell collateral, and supplies instead a right only to what the bankruptcy judge determines to be “adequate protection” of its interest in the collateral.

This toggling function can be useful, Property rules are often more efficient during a company’s financial health than during distress. A state-contingent meta rule that switches between the two thus might be optimal. But what about financial contracting? Why can’t investors stipulate state-contingent meta rules if indeed they can maximize surplus by doing so? The short answer is that in some cases contract is sufficient, but in other cases legal or practical impediments are insuperable. The marginal contribution of bankruptcy law, then, is to supply toggling rules where investors cannot practically do so on their own.

One implication of my approach is to index the justifiable scope of bankruptcy to contingent facts about the efficacy of financial contracting. In environments where it is difficult for investors to specify state-contingent toggling rules, whether because of legal prohibition or practical impossibility, the compass for bankruptcy law is wider. As contract becomes more efficacious, bankruptcy’s brief grows correspondingly shorter.

This normative schema can be used to assess one-by-one the many actual interventions of bankruptcy laws. I scrutinize three uses of bankruptcy that are important in today’s practice: to confirm prepackaged plans, to effect going-concern sales, and to take advantage of the automatic stay. I find plausible justifications for a legal institution to bind holdout creditors and to extinguish in rem claims against a debtor’s assets. The automatic stay, on the other hand, is harder to justify. (The curious must read within to find out why.) More generally, though, my approach shows how one can weigh the contributions of a bankruptcy regime against its redundant or even counterproductive in light of contracting innovations.

The complete article is available for download here.

Bankruptcy Sales: Is A Public Auction Required to Assure That Property Is Sold for The Highest and Best Price?

By Vicki R. Harding (Vicki R. Harding, PLLC)

A buyer negotiating acquisition of commercial real estate from a Chapter 7 trustee or a Chapter 11 debtor-in-possession will almost always hear the mantra: “I have a fiduciary duty to maximize value for the benefit of the bankruptcy estate” – which the seller insists means the property must be sold through a public auction. The potential buyer may be designated as the stalking horse (e.g. its offer will be treated as an opening bid), and it may have input on the bidding procedures (bidder qualifications, minimum overbid, purchase price payment terms, etc.). But at the end of the day it runs a risk that after investing time and money in pursuing the acquisition someone else may be selected as having made a “higher and better” offer.

However, that is not always the case.  In re 160 Royal Palm, LLC, 600 B.R. 119 (S.D. Fla. 2019) presents an interesting case study. As discussed in Bankruptcy Sales: Highest Is Not Always Best, the bankruptcy court allowed a debtor to withdraw property from a previously authorized public auction and to proceed with a private sale to a designated buyer, subject only to an overbid by the stalking horse from the public auction. The court approved the private sale over the objection of a third party that claimed that in a public auction it would bid at least $1 million more than the private sale purchase price.

The full article is available here.

Rent Extraction by Super-Priority Lenders

By B. Espen Eckbo (Tuck School of Business at Dartmouth), Kai Li (Sauder School of Business at University of British Columbia) and Wei Wang (Smith School of Business at Queen’s University)

After filing for Chapter 11 bankruptcy, it takes large firms on average 16 months to restructure debt obligations and emerge as a going concern. With little cash on hand at filing, many firms need an infusion of new debt capital in order to fund continued operations while in bankruptcy. The standard debt instrument for this purpose is a debtor-in-possession (DIP) loan. Clearly, for a lender to be willing to supply a DIP loan, the loan must be fully collateralized and grant the lender extensive control rights. With an unprecedented large sample of DIP loan packages over the period 2002-2014 – totaling $120 billion in constant 2017 dollars – we first show that DIP loan contracts are fully collateralized, highly restrictive instruments. Our main research question is whether the interest rate on DIP loans reflects the actual risk of the firm defaulting on its DIP loan obligation. Our evidence on actual loan defaults strongly indicates that DIP loans are nearly risk-free, with only a single economic default (without full recovery) going back to 1988 (a default rate of 0.13% or lower). Nevertheless, loan spreads (the interest rate in excess of the London Inter-bank Offered Rate or LIBOR) average 604 basis points (bps), which exceeds even the average spread of even high-risk (“junk”) bonds. While desperate borrowers are willing to pay supra-competitive DIP loan prices, the central question is why competition among lenders fails to bring down DIP-loan spreads.

To answer this question, we first show that prepetition lenders dominate the supply of DIP loans (more than 70% of the cases). This is hardly surprising since, under §364(d) of the Bankruptcy Code, granting collateral to the DIP lender requires “priming” the lien of prepetition lenders, the debtor must obtain their consent. Moreover, a prepetition lender may “roll up” portions of the existing debt into the DIP loan package, which lowers the risk of the prepetition loan as well. By blocking the debtor’s access to DIP loans from new lenders, prepetition DIP-loan providers are in a strong monopolistic bargaining position vis-à-vis the debtor – resulting in opportunities for rent extraction. However, when collateralizing the DIP loan does not require priming prepetition lenders, the debtor may turn to new lenders such as hedge funds (HF) or private equity funds (PE). In these cases, it is reasonable to expect competition among the prospective DIP-loan providers to lower spreads. However, we find the opposite: While there is no evidence that DIP loans provided by new lenders face a greater risk of default, loans spreads are significantly higher.

It is possible that, notwithstanding the strong contractual protection afforded by DIP loans, there may be unobservable heterogeneity in the risk of firms seeking DIP loans that only a skilled DIP-loan provider is able to detect ex ante. If so, a high loan spread may be viewed as a return to the loan provider’s unique screening ability. We investigate this possibility by comparing spreads and fees in DIP loans on leveraged loans (“junk” debt). Presumably, the much longer maturities of leveraged loans (on average five years), combined with their much lower control rights and degree of collateralization, renders leveraged loans more risky than DIP loans. In fact, using Moody’s rating information, the typical spread on a B-rated leveraged loan has an expected default rate that is much higher than what we estimate for our DIP loan sample. Therefore, we expect leveraged loans that are supplied by sophisticated financial institutions to have higher spreads. Instead, we find the opposite: DIP-loan spreads are 236 bps higher than leveraged loans matched on size, industry and year of issuance, 255 bps (152 bps) higher than leveraged loans by the same firm within three years (one year) of filing.

Last, but not least, we show that junior claimholders (unsecured creditor committees and suppliers) file objections to the DIP-loan terms in as much as over 60% of the cases in our sample. Moreover, spreads are 80+ bps higher when objections occur, suggesting that high spreads are a concern. However, reading case files, we do not find a single case where the court lowered the loan spread (or fee). Although both the spirit and the letter of §364 require the terms of DIP-loans to be “fair, reasonable and adequate”, courts appear not to act as a backstop for what our data strongly suggest is significant extraction of economic rents by DIP-loan providers.

The full article is available here.