A Functional Analysis of SIFI Insolvency

By Stephen J. Lubben (Seton Hall University School of Law)

Since the disgrace of Lehman, the question of how to handle failing SIFIs has been quite vexed.   On the one hand, governmental rescue of shareholders and other investors is beyond annoying, and there is some intuitive sense that if management does a poor job, they and their investor backers should face the consequences, just like any other firm.   That bank managers would have the temerity to pay themselves large bonuses shortly after a taxpayer rescue only emphasizes the point.

On the other hand, there is a widespread understanding that a large bank, or a sufficiently interconnected one, is not quite like Kmart, Enron, or even American Airlines, in that when the bank fails, it tends to take a large chunk of the economy along with it.   Pre-failure regulation can mitigate some of the effects, but by the time we get to insolvency—or “financial distress”—the regulatory string has pretty much played out.   And in the end, we have trouble deciding if we really mean to treat large financial institutions like normal failed firms.

In A Functional Analysis of SIFI Insolvency, I argue that we need to consider what it is that we are trying to achieve in a bank insolvency case, and how that compares with bankruptcy law in general.  Bank insolvency, I submit, is all about special priorities: both ordinal and temporal.  The Bankruptcy Code, on the other hand, takes an “equality is equity” approach to priorities as a baseline, mostly using state law to draw the claim-asset border.

Financial insolvency law expressly rejects this model; it instead is all about protecting some favored group from the effects of insolvency.   There is no equality here, and it was never intended that there would be equality.   And thus it is time to stop pretending SIFI insolvency is “normal” corporate insolvency but bigger.

The full article is available here.

Recent Developments in Bankruptcy Law, April 2018

By Richard Levin (Jenner & Block LLP)

The bankruptcy courts and their appellate courts continue to explore issues of interest to practitioners and academics. This quarterly summary of recent developments in bankruptcy law covers cases reported during the first quarter of 2018.

Most notable were two Supreme Court decisions. Merit Mgmt. Group, LP. v. FTI Consulting, Inc. substantially reduced the scope of the financial contracts avoiding power safe harbor by directing courts to focus on the ultimate recipient of the transfer, rather than on the intermediate financial institutions who participated in the transfer. Village at Lakeridge ducked the substantive bankruptcy law issue of the standard for determining who is a non-statutory insider (although the dissent tackled it) and instead ruled only on the appellate standard of review of such determinations. 

Moving in the opposite direction from the Supreme Court’s reduction of safe harbor protections, the New York district court, on an appeal from the bankruptcy court’s decision, gave a broad reading to the ability of swap counter-parties under section 560 to close out and distribute collateral upon a default. (Lehman Bros.).

The Ninth Circuit took a strong position on the open question in the application of section 1129(a)(10), requiring an impaired consenting class for confirmation, adopting the “per-plan” approach. (Transwest) And the Fourth Circuit gave another boost to reorganizing real estate debtors by permitting a bankruptcy court to value collateral in a partial “dirt-for-debt” plan. (Bates Land).

In a case largely of first impression, the Texas bankruptcy court proposed rules to apply the “single satisfaction” rule of section 550(d) when the trustee settles with some but not all defendants. (Provident Royalties).

During the first quarter, the bankruptcy courts also expanded the reach of chapter 15 and its effectiveness. (Manley Toys, B.C.I. Finances Pty Ltd., Energy Coal S.P.A., Avanti, and Platinum Partners).

The full memo, discussing these and other cases, is available here, and the full (900-page) compilation of all prior editions is available here.

Do Managers Strategically Change Their Disclosure Before a Debt Covenant Violation?

By Thomas Bourveau (Hong Kong University of Science and Technology), Derrald Stice (Hong Kong University of Science and Technology), and Rencheng Wang (University of Melbourne)

Little is known about how managers change their voluntary forecasting behavior as a debt covenant violation approaches. We find that management forecasts are more optimistic in the period leading up to a debt covenant violation (“DCV”), based on a sample of firms in the period before they disclose a DCV in their financial statements. Additionally, we find that managers who are most optimistic in their forecasts also take on more risk and increase dividend payouts before violations. Those managers tend to take actions consistent with last-resort efforts to delay the discovery of DCV and opportunistically engage in activities likely to be curtailed by lenders in the event of a covenant violation.

In further analyses, we partition our sample and find that managers are more likely to optimistically bias their earnings forecasts when they have a higher risk of losing control rights in the event of a DCV. Managers are less likely, however, to bias forecasts if lenders have greater ability to detect bias or if managers have higher reputation concerns. Finally, we perform additional analyses to rule out potential reverse causality and omitted variable issues. Overall, our results are consistent with managers changing their disclosure behavior in order to conceal upcoming covenant violations from debtholders and to justify taking actions that are favorable to equity investors and would likely be opposed by debtholders.

The full article is available here.

Bankruptcy Forum Shopping in Europe

By Wolf-Georg Ringe (University of Hamburg – Institute of Law & Economics; University of Oxford – Faculty of Law).

Over the past several years, European firms have been active in cross-border arbitrage to benefit from a more favorable bankruptcy regime. The European Insolvency Regulation (EIR), an instrument determining the competent courts and the applicable law in EU cross-border insolvency proceedings, has long sought to curb such efforts. A major reform which came into force in 2017 has the specific objective of further restricting abusive versions of forum shopping, in particular by introducing a three-month “suspension period” for forum shopping activities carried out shortly before the debtor files for insolvency.

In a recent article, I demonstrate that these efforts fail to achieve a satisfactory response to forum shopping. The key element of the reform, the suspension period, is both over-inclusive and under-inclusive in its scope of application and may, at best, be entirely without effect. The new rule will also create significant uncertainty and undermine effective ways of business restructuring.

Meanwhile, the reform does not address new variants of forum shopping, such as the use of the British “scheme of arrangement” by continental European firms. Such “procedural” forum shopping may be effected entirely without any physical relocation, as it does not come within the scope of application of the EIR.

The laudable goal of the EIR to improve the pricing of risks in cross-border insolvencies is jeopardized where the rules on jurisdiction are unclear or uncertain. The 2017 reform is a missed opportunity to improve the system by attaching substantive bankruptcy law and jurisdiction to a company’s registered office as the only clear and predictable connecting factor. Instead, the reform introduces new riddles and inconsistencies. Such steps will blur rather than improve the pricing of insolvency risk and thereby ultimately drive up the cost of capital.

The full article is available here.

Inequality and Equity in Bankruptcy Reorganization

Richard M. Hynes and Steven D. Walt (University of Virginia School of Law).

Courts have developed a series of controversial doctrines that allow a debtor to depart from bankruptcy’s standard priority rules.  In a recent decision, the Supreme Court signaled tolerance of one type of departure, the critical vendor payment, as long as it occurs early in the case and is what an economist would call a strict Pareto improvement: a payment that makes all creditors better off.  This essay demonstrates that Pareto improvements appear in the stated tests governing other departures, including roll-ups and substantive consolidations.  Some scholars, and a few courts, would apply much more permissive tests similar to economists’ Kaldor-Hicks standard and allow deviations as long as the winners gain more than the losers lose.  Still other courts would do away with these doctrines entirely and allow departures only with the consent of the disfavored.  Defending the judicial use of the Pareto standard in reorganizations, the essay further discusses some of the normative considerations in the choice between a Pareto standard, a Kaldor-Hicks standard, and an absolute prohibition.

The full article can be found here.

Courts As Institutional Reformers: Bankruptcy and Public Law Litigation

Kathleen G. Noonan (University of Pennsylvania), Jonathan C. Lipson (Temple University—Beasley School of Law), and William H. Simon (Columbia Law School)

Wags sometimes ask: What is chapter 11 good for?

In a new paper, we show that, among other things, it provides a template that both legitimates and explicates Public Law Litigation (PLL), civil class action suits against public agencies such as police departments and prison systems. These are among the most controversial disputes that courts face; often criticized, and widely misunderstood. Analogies to chapter 11 practice show how critics err, and how PLL works.

We make three basic points. First, we show that both bankruptcy and PLL, which share roots in the federal equity receivership, are judicial responses to collective action problems that other institutional mechanisms (e.g., markets or electoral politics) cannot or will not address.

Second, we show that courts in neither context “run” the organizations in question. In both types of case, management (of the debtor or agency) remains in possession and control, subject to judicial and stakeholder (e.g., creditor or plaintiff) oversight.

Third, chapter 11 and PLL both operate at the organizational level, through “restructuring.” For chapter 11, this will usually involve a plan of reorganization. The PLL analogue is a settlement agreement in a consent decree. Like plans, consent decrees typically reflect negotiated improvements in operations designed to increase the agency’s chances of success.

Critics of PLL sometimes claim that courts commandeer public instrumentalities, exceeding their expertise and authority. But this is no truer in PLL than it is in chapter 11 reorganization. Rather, judges in both spheres facilitate consensual resolutions that seek to balance stakeholder participation against managerial discretion.

This matters because the Trump Administration has vowed to “deconstruct the administrative state,” which implies a reduction in the amount and quality of public services. Increased PLL would be a plausible response.

If that happens, courts should focus not on whether they can supervise the restructuring of public agencies, but how to do so more effectively. We show that the chapter 11 system can provide helpful guidance.

The full article is available here.

The Impact of Brexit on Debt Restructuring and Insolvency Practice

By Manuel Penades and Michael Schillig (King’s College London – The Dickson Poon School of Law).

With its flexible restructuring framework and experienced courts, England has become the foremost restructuring destination in Europe. A restructuring typically combines a scheme of arrangement with a pre-pack administration. Under the former, lenders exchange their debt for equity or new debt in a new corporate holding structure; the latter facilitates the transfer of the business to this new holding structure. The effectiveness of these restructuring measures in all EU Member States is currently guaranteed by the combined effect of the European Insolvency Regulation (EIR), the Judgments Regulation (Brussels Ibis), and the Regulation on the law applicable to contractual obligations (Rome I).

This regime currently ensures the availability of English-law pre-pack administration and other insolvency procedures to many EU debtors. The EIR ties exclusive jurisdiction and applicable insolvency law to the debtor’s Centre of Main Interests (COMI). Insolvency measures issued by the opening court are automatically recognised and enforced throughout the EU. Subject to a COMI transfer to England, any debtor can benefit from English insolvency and restructuring mechanisms (including pre-pack administration) and their automatic EU-wide effect.

Post-Brexit, the EIR will cease to apply in the UK and insolvencies opened therein will lose their automatic EU effect. English domestic law alone will be insufficient to achieve this result. Only a new international instrument, probably in the form of a convention, could maintain the effectiveness of the current practice.

By contrast, schemes of arrangement are not covered by the EIR and their enforceability across the EU is currently ensured by Brussels Ibis and/or Rome I. The UK will be able to retain the Rome I regime through a unilateral instrument, but not the Brussels Ibis, which requires reciprocity, like the EIR.

Given that schemes and insolvency procedures are usually combined, absent new international instruments, Brexit is likely to result in significant uncertainty and disruption for European restructuring practice.

The article is available here.

The Pari Passu Fallacy – Requiescat in Pace

Lee C. Buchheit (Cleary Gottlieb Steen & Hamilton LLP)

The pari passu fallacy, first uncloaked in 2000, posits that when a sovereign borrower promises to maintain the equal ranking of a debt with the borrower’s other senior indebtedness, it thereby implicitly promises to pay all of those debts on a ratable basis.  In its 18-year life span, the fallacy has caused considerable mischief in the sovereign debt market.  It even prompted a wholesale change in the drafting of the pari passu clause in sovereign bonds expressly to disavow the ratable payment interpretation of the provision.  Recent decisions of the US federal courts in New York have clarified the circumstances in which a sovereign borrower will be held to breach, and just as importantly when it will be held not to breach, a contractual pari passu undertaking.  These cases confirm that a sovereign borrower will not breach a pari passu covenant merely by paying one creditor while not paying another, equally ranking, lender.

The full paper can be found here.

The Year in Bankruptcy: 2017

by Charles M. Oellermann and Mark G. Douglas (Jones Day).

In their annual chronicle of business bankruptcy, financial, economic, and related developments in the U.S., Charles M. Oellermann and Mark G. Douglas of Jones Day review the most significant events of 2017, including business bankruptcy filing statistics and industry trends; newsworthy developments regarding sovereign and commonwealth debt; the top 10 public-company bankruptcies of the year; notable private and cross-border bankruptcy cases; significant business bankruptcy and U.S. Supreme Court bankruptcy rulings; bankruptcy-related legislative and regulatory developments; noteworthy chapter 11 plan confirmations and exits from bankruptcy; and more.

The article is available here.

Practice Makes Perfect: Judge Experience and Bankruptcy Outcomes

By Benjamin Charles Iverson (Brigham Young University), Joshua Madsen (University of Minnesota, Twin Cities, Carlson School of Management), Wei Wang (Queen’s School of Business), and Qiping Xu (University of Notre Dame, Department of Finance).

Prior studies document the influence of bankruptcy judges’ discretion on restructuring outcomes, yet we know little about how judicial experience affects the bankruptcy process. We study how the accumulation of job-specific human capital influences judges’ efficiency in handling large corporate bankruptcy filings, using 1,310 Chapter 11 filings by large U.S. public firms overseen by 309 unique bankruptcy judges in 75 bankruptcy courts between 1980 and 2012.

Using random assignment of judges to cases for empirical identification, we show that cases assigned to a judge with twice as much time on the bench realize a 5.5% decrease in time spent in reorganization. This reduced time in court translates into savings of approximately $2 million in legal fees alone for a typical case in our sample. Judges’ time on the bench is associated with higher probability of emergence but not higher recidivism. The combined evidence suggests that more experienced judges are overall more efficient. We also find that it takes up to four years for a new judge to become efficient and that judges who see a higher volume of business filings and a greater diversity of cases by size and industry early in their tenure become efficient faster than those who don’t. We find little evidence that judges’ general experience and personal attributes consistently affect case outcomes.

Our analyses highlight a potential benefit of allowing firms to file in courts with more experienced judges. Restricting this flexibility (e.g., through the proposed Bankruptcy Venue Reform Act of 2017) may impose a cost on firms by forcing them to file in courts with less experienced judges.

The full article is available here.


The Roundtable has previously posted on potential Bankruptcy venue reforms, including a summary of the Bankruptcy Venue Reform Act of 2018 introduced by Senators John Cornyn, R-TX, and Elizabeth Warren, D-MA. For a critique of current venue rules—and a possible solution—see Prof. Lynn LoPucki, “Venue Reform Can Save Companies.” For a defense of the current system, see the Roundtable’s summary of the Wall Street Journal’s “Examiners” Panel on venue reform.

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