By Kenneth Ayotte (University of California Berkeley School of Law) and Jared A. Ellias (University of California Hastings College of the Law)
The lenders that fund Chapter 11 reorganizations exert significant influence over the bankruptcy process through the contract associated with the debtor-in-possession (“DIP”) loan. In this Article, we study a large sample of DIP loan contracts and document a trend: over the past three decades, DIP lenders have steadily increased their contractual control of Chapter 11. In fact, today’s DIP loan agreements routinely go so far as to dictate the very outcome of the restructuring process. When managers sell control over the bankruptcy case to a subset of the creditors in exchange for compensation, we call this transaction a “bankruptcy process sale.” We model two situations where process sales raise bankruptcy policy concerns: (1) when a senior creditor leverages the debtor’s need for financing to lock in a preferred outcome at the outset of the case (“plan protection”); and (2) when a senior creditor steers the case to protect its claim against litigation (“entitlement protection”). We show that both scenarios can lead to bankruptcy outcomes that fail to maximize the value of the firm for creditors as a whole. We study a new dataset that uses the text of 1.5 million court documents to identify creditor conflict over process sales, and our analysis offers evidence consistent with the predictions of the model.
By Tomas Richter (Clifford Chance) and Adrian Thery (Garrigues)
Under EU Directive 2019/1023 promulgated in June 2019, the 27 Member States of the European Union must enact rules supporting preventive restructurings of businesses threatened by insolvency. The restructuring frameworks to be enacted are in a large part modelled after the U.S. Chapter 11 yet they are not carbon copies of it. Also, the 27 Member States have widely differing insolvency laws against whose background the preventive restructuring frameworks must operate, and significantly diverging institutions by which they will have to be applied. The implementation tasks will be both varied and formidable.
However, certain threshold questions are very similar across jurisdictions when it comes to particular topics relevant to corporate restructurings. In the context of agreeing to and adopting a restructuring plan, some of the key questions arise in relation to classification of investors’ claims and interests, grouping these claims and interests into classes, voting in the classes, and obtaining an official approval of the restructuring plan after investors have expressed their opinions on it via the voting mechanism.
The purpose of this first guidance note, published by INSOL Europe, is to flag some of the key issues that national legislators will want to consider in this particular context when implementing the restructuring frameworks prescribed by Title II of the Directive, and, at least at times, also to respectfully suggest which approaches, in the authors’ humble opinions, might perhaps be explored more productively than others.
By Axel Krohn (Martin-Luther-University Halle-Wittenberg, Germany)
The European Directive on restructuring and insolvency (“Directive”), which came into force in July 2019, has triggered a series of interesting debates. The possibility for EU Member States to subject the cram-down from Article 11 to a “relative priority rule” (“EU RPR”) when implementing the Directive into national law has proven to be particularly controversial.
Despite a confusing conceptual overlap with approaches presented in the U.S., the European interpretation of “relative priority” breaks new ground. The rule stipulates that, under a restructuring plan, dissenting voting classes have to be treated merely more favorably than any junior class. Although the Directive allows national lawmakers to refrain from the EU RPR and introduce a familiar “absolute priority rule” (“APR”)—that is, that a dissenting class of creditors must be paid in full before junior parties may receive any distributions—the EU RPR has already found supporters in various jurisdictions and should therefore be thoroughly examined.
This article identifies one aspect of the cram-down that has received little attention to date. In addition to the EU RPR, the European legislature has introduced a new “best interest of creditors” test (“EU BIT”), which does not—as in 11 U.S.C. § 1129(a)(7)(ii)—use the value that a party could expect in a hypothetical liquidation as a comparator, but refers to the “next-best-alternative scenario.” Although the concept of combining the EU RPR and the EU BIT is coherent in theory and may even eliminate some misconceptions about the EU RPR, the interaction of the two cram-down elements is likely to raise problems in practice.
First, this article discusses the concepts of the two priority rules and traces the motives of the European legislature for introducing the EU RPR.
Three aspects in particular appear to have motivated the legislature in drawing up the rule. For one, the legislature wished to create more flexibility in plan negotiations and thus respond in particular to special needs in the restructuring of smaller businesses. The rule may bring advantages, especially when it is reasonable to enable existing shareholders to participate in the continued business by means of an equity interest. Second, with regard to some Member States, the desire has arisen to create an instrument to overcome structural blocking positions of certain preferential (priority) creditors, in particular tax authorities. Finally, there is a trend in Europe which sees in the Directive a procedure that enables a structured contractual renegotiation of debts and detaches itself from the “traditional laws of insolvency law,” including the APR.
This article then deals with the new EU BIT and examines its interaction with the EU RPR.
It is worth noting that the EU BIT plays a much more important role in an EU RPR cram-down than under an APR. By moving away from the traditional liquidation benchmark and instead linking to the “next-best-alternative scenario,” the test protects precisely the value that can be achieved from the perspective of a creditor outside insolvency without cooperating with other parties. The then remaining reorganization surplus, which is subject to the EU RPR, is that fraction of the going concern surplus which can only be achieved through the combined efforts of all parties involved, but which creditors cannot claim in an individual case of enforcement.
Despite this harmonious interaction in theory, doubts may be expressed as to whether the combination of the EU RPR and the EU BIT would work in practice. The new focus on the hypothetical next-best-alternative scenario value will likely lead to an additional stress point in plan negotiations. The EU RPR, which does not itself contain a clear guideline for the distribution of the remaining surplus, is then to be applied between two unclear values, namely the hypothetical next-best-alternative value and the presumed reorganization value. It is reasonable to assume that the resulting distributional uncertainty will cause new hold-up potential and render it difficult to realize consensual plans, especially in larger restructuring cases. Also, it seems likely that unsophisticated junior creditors will face difficulties in defending their rights adequately in view of the potentially unclear next-best-alternative scenario value, and that others will try to use this to their advantage in complex negotiations.
By Jared A. Ellias (University of California Hastings College of the Law)
When commentators describe American bankruptcy law as “the model to which European restructuring laws should aspire,” they are really speaking about an ‘American bankruptcy ecosystem’ of which law is only a significant part. The American bankruptcy ecosystem is best understood as a complex system inhabited by bankruptcy judges, law firms, investment bankers and activist investors. In this Report, I focus on one of the major components of this ecosystem: specialized investors that participate in the ‘bankruptcy claims trade.’ As I discuss, American bankruptcy courts today are best understood not as a place of shame and failure but rather as an integrated part of the capital markets, similar to the private equity firms of New York and the venture capital investors of Palo Alto. As this view of bankruptcy law took hold, investors, typically hedge funds, began to raise a large stock of capital to deploy in it. Importantly, while these investors were born of the bankruptcy bar’s development of institutions that situated bankruptcy courts within the capital markets, they have deployed their capital to accelerate it. This Report chronicles the rise of claims trading and the state of the academic literature on activist investing. In sum, the best interpretation of the available empirical evidence is that claims trading and activist investing have, at the very least, not harmed Chapter 11 or distressed corporations, and may have actually improved the capacity of the American bankruptcy system to reorganize distressed assets.
By Clayton Gillette (New York University School of Law)
Courts in municipal bankruptcy cases have confronted the inherent vagueness in the statutory tests for municipal “insolvency” by embracing a test of “service delivery insolvency.” That test is typically evaluated in terms of a significant reduction in the availability of city services. Focus on a municipality’s failure to deliver services certainly serves as a plausible proxy for fiscal health, since provision of services is a primary function of local governments and thus a function that a financially healthy municipality would satisfy. Initially, such a test appears to be viable, since it invites both temporal and interlocal comparison service levels as a measure of fiscal health. Nevertheless, this article indicates severe limitations of a service delivery insolvency test. Reductions in service may indicate efforts to recover fiscal health rather than indicating fiscal distress, because that distress was generated by overspending on services. In addition, focus on particular service reductions as a measure of insolvency creates perverse incentives for local officials who desire to obtain debt relief to diminish those services most susceptible to measurement. When determining eligibility for Chapter 9, two potential measures other than service delivery insolvency may serve as alternative or complementary proxies for the need to adjust municipal debt: population outflows and loss of agglomeration benefits.
Population outflows may serve as an alternative indicator of fiscal distress. A city that fails to provide services at a level commensurate with its tax prices may lose mobile residents, and population declines imply that the per capita debt of the municipality is increasing. But that measure does not necessarily distinguish among emigrants. If those who exit consumed more services than they paid for, then exit will not necessarily betoken fiscal distress.
Local fiscal health is often dependent on the capacity of the locality to obtain the benefits of agglomeration. As a result, and notwithstanding measurement difficulties, one promising proxy for fiscal distress entails identifying whether those who have exited would otherwise have contributed agglomeration benefits to the locality. Agglomeration effects are related to the benefits that individuals or firms receive from being located within a network of other individuals or firms, such as sharing of knowledge and information, reducing spatial mismatches between jobs and places of residence, and neighborhood effects which are necessary for the development of social capital. Agglomeration may affect decision making by prompting residents to remain when they might otherwise emigrate because they would lose network benefits in excess of the gains they would obtain from exit. Demonstrable declines in agglomeration benefits could, more than population declines or rough measures of service delivery insolvency alone, inform judgments about the potential sources of fiscal distress and the likelihood that debt adjustment would be appropriate. If population decline is largely attributable to exit by firms that tend to generate local agglomeration benefits, then continued and declining fiscal distress is more likely to occur without intervention than if population decline results from exit that creates less of a reduction of those benefits.
By Vincent S.J. Buccola (University of Pennsylvania – The Wharton School), Jameson K. Mah (Cyrus Capital Partners), Tai Yi Zhang (University of Pennsylvania – The Wharton School)
Bankruptcy scholars have worried about the potential for credit derivatives to frustrate sensible out-of-court reorganizations since such derivatives became widespread in the 2000s. The basic problem they saw was that derivative contracting could complicate dealmaking by disguising investors’ true interests vis-à-vis a distressed company. Most perniciously, derivatives could lead creditors to oppose value-maximizing restructuring plans that offer fair treatment—not just for the familiar purpose of furthering a holdout strategy, but with the very aim of opposing the general welfare. In particular, a creditor with a large derivative position betting against its debtor could actively use its rights as creditor to drive the debtor into a messy and value-destroying default.
Many debt-market observers are sure that a recent episode pitting the hedge fund Aurelius against Windstream was a case in point. That episode has only increased attention on the subject, and issuers are experimenting with contractual devices that purport to muffle the influence of net-short activists at the expense, presumably, of secondary-market liquidity.
Our recent article argues that commotion over net-short creditor activism is misplaced—indeed that such activism is implausible. The nub of our skepticism lies in the incentives and capacities of investors other than a hypothetical net-short activist to foil the activist’s plans. The objective of net-short tactics, according to the story’s logic, is to cause a liquidity crisis that will reduce a targeted company’s value and prompt default. This objective implies, however, as a matter of arithmetic, that others can make money supplying offsetting liquidity.
Our article explores some of the channels through which this responsive liquidity is most likely to flow. We conclude that in the ordinary case one should expect parties other than the would-be saboteur to undermine its plans. If we are right, then it is a puzzle why a sophisticated potential activist would think it could succeed. A net-short activist bets not just on debt prices falling, as all short investors do. It bets rather on its own ability to cause the prices to fall. But in placing such a bet, the activist must know it is daring rival investors to profit by punishing it. The whole approach seems misguided. Which brings us to Windstream. Why did Aurelius think it could prevail at sabotage? As the article explains, we don’t believe it did and don’t believe it tried. We can’t say for sure, because lack access to the fund’s books and records. But so do the many other commentators who have opined on the story.
To us, then, one of the most intriguing features net-short activism is its rhetorical appeal. We suggest that the appeal lies in a kind of mythological function—that net-short sabotage has, in particular, the cautionary form of a good urban legend.
By Shana A. Elberg, Seth E. Jacobson, & George R. Howard (Skadden)
Today, U.S. borrowers are more indebted than ever before. Borrowers have become increasingly aggressive in using secured leverage, and in taking advantage of “cov-lite” loan documents to engage in creative (and sometimes controversial) transactions to transfer assets beyond the reach of existing secured lenders by way of distributions to shareholders or contributions to unrestricted subsidiaries and then utilize those assets to raise additional secured financing. While the debt levels and cov-lite structures of leveraged loans may create risks for many stakeholders, lenders under asset-based loan facilities (“ABL facilities”) should be well-positioned to weather any storm. ABL facilities typically offer lenders greater protections in a liquidation scenario. In addition, ABL facilities often are a critical lynchpin of debtor-in-possession financing facilities when borrowers are looking to effectuate comprehensive restructurings through chapter 11. There are several tools available to ABL lenders to protect their credit position in the event that a borrower finds itself in a distressed situation. Lenders should position themselves to understand and use the chapter 11 process to ensure their debt claims retain, and even gain, protections in bankruptcy.
By Efraim Benmelech (Northwestern University – Kellogg School of Managemen, Nitish Kumar (University of Florida), and Raghuram Rajan (University of Chicago – Booth School of Business)
Is collateral at all valuable to creditors in corporate lending? At one level, it is clear why collateral should be important for lenders: it consists of hard assets that are not subject to asymmetric valuations in markets and that the borrower cannot alter easily. Collateral gives comfort to a lender that, even if the lender does little to monitor the borrower’s activity and the borrower’s cash flows prove inadequate to service the debt, the lender’s claim is protected by underlying value.
Yet even if assets are important to lending, why does debt need to be secured by them? After all, in a bankruptcy filing the firm’s assets will all be there to support the lender’s claim. Why protect the lender further through claims on specific collateral? In a related work (The Decline of Secured Debt), we find that firms tend to issue more secured debt when their credit quality is low or at times when average credit spreads across firms are higher or economic growth is slower. These are times when firms may find access to credit more difficult, creditors may fear greater stockholder-debtholder conflicts, and borrowers may need to collateralize debt issuances in order to regain access to funding. Moreover, with new lenders unwilling to lend without the comfort of collateral, existing lenders might rush to secure their claims so as not to be diluted. Indeed, negative pledge clauses (whereby the borrower commits to a lender that it will not issue secured debt to any other lender, failing which the debt payment will be accelerated) allow creditors to large companies to stay unsecured until they sense a greater likelihood of borrower distress, at which point they will move to secure their claims.
If collateral matters to creditors for the enforcement of debt claims, even in the case of large, mature companies but in a more contingent way, we should see it reflected in the pricing of secured claims vis-à-vis unsecured claims, especially in how that pricing moves with the state of the firm and the economy. Security should be of little value to lenders when a firm is far from distress or the economy is healthy, and it should become much more valuable (and hence secured debt should promise lower interest rates than unsecured debt) as a firm nears distress or the economy deteriorates.
The difficulty in identifying the effects of security on debt pricing derives from the circumstances under which it is offered. Since riskier firms will offer security at riskier times, a comparison of rates offered by secured debt issuances against rates offered by unsecured debt issuances across firms, or by the same firm over time, will tend to be biased toward suggesting higher rates for secured debt issuances.
In this paper, we use multiple data sets to get at the true pricing of secured debt, stripped as best as possible of the selection bias. Our identification strategy compares spreads on secured and unsecured credit of the same firm and at the same point in time.
We conclude from all these ways of obtaining the value of security that the selection bias is important, and correcting for it suggests that security is valuable to creditors – creditors typically require a lower spread when their claim is secured. Most important, however, we show that creditors value security differently for different firms and at different times.
For highly rated firms, creditors pay almost nothing for the added protection afforded by security, whereas for low-rated firms, they pay a lot. Yields on bonds issued by investment grade firms (those with an S&P rating of BBB− or better) are 20 basis points lower when secured, whereas this yield differential (unsecured versus secured) jumps to 112 basis points for a firm having a non-investment grade rating. Similarly, implied yields from bond trades in secondary market suggest that investors are willing to give up almost 161 basis points in spread for the added protection of security for non-investment grade issuers, whereas they are not willing to reduce spread at all for the added protection of security in the case of investment grade issuers.
Equally important, as a firm’s credit quality deteriorates, we see the valuation of secured claims improve relative to unsecured claims, suggesting that security becomes more valuable. We also find that secured spreads decline relative to unsecured spreads as the economy’s health – as reflected in GDP growth or the economywide Baa–Aaa spread – deteriorates.
The upshot is that collateral does not seem to matter for debt enforcement in normal times for a healthy firm, since debt linked to specific assets do not seem to enjoy better prices. Indeed, given the negligible pricing benefit, firms may want to avoid any loss in financial slack and operational flexibility at such times by not issuing secured debt. However, in tougher times, creditors do seem to value security, and firms do issue secured debt, either because creditors demand it or because of the better pricing.
By Professor Nancy Rapoport (William S. Boyd School of Law, University of Nevada, Las Vegas)
As someone who studies professional fees in large chapter 11 cases, I’ve thought a lot about how quickly those professional fees can escalate. Successful chapter 11 bankruptcies are expensive, though, in almost all cases, the end result—a successful reorganization—is a good result. But can the fees be controlled effectively?
I think that they can, although there are all sorts of reasons why, often, fees aren’t monitored very closely. There’s usually a disconnect between who’s paying those fees and who’s monitoring the work. In a non-bankruptcy context, a lawyer might bill a client on a monthly basis and get relatively fast feedback from the client regarding issues of reasonableness. The image that comes to mind is of a lawyer pushing a bill across a table and an experienced client pushing it back to request reductions for potentially unreasonable fees or expenses. But the process is different for fees paid to professionals in chapter 11 cases. Bankruptcy courts are charged with the responsibility of reviewing the fees and expenses for reasonableness, and the Office of the United States Trustee serves as another set of eyes, as would a fee examiner.
For estate-paid professionals, the bankruptcy court must first approve the fee applications, which then get paid either from a carveout of a secured creditor’s collateral or as administrative expenses. Imagine a typical list of estate-paid professionals: the debtor’s counsel (plus conflicts counsel and local counsel), the creditors’ committee counsel (plus conflicts counsel and local counsel), investment banks and financial advisors (often for both the debtor and the committee), along with other, more specialized counsel. All of those professionals are working at warp speed, because large chapter 11 cases are literally bet-the-company actions. The fee applications themselves can run into the thousands of pages, per professional, with the time entries showing who worked on what, and for how long, on a day-by-day basis. There’s also often a lag between the work done and the submission of the fee applications, and few actors—other than the professionals themselves and some large institutional creditors—are repeat players. If the client isn’t familiar with the rhythm of chapter 11 bankruptcies, then that client has to take the professionals’ word for whether the tasks were both reasonable and necessary. Parsing the fee applications is a complicated task.
Let me be clear: I’m not suggesting that bankruptcy professionals try to gouge the estate by performing unnecessary tasks. Far from it. The professionals whose fees I’ve reviewed have genuinely been trying to work within the reasonableness guidelines. But the staffing choices that get made—which level of professional works on which tasks, how long it takes to do the work, how many people review that work, how often all of the professionals touch base on the case’s progress, and how a professional must react to actions taken by a different professional—often don’t have the luxury, on the front end, of data-driven planning to eke out the most efficient workflows. Add to that the fact that all of these professionals worry about missing something important, and it’s not hard to see how fees can mount up.
I’ve written a lot about how to think about fees in chapter 11 cases, including these articles (here, here, and here). Most recently, I’ve been working with a co-author, Joe Tiano of Legal Decoder, to imagine a world in which big data can help professionals perform more efficiently (here and here). (Full disclosure: Legal Decoder helped me review the fees and expenses in the Toys R Us cases.) In a recent piece for the American Bankruptcy Institute Law Review, I’ve taken what we know about how a company’s general counsel works with outside professionals outside bankruptcy and suggested that, in a chapter 11 context, many of those behaviors can help to control the size of the professional fees and expenses: by paying closer attention to staffing and monthly budget-to-actual reconciliations, by using legal analytics to measure efficiency, and by using artificial intelligence for certain types of tasks. The point is that paying attention to efficient behavior on the front end benefits everyone, including the professionals themselves, who won’t have to negotiate reductions of their already billed work. The ABI Law Review article is available here.
On November 26, 2019, the Fifth Circuit granted a petition for rehearing en banc and issued a revised opinion in In re Ultra Petroleum Corp., No. 17-20793 (5th Cir. Nov. 26, 2019). The new opinion reaffirmed the court’s prior holding that the alternation of a claim by the Bankruptcy Code does not render a claim impaired under 11 U.S.C. § 1124(1), while withdrew the court’s earlier guidance that make-whole premium was the “economic equivalent of ‘interest’” together with its prior suggestion on setting the appropriate post-petition interest rate via reference to general post-judgment interest statute or bankruptcy court’s equitable discretion.
Noting that issues relating to make-whole premiums is a common dispute in modern bankruptcy, the Fifth Circuit retracted its dicta and emphasized in the revised opinion that specific facts are essential in determining the difficult question of whether any premiums are effectively unmatured interest. The court concluded that “[t]he bankruptcy court is often best equipped to understand these individual dynamics – at least in the first instance.”
Firms took notice of the issues remain unsolved and offered perspectives on implications of this case. Morgan Lewis specifically notes that the revised opinion did not alter the original opinion’s reversal of the bankruptcy court’s ruling that creditors who are unimpaired in a bankruptcy plan pursuant to section 1124(a)(1) must receive the full amount of their claim under state law. Weil finds the opinion “does not answer the question of whether, or when, a make-whole may be payable in the Fifth Circuit”, but acknowledges that the ruling is “viewed by some as a victory” for certain creditors. Cleary highlights that the court’s revised opinion “withdrew essentially all of the guidance it had offered in its prior opinion” which had cast doubt on the enforceability of make-whole claims in bankruptcy. “Given the legal and economic significance of the questions left to be resolved”, debtors and creditors alike are likely to watch closely how the questions will proceed at the bankruptcy court, says Mayer Brown.