Secured Transactions and Financial Stability: Regulatory Challenges

By Steven L. Schwarcz (Duke University School of Law)

Secured transactions traditionally are regulated to protect transacting parties and to increase transactional efficiency. This essay argues they should also be regulated to protect the stability of the financial system. This raises numerous challenges.

In our increasingly complex financial system, for example, regulation to control moral hazard in the originate-to-distribute model of secured loan origination faces the challenge that the relevant market failure is less likely to be asymmetric information than mutual misinformation—neither the originator (i.e., seller) of the loans nor the buyer may fully understand the risks. Non-traditional secured transactions, including securitization and other forms of structured finance, exacerbate the challenges of complexity and the limits of disclosure.

The regulation of collateralization levels and interconnectedness faces fundamentally different challenges than those underlying the (technically) analogous post-Depression regulation of “margin” lending to acquire publicly traded stock. The Fed’s Regulation U then required that stock pledged as collateral be worth at least twice the loan amount. Requiring overcollateralization of home-mortgage lending, however, could be highly regressive.

The potential for the widening gap between the rich and the poor to undermine stability also raises the challenge of whether to recognize de facto rights, in order to enable the poor to use their homes as collateral to raise capital. This challenge is itself partly informed by the Uniform Commercial Code’s innovative disentanglement of commercial and property law, which articulates the former to reflect commercial realities rather than the arbitrary shifting of rights based on property. Innovating secured transactions law to recognize those de facto rights could help to unlock a worldwide entrepreneurial potential.

The full paper can be found here.

Bankruptcy Court Rules That It Has Constitutional Authority to Grant Nonconsensual Releases in Chapter 11 Plan

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

Many chapter 11 plans include nonconsensual third-party releases that preclude certain non-debtors from pursuing claims against other non-debtors as part of a restructuring deal in which such releases are a quid pro quo for financial contributions made by prepetition lenders or old equity holders. However, bankruptcy and appellate courts disagree as to whether such non-consensual plan releases should be permitted due, among other things, to concerns regarding the scope of a bankruptcy court’s subject matter jurisdiction and constitutional authority. Several court rulings handed down in 2017 addressed these concerns.

For example, In In re Midway Gold US, Inc., 575 B.R. 475 (Bankr. D. Colo. 2017), the court held that, although Tenth Circuit law does not categorically forbid third-party releases in chapter 11 plans, it lacked jurisdiction to “adjudicate” plan releases of claims against non-debtors because the underlying claims should not be considered as part of the proceedings to confirm the plan and were not within either its “core” or “related to” jurisdiction. In addition, in In re SunEdison, Inc., 2017 BL 401968 (Bankr. S.D.N.Y. Nov. 8, 2017), the court ruled that, as a matter of contract law, merely implied consent for plan releases is insufficient, and it lacked subject matter jurisdiction to approve releases that were overly broad.

By contrast, in In re Millennium Lab Holdings II, LLC,  2017 WL 4417562 (Bankr. D. Del. Oct. 3, 2017), the court held that it had the constitutional jurisdiction to authorize nonconsensual releases, despite the existence of litigation in another forum to adjudicate one of the claims to be released. A discussion of the court’s ruling in Millennium is available here.

Proposed Bill: Bankruptcy Venue Reform Act of 2018

posted in: Bankruptcy Reform, Legislation | 0

Earlier this month, Senators John Cornyn, R-TX, and Elizabeth Warren, D-MA, introduced the Bankruptcy Venue Reform Act of 2018. With the aim of “prevent[ing] big companies from cherry-picking courts that they think will rule in their favor and to crack down on this corporate abuse of our nation’s bankruptcy laws,” the Act would amend §1408 of the Bankruptcy Act to require debtors to file in the district “in which the principal assets or principal place of business” are located. It would also bar debtors from tag-along filings in jurisdictions where their affiliates have ongoing bankruptcy proceedings unless that affiliate “owns, controls, is the general partner, or holds 50 percent or more of the outstanding voting securities” of the debtor. In short, the proposed Act would eliminate the domicile venue option and the affiliate option that allows larger parent companies to file in the same venue as a smaller subsidiary.

Significantly, the Act would oust Delaware from its position of bankruptcy venue of choice for the many businesses that do not operate in Delaware but are domiciled in Delaware by virtue of having incorporated there. The bankruptcy court in Delaware is the venue now chosen by many public firms that file to reorganize in chapter 11.

In response to the bill’s introduction, Delaware’s Governor and congressional delegation issued a joint statement:

Many American companies, large and small, choose to incorporate in Delaware because of the expertise and experience of our judges, attorneys, and business leaders. Denying American businesses the ability to file for bankruptcy in the courts of their choice would not only hurt Delaware’s economy but also hurt businesses of all sizes and the national economy as a whole. This is a misguided policy, and we strongly oppose it.

Senator Coons later published an additional statement emphasizing that the “Cornyn-Warren bill is bad for businesses everywhere, but it would be a disaster for Delaware.”

Bankruptcy venue reform was proposed, but not passed, in 2005 (S.314) and again in 2011 (H.R.2533). In seeking to remove the domicile and affiliate bankruptcy venue options, the Cornyn-Warren bill most closely mirrors the 2011 bill, H.R.2533, which Professor David Skeel has stated “would [have] overturn[ed] a long history of bankruptcy practice; it would undermine the effectiveness of our corporate bankruptcy system; it would increase the administrative costs of the system; and it would not help the very parties the proposal is ostensibly designed to help.”

If passed, the Act would require a major change in bankruptcy strategy for many businesses, but it remains to be seen whether the Act will gain traction in Congress.

(By Harold King, Harvard Law School, J.D. 2019.)

Mandatory Contractual Stay Requirements for Qualified Financial Contracts

By Erika D. White and Donald S. Bernstein of Davis Polk & Wardwell LLP.

The U.S. banking agencies have issued rules that require U.S. G-SIBs and the U.S. operations of foreign G-SIBs to amend their swaps, repurchase agreements and other qualified financial contracts (QFCs) to include certain provisions designed to mitigate the risk of destabilizing close-outs of QFCs in the event the G-SIB enters resolution. The rules are part of a package of reforms implemented by the industry, Congress and the U.S. banking agencies since the financial crisis in an attempt to ensure that the largest financial institutions can be resolved in an orderly manner. Specifically, the rules seek to (1) mitigate the risk that the FDIC’s stay-and-transfer powers with respect to QFCs under Title II of the Dodd-Frank Act and the Federal Deposit Insurance Act may not be recognized and given effect outside of the United States and (2) improve the likelihood of success of a single-point-of entry resolution strategy under the Bankruptcy Code by limiting the ability of counterparties to terminate their QFCs with a solvent and performing operating entity based on cross-defaults triggered by the bankruptcy of the operating entity’s parent or other affiliate. The QFC Stay Rules do not, however, affect the rights of counterparties to terminate QFCs under the safe harbor provisions of the Bankruptcy Code in the event the operating subsidiary itself were to enter bankruptcy proceedings.


The full visual memo is available here.

How to Restructure Venezuelan Debt

By Lee C. Buchheit (Cleary Gottlieb Steen & Hamilton LLP) & G. Mitu Gulati (Duke University School of Law).

There is a growing consensus that Venezuela will not be able to persist for much longer with its policy of full external debt service. The social costs are just too great. This implies a debt restructuring of some kind. Venezuela, principally through its state-owned oil company, Petróleos de Venezuela, S.A. (“PDVSA”), has extensive commercial contacts with the United States. Not since Mexico in the 1980s has an emerging market country with this level of commercial contacts attempted to restructure its New York law-governed sovereign debt. Holdout creditors in a restructuring of Venezuelan sovereign debt will therefore present a serious, potentially a debilitating, legal risk. The prime directive for the architects of a restructuring of Venezuelan debt will be to neutralize this risk.

The full article is available here.

Deterring Holdout Creditors in a Restructuring of PDVSA Bonds and Promissory Notes

By Lee C. Buchheit (Cleary Gottlieb Steen & Hamilton LLP) & G. Mitu Gulati (Duke University School of Law).

Probably the main reason why the Maduro administration has not attempted to restructure Venezuelan sovereign debt is the potential mischief that may be caused by holdout creditors. The next administration in Venezuela — whenever and however it may arrive — will not want for suggestions about how to minimize or neutralize this holdout creditor threat. One option, before a generalized debt restructuring of some kind affecting all outstanding bonds, is for Venezuela to acknowledge that there really is only one public sector credit risk in the country and that the distinction between Republic bonds and its state-owned oil company, Petróleos de Venezuela, S.A. (“PDVSA”) bonds is artificial, and then to offer to exchange PDVSA bonds for new Republic bonds at par. The question will be, as it always is, how to discourage PDVSA creditors from declining to participate in such an exchange offer.

We suggest that one method might be for PDVSA to pledge all of its assets to the Republic in consideration for the Republic’s assumption of PDVSA’s indebtedness under its outstanding bonds and promissory notes. This is a step expressly permitted by PDVSA’s bonds and promissory notes. Existing PDVSA creditors would be perfectly free to decline to exchange their exposure for new Republic bonds, but they would face the prospect that a senior lienholder (the Republic) would have a first priority claim over any PDVSA assets that the holdout may attempt to attach to satisfy a judgment against PDVSA. That realization should make them think twice about the wisdom of holding out.

The full article is available here.

Debt Priority Structure, Market Discipline and Bank Conduct

By Piotr Danisewicz (University of Bristol), Danny McGowan (University of Nottingham), Enrico Onali (Aston University; University of Wales System – Bangor University), and Klaus Schaeck (University of Bristol).

This article explores how changes in debt priority structure affect banks’ funding costs and soundness. We exploit the staggered introduction of depositor preference laws across 15 U.S. states between 1983 and 1993 which confer priority to deposit claims in case of bank liquidation. The laws are exogenous with respect to the outcomes of interest and apply to state-chartered banks but not to nationally-chartered banks, allowing us to isolate causality using difference-in-difference methods.

We document changes in monitoring intensity by various creditors depending on whether creditors move up or down the priority ladder. Enactment of depositor preference reduces deposit interest rates, consistent with the fact that deposit claims are protected in case of bankruptcy thereby reducing depositors’ monitoring incentives. However, non-deposit interest rates increase as these creditors are exposed to greater losses in bankruptcy which leads them to more intensively monitor banks’ conditions.

Subordinating non-depositor claims also reduces banks’ risk-taking and leverage, consistent with market discipline. For example, non-depositors who receive negative signals about project returns may refuse to roll over funds which motivates banks to improve soundness to maintain access to key funding sources such as Fed Funds.

These insights highlight a role for debt priority structure in the regulatory framework, and support recent innovations in banking regulation that reallocate monitoring incentives towards non-depositors.

The full paper can be found here.

Selling Innovation in Bankruptcy

posted in: 363 Sale, Valuation | 0

By Song Ma (Yale School of Management), (Joy) Tianjiao Tong (Duke University, Fuqua School of Business), and Wei Wang (Queen’s School of Business).

The past decades have witnessed the emergence of patent sales in corporate bankruptcies. Yet we know little about the facts and rationales of these important economic transactions.

In this working paper, we assemble a comprehensive data set of US Chapter 11 filings, USPTO patent transaction documents, and court records on assets sales from the past three decades. We document three stylized facts on patent sales in bankruptcy. First, patent sales are pervasive — more than 40% of bankrupt firms sell at least one patent, and on average they sell 18% of their patent portfolios. Second, patent transactions occur immediately after bankruptcy filing — concentrating largely within the first two quarters after filing. Third, patents are frontloaded in general asset sales in bankruptcy — firms sell a disproportionately large quantity of patents in asset sales during the early period of reorganization.

Why do firms sell patents during bankruptcy? We design a set of empirical tests to study the economic decisions behind patent sales based on the two economic views on assets reallocation in bankruptcy, namely asset restructuring and financing through asset sales. Our results show that bankrupt firms reallocate patents that are more redeployable and trade in a more liquid market . We find no evidence that they sell underexploited or underperforming patents. This pattern of selling more liquid patents holds stronger in firms with financial distress, firms undergoing poor industry conditions, and firms lacking external financing. The combined evidence lends support to the view that firms sell innovation during bankruptcy for financing purposes rather than for asset restructuring. Additionally, we find that bankrupt firms try to retain the inventors of sold patents and continue to cite sold patents after their sale. The evidence overall suggests that a firm’s imminent financing needs interact with its intent to avoid bankruptcy costs in shaping a firm’s decision to sell patents in bankruptcy.

The full paper is available here.


The Roundtable will be off for the holidays. We’ll be back early after the New Year.

Fiduciary Duties in Bankruptcy and Insolvency

By John A. E. Pottow (University of Michigan Law School).

Although discussed nowhere in the U.S. Bankruptcy Code, fiduciary duties play a central role in guiding the administration of an insolvent debtor’s assets. Regulatory oversight of trustees is only loosely circumscribed by statute, but significant lacunae exist regarding specification of the duties of loyalty.  In assessing what fiduciary obligations are owed to secured creditors, unsecured creditors, and debtors, some courts build upon the general principle that the trustee’s fiduciary duty of loyalty flows to all creditors. Other courts, though, work from the premise that secured creditors are better situated to look after themselves and that a trustee’s primary obligation is to unsecured creditors, perhaps especially non-priority general creditors. The Supreme Court has also weighed in, stating that a DIP’s fiduciary duties run directly (if somewhat delphically) to “the corporation.” How then does a trustee choose between beneficiaries of the estate, and what remedies are there for losing parties disappointed with this allegiance decision?  This book chapter explores the fiduciary obligations of trustees (including DIPs) under both statute and common law. There is a special focus on the intrinsic conflicts that arise within the “menagerie of heterogeneous creditors” that constitute the claimants of a bankruptcy estate.  A single normative theory seems unlikely to explain the results (so much for the “residual fiduciary beneficiary”!).  What does seem clear is that trustees are “more fiduciary” for some constituencies than for others.  Fortunately, U.S. bankruptcy courts are accustomed to shifting allegiances and disalignments of interest. Thus, the bankruptcy system may be well-suited to handle the endemic conflicts of interest between corporate constituencies through various bankruptcy-specific mechanisms, such as the institution of the Creditors Committee and the norm of engaged judicial oversight.

The full article is available here.

Optimal Capital Structure and Bankruptcy Choice: Dynamic Bargaining vs. Liquidation

posted in: Valuation | 0

By Samuel Antill and Steven R. Grenadier (Stanford Graduate School of Business)

In this work, we develop and solve a continuous-time dynamic bargaining model of Chapter 11 reorganization. We include many features of the Chapter 11 process, such as the automatic stay, suspension of dividends, the exclusivity period, post-exclusivity proposals by creditors, and the potential for forced conversion to Chapter 7. The reorganized firm may issue new debt and continue operating. Moreover, both debtors and creditors face uncertainty over future asset values as they debate reorganization plans. We solve for the equilibrium and the corresponding expected payoffs to creditors and equityholders.

Using this equilibrium, we proceed to model a firm’s optimal capital structure decision in a framework in which the firm may later choose to enter either Chapter 11 reorganization or Chapter 7 liquidation. Creditors anticipate equityholders’ future reorganization incentives and price them into credit spreads when the debt is issued (ex ante). The implied capital structure results in both higher credit spreads and dramatically lower leverage than existing models suggest. Giving creditors more bargaining power in bankruptcy typically leads to higher leverage and ex ante firm value, consistent with empirical evidence. If reorganization is less efficient than liquidation, the added option of reorganization can actually make equityholders worse off ex ante, even if the firm is eventually liquidated.

The full article is available here.

1 2 3 4 5 6 19