The Costs of Corporate Bankruptcy: How Little We Know

Author: Stephen J. Lubben, Seton Hall University School of Law

lubben-176x220_1 For almost as long as there have been bankruptcy laws, there have been complaints that the primary beneficiaries of these laws are insiders who administer the bankruptcy system. In recent decades, this line of criticism has carried with it an implicit criticism of bankruptcy courts, which are urged to more aggressively police the costs of bankruptcy. Indeed, at least one recent critic has unkindly suggested that the failure of the courts to control bankruptcy costs is the result of a corrupt bargain between bankruptcy courts and practitioners.

Rarely addressed is why bankruptcy courts regulate professional costs at all. In most areas of American law, a professional is accountable solely to its client. Complaints about excessive cost might result in a separate malpractice action, but a client who thinks they have been overcharged for the defense of their speeding ticket will find little relief in traffic court. Why is bankruptcy different?

This paper begins to look at this question with brief overview of the concept of bankruptcy costs, traditionally divided between direct and indirect costs. I next turn to a consideration of the process for overseeing bankruptcy costs. I briefly trace the history of court control of compensation in corporate bankruptcy, and then detail the current legal structure. The final part of the chapter then surveys the existing understanding of chapter 11 cost, and concludes with a some thoughts on the important questions that remain unanswered.

In short, we know a bit about direct costs, but very little about any other sort of costs. Moreover, what we know is almost entirely lacking in context. This makes it quite hard to understand if the existing system of cost regulation is either useful or justified.

This article is available here.


The Value of Soft Variables in Corporate Reorganizations

By Michelle Harner, University of Maryland Francis King Carey School of Law

When a company is worth more as a going concern than on a liquidation basis, what creates that additional value?  Is it the people, management decisions, the simple synergies of the operating business, or some combination of these types of soft variables?  And perhaps more importantly, who owns or has an interest in such soft variables?  These questions are important in all contexts, but hold particular significance in corporate reorganizations where a company’s liabilities frequently exceed the value of its assets.  The value available to satisfy creditors’ claims is limited, and determining the parties’ respective rights to that value is often hotly contested and critical to an effective resolution.  My article, The Value of Soft Variables in Corporate Reorganizations, 2015 Ill. L. Rev. ___ (forthcoming), explores these questions under existing legal doctrine and practice norms.

The basic thesis of the article is that soft variables contribute meaningful value to the operation of a company as a going concern but are often overlooked or undervalued in corporate reorganizations.  Ignoring soft variables not only does a disservice to those working hardest to save the company but also arguably steals value from the company and those constituencies.  If a company’s soft variables do not hold such value, it may indicate that a chapter 7 liquidation is the more appropriate resolution for the company.  But if the company invokes the chapter 11 process and the resolution generates value above liquidation or book value, the court and the parties should identify the relevant soft variables and allocate value accordingly.

A longer summary of the article can be found here, and the full article can be found here.

Creditor Conflict and the Efficiency of Corporate Reorganization

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By Mark Jenkins at University of Pennsylvania and David C. Smith at University of Virginia

While a rich set of theories make clear that incentive conflicts between senior and junior claimants in a company’s capital structure may lead to inefficient outcomes, empirical evidence on how often these conflicts do so has been limited. In this paper, we study the incentives of senior claimants to force inefficient liquidations, or liquidations in which a firm’s assets are sold for less than the firm’s value as a going concern. We develop a bargaining model that assumes senior creditors can exert strong control over whether a firm reorganizes or liquidates during the bankruptcy process. The estimable parameters of the model allow us to gauge the efficiency of bankruptcy outcomes using a large sample of U.S. corporate bankruptcy cases over the period 1989 to 2011.

The main result of the paper is an estimate of the value loss that results from inefficient liquidations in bankruptcy. We estimate these losses to be up to 0.28 percent of the going-concern value of the firm, on average, across all bankrupt firms in our sample. As predicted by theory, these losses are realized primarily by firms with asset values that are close to the face value of secured debt. Our estimate of efficiency losses is driven by several auxiliary findings, including estimates of the fraction of firms that are efficiently reorganized, the fraction of firms that are efficiently and inefficiently liquidated, and the average liquidation discount faced by firms in bankruptcy.

The full article can be found here.

Delaware District Court Affirms Order Approving Gifting In Chapter 11 Case

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Author: Mindy Mora of Billzin Sumberg Baena Price & Axelrod, LLP

In an unusual but practical decision, the U.S. District Court for the District of Delaware affirmed a bankruptcy court order which approved both a sale of the debtors’ assets and the establishment of an escrow account to provide a “gift” to fund a distribution to the debtors’ unsecured creditors.  What is significant about this decision is that it approved the use of gifting in a chapter 11 bankruptcy case.  LCI Holding Company, Inc., civ. no. 13-924 (D. Del. March 10, 2014).

The concept of gifting in a bankruptcy case allows a secured creditor or purchaser to overcome objections to a sale of assets interposed by the debtor’s unsecured creditors.  Often, the gift consists of a pool of funds for distribution to the debtors’ unsecured creditors, and bypasses the claims of priority creditors with more senior claims.  See In re SPM Mfg. Corp., 984 F.2d 1305 (1st Cir. 1993).

A distribution that bypasses priority claims raises the issue of whether gifting is permissible in a chapter 11 case, based upon the requirement that distributions under a plan of reorganization must comply with the Bankruptcy Code, including the priority scheme for distributions to creditors and the absolute priority rule set forth in Bankruptcy Code § 1129(b)(2)(B).  This type of compliance is not mandated in chapter 7 cases, in which bankruptcy courts have authorized gifting more regularly.  See id.  Apparently in Delaware, gifting is permitted in a chapter 11 case, so long as the sale of assets is followed by a dismissal of the case without the confirmation of a plan.

Link to full article

Eighth Circuit Expands Subsequent New Value Preference Defense in Cases Involving Three-Party Relationships

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Authors:  Charles M. Oellermann and Mark G. Douglas

A bankruptcy trustee or chapter 11 debtor-in-possession has the power under section 547 of the Bankruptcy Code to avoid a transfer made immediately prior to bankruptcy if the transfer unfairly prefers one or more creditors over the rest of the creditor body. However, not every payment made by a debtor on the eve of bankruptcy can be avoided merely because it appears to be preferential. Indeed, section 547 provides several statutory defenses to preference liability. The Eighth Circuit Court of Appeals recently addressed one such defense to preference avoidance—the “subsequent new value” exception. In Stoebner v. San Diego Gas & Electric Co. (In re LGI Energy Solutions, Inc.), 746 F.3d 350 ( (8th Cir. 2014), the court, in a matter of first impression, ruled that “new value” (either contemporaneous or subsequent) for purposes of section 547(c) can be provided by an entity other than the transferee.

LGI Energy is a positive development for those doing business with financially troubled entities because it expands the scope of the subsequent new value defense to encompass payment relationships involving multiple parties. In one sense, the ruling can be viewed as an instance of judicial activism directed at harmonizing the Bankruptcy Code with the realities of complex financial transactions. However, it could be argued that the Eighth Circuit’s decision was motivated more by equitable and policy considerations than by a careful examination of the plain meaning of section 547(c)(4).

The full-length article can be found here.

Bankruptcy’s Corporate Tax Loophole

By Diane Lourdes Dick, Seattle University School of Law

AvvoPhotoMy recent article, Bankruptcy’s Corporate Tax Loophole, 82 Fordham L. Rev. 2273 (2014), explains how corporate debtors use Chapter 11 to divert the value of tax losses and credits to a select group of stakeholders in contravention of bankruptcy’s distributional norms.

The problem stems from an ambiguity at the intersection of federal tax and bankruptcy law. Bankruptcy-specific exceptions in the tax laws transform a corporate debtor’s tax attributes into marketable property that, in many cases, gives the bankruptcy estate its intrinsic value. Yet bankruptcy law’s most vital safeguards neglect to fully take into account these tax assets, leaving them vulnerable to siphoning by dominant stakeholders who are in a position to extract excess returns.

Most notably, the debtor’s valuable tax attributes slip through the cracks of the “fair and equitable” test for contested Chapter 11 plans. The analysis requires, in pertinent part, that the court evaluate whether the plan provides each impaired and dissenting creditor with at least as much as it would have received in a hypothetical Chapter 7 liquidation. But testing a Chapter 11 plan against a hypothetical liquidation naturally omits the debtor’s tax attributes from consideration, as they would be extinguished when the liquidated debtor is subsequently dissolved. This means that the “fair and equitable” analysis ignores the very existence of what may be the debtor’s most valuable asset.

This extraordinary gap not only facilitates inequitable allocations of economic benefits and burdens in Chapter 11 but also causes a much broader, systematic misallocation of resources. I recommend statutory revisions to the federal tax and bankruptcy laws to neutralize the tax consequences of corporate restructuring decisions.

The full-length article can be found here and here. 

The Case in Brief Against Chapter 14

Author: Bruce Grohsgal, Pachulski Stang Ziehl & Jones, LLP

Grohsgal-BruceResolution of a distressed financial company under Dodd-Frank Title II is a last – but crucial – resort.  Dodd-Frank, Title I, requires each large financial enterprise to file a “living will” that provides for its orderly resolution under the Bankruptcy Code.  Dodd-Frank Title II may only be used to liquidate a failing financial company that would “pose a significant risk to the financial stability of the United States” if resolved in a bankruptcy proceeding or under other federal or state law.  The FDIC must conduct a Title II resolution “in a manner that mitigates such risk and minimizes moral hazard.”  Dodd-Frank also expressly prohibits both a taxpayer-funded bailout and the Federal Reserve’s lending to a failing or failed financial firm.

Dodd-Frank has drawn fire, nonetheless, as encouraging, rather than preventing, bailouts.  Detractors urge repealing Title II of Dodd-Frank and amending the Bankruptcy Code to include a new Chapter 14 in its place.

The proposed Chapter 14’s central flaw is that it does nothing to reconcile Dodd-Frank’s purposes of mitigating systemic risk and minimizing moral hazard with the Bankruptcy Code’s starkly contrasting aims of reorganizing troubled companies, preserving going concerns and maximizing payments to creditors.

This article briefly summarizes Dodd-Frank’s orderly resolution regime and then addresses some of the core proposals for a new Chapter 14.  It concludes that the proposed Chapter 14 will not mitigate systemic risk, minimize moral hazard, or improve on Dodd-Frank’s prohibitions against bailouts, which are the primary purposes of Title II of Dodd-Frank.

The article is available here.

The Chapter 14 Proposal in the Senate

Author: Stephen D. Adams*

[This week the Roundtable looks at the Chapter 14 proposal in the Senate.  This post provides an overview of Chapter 14 as background to Bruce Grohsgal’s thoughtful piece from the ABI Journal available here.]

The Taxpayer Protection and Responsible Resolution Act of 2014 (S. 1861), commonly known as “Chapter 14”, aims to “end ‘too big to fail’ by repealing Dodd-Frank’s Title II” and “replacing it with a bankruptcy process” capable of safely resolving a Systemically Important Financial Institution.

The Chapter 14 proposal envisions a number of changes to the bankruptcy process, grouped into a new bankruptcy chapter (hence “Chapter 14”, a previously unused chapter) that would be available to bank holding companies. Chapter 14 would be run by a special group of financially experienced district judges, could allow for the FDIC to be appointed as trustee, and would have no period of plan exclusivity. In order to effect a quick sale similar to the FDIC’s single point of entry strategy for Title II, the Senate bill would add a two-day stay to bankruptcy’s swap safe harbors to give the trustee a chance to transfer the entire swap portfolio to a new company that is solvent. Repos, however, are treated like secured debt, but with the ability to immediately sell off high quality collateral (though not non-agency Mortgage-Backed Securities).

The Senate Bill draws on work from the Hoover Institution’s Resolution Project that proposed the original Chapter 14 in 2009 and 2010 and updated it recently.

Documents related to the original Chapter 14 proposal work, including proponents’ descriptions of the case for a new Chapter 14, can be found here. The text of S. 1861 can be found here. Professor Thomas Jackson’s Congressional testimony about Chapter 14 in 2014 can be found here.

*Editor, Harvard Law School Bankruptcy Roundtable, and Research Director, Harvard Law School Bankruptcy and Corporate Restructuring Project.

Reports of Equity’s Death Have Been Greatly Exaggerated

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By Adam J. Levitin, Georgetown University Law Center

Mark Berman is veryLevitin Headshot kind to take notice of my article in his recent analysis of Law v. Siegel, posted on the HLS Bankruptcy Roundtable, here.  We agree on a great deal about the case and scope of equity practice.  A question persists about the scope of Law v. Siegel, though, and what it is proscribing when it reiterates the view that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.”  The question, then, is which non-Code practices are properly characterized as “equity”.  My own view is that very little of modern bankruptcy practice is in fact “equity.”

Law v. Siegel, for example, should not affect such important non-Code practices as judicial interpretation of Bankruptcy Code statutory terms or judicially-created doctrines like substantial consolidation, which are sometimes mistakenly listed among the bankruptcy court’s “equitable powers”.  As I wrote earlier, though, because such practices are interstitial and formed as broad principles, they are, in my view, better understood as part of a federal common law of bankruptcy, and distinguished from equitable powers, which are based on case-by-case specifics, as in Law v. Siegel.  As interstitial powers, these lie outside any widening or narrowing of bankruptcy court’s equitable powers.

Moreover, the uncertainties about when actual equitable practices contradict statutes will continue.  In cases of clear contradiction, the interpretive result will be easy. But cases where it is unclear whether a conflict truly exists will continue to invite negotiation between and among the parties because of the cost and uncertainty of litigation.  Despite the Supreme Court’s best efforts, consideration of the equities will likely remain a part of our bankruptcy system.

For a fuller treatment of this subject, please continue here.

Revisiting the Recidivism-Chapter 22 Phenomenon in the U.S. Bankruptcy System

Author: Edward I. Altman, NYU Stern School of Business

Altman bio picThis study finds that about 15% of all debtors, who emerge as continuing entities from reorganization under Chapter 11 bankruptcy, or are acquired as part of the bankruptcy process, ultimately file for bankruptcy protection again. This recidivism rate spikes to 18.25% when considering only those firms which emerge as a continuing, independent entity. This highlights what appears to be a significant recidivism problem of our Chapter 11 system.

This article argues that the so-called “Chapter 22” issue should not be dismissed by the bankruptcy community as acceptable just because no interested party objected to the plan of reorganization during the confirmation hearing. Indeed, by applying the Z-Score model to large samples of Chapter 11 and Chapters 22, 33, and 44 firms, highly different and significant expected survival profiles are shown at the time of emergence. The bond-rating-equivalent of the multi-filing sample was CCC versus a BB-profile for the single-filing Chapter 11 sample. I believe that credible distress prediction techniques can be important indicators of the future success of firms emerging from bankruptcy and could even be used by the bankruptcy court in assessing the feasibility of the plan of reorganization – a responsibility that is embedded in the Bankruptcy Code.

The full article is available here.


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