Repo Markets Across the Atlantic: Similar but Unalike

By Songjiwen Wu (University of Heidelberg) and Hossein Nabilou (Universite du Luxembourg – Faculty of Law, Economics and Finance)

The vulnerabilities in the wholesale funding and in particular short-term (overnight) repurchase agreement (repo) markets were significant sources of systemic risk in the Global Financial Crisis. Numerous studies have investigated the role of repos in the crisis, but only a few scholars have explored why the European repo markets have weathered the crisis better than their US counterparts. With a focus on the underlying legal and structural features of repo markets across the Atlantic, our paper sets out to explain such a different outcome. In doing so, it sketches the key differences in the EU and the US repos by focusing on three main aspects of repo markets that are pivotal to highlighting potential vulnerabilities. First, it highlights the differences in the legal framework governing repos, such as legal construction of repo contracts, special bankruptcy treatment—the reform of which has been a key controversial issue across the Atlantic—and legal treatment of the reuse of collateral. Second, it discusses the composition, structure, and organization of the repo markets, such as differences in the composition of repo participants, maturity of repos, and the composition of the underlying collateral in repo contracts. Finally, it investigates the differences in the issues related to the market infrastructure of repo markets such as differences in the clearing and collateral management stages. The findings of our paper suggest that multiple legal and regulatory divergences, which could still pose challenges to the short-term funding markets, exist in repo markets across the Atlantic.

The full article is available here.


For previous Roundtable posts on repo markets, see Ganduri, “Repo Regret?“, and Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“.

Bankruptcy Law as a Balancing System – Lessons from a Comparative Analysis of the Interaction Between Labor and Bankruptcy Laws

By Omer Kimhi (Haifa University Faculty of Law) and Arno Doebert (Independent)

The rehabilitation of distressed corporations often requires the reduction of labor costs. In order to regain economic stability, distressed firms need to terminate employees or modify their employment conditions. When employees are protected by statutes or by collective bargaining agreements, however, such measures are not always possible. The employer’s freedom to manage its work force is limited, and it may fail to implement labor reforms necessary for the firm’s recovery.

In the paper, we examine the intersection between bankruptcy and labor laws from a comparative perspective. We study the labor and bankruptcy laws of three different jurisdictions, the Netherlands, France, and Germany, and find a so far unexplored trend. Jurisdictions with high employment protection levels relax their otherwise rigid labor rules through their bankruptcy system. Within bankruptcy, employers enjoy greater flexibility and thus are better situated to decrease their labor costs and to reorganize.

The paper explores this trend vis-à-vis the arguments brought up by the procedural approach to bankruptcy. It looks at the rationale of the bankruptcy-induced modifications to the labor laws, and the effects these changes have on the bankruptcy process. We show that although the modifications are designed to promote the preservation of firms as going concerns, forum-shopping problems may lead to the opposite outcome. The analysis contributes to the ongoing debate between the traditional and procedural approaches, and sheds light on the interpretation of section 1113 of the Bankruptcy Code as well.

The full article is available here.

 

 

 

Valuation Disputes in Corporate Bankruptcy

Kenneth Ayotte (U.C. Berkeley School of Law); Edward R. Morrison (Columbia Law School)

In bankruptcy, valuation drives disputes. Prior bankruptcy scholarship points to disagreements about valuation and judicial valuation error as key drivers of Chapter 11 outcomes. Avoiding valuation disputes and errors is also the underlying driver of most proposed reforms to Chapter 11.

This paper studies all reported bankruptcy court opinions filed between 1990 and mid-2017 that provide detail about a valuation dispute and methodologies employed. We have two goals. The first is to understand how parties and their expert witnesses justify opposing views, and how judges decide between them. The second is to provide practical guidance to judges.

We find sharper disagreement among experts regarding inputs to the discounted cash flow method (DCF) than regarding inputs to multiples-based methods. In nearly half of cases involving DCF, experts fight over the discount rate; in nearly three quarters, they fight over cash flow projections. By contrast, disagreement over inputs to multiples-based methods, such as the choice of comparable companies, occurs in less than a fifth of the cases. This pattern helps explain why many judges view DCF as far more complex and error-prone than multiples-based methods.

There are also surprisingly pervasive (and often self-serving) errors in expert testimony. This is particularly true when valuation experts apply DCF. The choice of discount rates is frequently unsupported by, and often at odds with, finance theory and evidence. We also find experts strategically weighting methods with values most favorable to their clients.

We propose simple strategies based in finance theory that judges can employ to reduce the scope for valuation disagreements in Chapter 11. For example, we argue that courts should reject the use of company-specific risk premia in discount rates and be highly skeptical whenever experts weight some valuation methods more than others in calculating “average” estimated values.

The full article is available here.

 

The Effect of Creditor Rights on Capital Structure, Investment, Profitability, and Risk: Evidence from a Natural Experiment

By Aras Canipek (University of Konstanz), Axel Kind (University of Konstanz; University of Basel; University of St. Gallen), and Sabine Wende (University of Cologne)

Supply-side scholars have argued that laws which mandate managers to leave upon bankruptcy filing and which grant secured creditors strong power to quickly seize their collateralized assets lead to higher recovery rates, lower interest costs, and relaxed financial constraints, and that these consequences ultimately foster economic growth. In contrast, a more recent demand-side view raises the concern that borrowers can feel threatened by such liquidation-oriented regimes. Threatened borrowers may take (economically undesirable) actions to reduce the likelihood of having to bear high distress costs.

We find evidence in favor of the demand-side view by using Germany’s bankruptcy reform (ESUG) of 2012 and studying the causal effects of an exogenous downward shock to creditor rights on firms’ financial and investment policy. ESUG limited the rights of secured creditors by strongly facilitating firm continuation and allowing the manager to stay in unrestricted corporate control. In the study, we show that high-tangible-asset companies – which the reform predominantly affected – turned away from being overly risk-averse at the cost of profitability, relative to low-tangibility control firms. Specifically, weaker creditor rights motivated affected firms to increase financial leverage and to prefer the more flexible unsecured debt. Moreover, affected firms reduced unprofitable but risk-lowering expansions and sold off less profitable but easily-marketable assets that are useful in downturns by providing the liquidity that can prevent bankruptcy. Our results suggest that weaker creditor rights encourage firms to eliminate protection mechanisms formerly constructed to contract around liquidation-oriented bankruptcy provisions. This view is supported by the increased profitability and higher risk of treated firms after the reform.

The stronger pre-ESUG creditor rights not only produced ex post deadweight losses in terms of inefficient liquidation, but also discouraged firms to make profitable investment decisions. This reveals ex ante inefficiencies of creditor rights, an aspect largely ignored in the extant literature.

The article can be found here.

Beyond Common Equity: The Influence of Secondary Capital on Bank Insolvency Risk

By Thomas Conlon (University College Dublin), John Cotter (University College Dublin; UCLA Anderson School of Management); Philip Molyneux (University of Sharjah – College of Business Administration)

Prudential regulation requires banks to hold capital as a buffer in the event of losses and as a means to mitigate risk shifting by shareholders. Under capital regulation, a large menu of securities is permitted to contribute to regulatory capital. While previous studies have predominantly concentrated on the relationship between bank risks and narrow capital measures (such as tier 1 capital or equity capital), we further develop this work by looking at a broader menu of capital components. We examine bank insolvency risk (distance to default) for listed North American and European banks over the period from 2002 to 2014, with a focus on sensitivity to capital other than common equity. Decomposing tier 1 capital into equity and non-core components reveals a heretofore unidentified variation in risk reduction capacity. Greater non-core tier 1 capital is associated with increased insolvency risk for larger and more diversified banks, impairing the risk reducing capacity of aggregate tier 1 capital. Overall, tier 2 capital is not linked with insolvency risk, although a conflicting relationship is isolated conditional on the level of total regulatory capital held. Finally, the association between risk and capital is weakened when the latter is defined relative to risk-weighted assets.

The full article is available here.

Debate Intensifies as to Whether the Bankruptcy Code’s Avoidance Provisions Apply Extraterritorially

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

The ability to avoid fraudulent or preferential transfers is a fundamental part of U.S. bankruptcy law. However, when a transfer by a U.S. entity takes place outside the U.S. to a non-U.S. transferee—as is increasingly common in the global economy—courts disagree as to whether the Bankruptcy Code’s avoidance provisions apply extraterritorially to avoid the transfer and recover the transferred assets. Several bankruptcy courts have addressed this issue in recent years, with inconsistent results.

In a recent example, in In re CIL Limited, 582 B.R. 46 (Bankr. S.D.N.Y. 2018), the U.S. Bankruptcy Court for the Southern District of New York, disagreeing with other courts both within and outside its own district, ruled that the “transfer of an equity interest in a U.K. entity to a Marshall Islands entity was a foreign transfer” and that the Bankruptcy Code’s avoidance provisions do not apply extraterritorially because “[n]othing in the language of sections 544, 548 and 550 of the Bankruptcy Code suggests that Congress intended those provisions to apply to foreign transfers.”

The decision further muddies the waters on an issue that has become increasingly prominent as the volume of cross-border bankruptcy cases continues to grow and cross-border transactions become ubiquitous. The split on this issue exists not merely between courts in different jurisdictions, but also among courts in the Southern District of New York, where the majority of cross-border bankruptcy cases have traditionally been filed.

The full article is available here.

Optimal Deterrence and the Preference Gap

By Brook Gotberg (University of Missouri School of Law)

It is generally understood that the way to discourage particular behavior in individuals is to punish that behavior, on the theory that rational individuals seek to avoid punishment. Laws aimed at deterring behavior operate on the assumption that increasing the likelihood of punishment, the severity of punishment, or both, will decrease the behavior. The success of these laws is also evaluated by how much the targeted behavior decreases. The law of preferential transfers, which effectively punishes creditors who have been paid prior to the bankruptcy has been defended on the grounds that it deters a race to collect from a struggling debtor. However, deterrence theory suggests that the low likelihood of punishment and the cap on punishment associated with preference law make it a very poor deterrence. Further, statements pulled from interviews with affected creditors, debtors, and attorneys demonstrate that in practice, preference law does little or nothing to deter targeted behavior, and in the process imposes significant costs. The weaknesses of preference law call for its significant revision to place a greater focus on specific categories of creditors to be punished on account of their pre-bankruptcy activities.

The full article is available here.

 

The Changing Landscape of Consensual Third-Party Releases in Chapter 11 Plans: Does Silence = Consent?

By Kathrine A. McLendon and Lily Picón (Simpson Thacher & Bartlett LLP)

There has been increasing focus on what evidences implicit consent to a third-party release in a chapter 11 plan.  This article examines the statutory framework underlying consensual third-party releases and then discusses recent cases in which consensual releases have been challenged by the Office of the United States Trustee and by courts sua sponte. Although various forms of implicit consent were often approved in the past with little or no scrutiny, these cases highlight trends toward stronger indicia of consent and greater attention to the factual context of the particular case.  These developments also underscore the importance of making the appropriate evidentiary record to support approval of consensual third-party releases. We conclude with practice pointers to support the case for confirmation of chapter 11 plans containing consensual third-party releases.

The full article can be found 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.

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