The Rise and Fall of Regulatory Competition in Corporate Insolvency Law in the European Union

By Horst Eidenmüller (University of Oxford; European Corporate Governance Institute – ECGI)

In a recent paper, I discuss the rise and fall of regulatory competition in corporate insolvency law in the European Union. The rise is closely associated with the European Insolvency Regulation (EIR, 2002), and it is well-documented. The United Kingdom (UK) has emerged as the ‘market leader’, especially for corporate restructurings. The fall is about to happen, triggered by a combination of factors: the recasting of the EIR (2017), the European Restructuring Directive (ERD, 2019) and, most importantly, Brexit (2019). The UK will lose its dominant market position. I present evidence to support this hypothesis.

Regulatory competition in European corporate insolvency law happened by accident: it was the unwelcome consequence of the entering into force of the EIR in 2002. The EIR was designed to eliminate forum shopping and to harmonize Member States’ jurisdiction and conflicts rules for international insolvencies. However, in practice, it did not achieve this end. The Regulation’s test for main insolvency proceedings, a company’s ‘Centre of Main Interests’, can be manipulated. Forum shopping became almost a signature feature of the EIR, and the UK emerged as the ‘market leader’ for corporate restructurings in the European Union (EU). The available data clearly confirms this assessment. The popularity of the UK as a restructuring venue also stems from the attractiveness of the Scheme of Arrangement—a procedure that is not within the scope of the EIR. Under the applicable European rules, restructuring decisions taken by courts in one Member State must be automatically recognized in all other Member States.

The regulatory landscape for corporate insolvency law in the EU is changing. The EIR was recast in 2017, the EU passed the ERD in 2019, seeking to harmonize Member States’ pre-insolvency restructuring regimes so that local businesses get local access to restructuring processes, and the UK will probably leave the EU in 2019.

I argue that the recast EIR will not significantly affect forum shopping and regulatory competition in corporate restructurings. However, the ERD will have such an effect, i.e. it will significantly reduce forum shopping and regulatory competition in corporate restructurings. This is because the ERD mandates that Member States implement certain key features of pre-insolvency restructuring regimes by 2021, effectively ruling out radical legal innovations departing from the new European standard. Unfortunately, the ERD is a ‘defective product’: it mandates inefficient procedures and should be repealed.

Most importantly, Brexit will eliminate the dominant competitor in the European restructuring market, i.e. the UK. This is because Member States will no longer be forced to automatically recognize decisions taken in UK restructuring proceedings. It appears that the restructuring market already anticipates this effect: one can observe a decline of the popularity of the Scheme of Arrangement in cross-border cases from 2016 onwards. I present evidence in the form of hand-collected data on cross-border Schemes of Arrangement to support this hypothesis.

The full article is available here.

Indenture Trustee Duties: The Pre-Default Puzzle

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

Indenture trustees act for the benefit of the investors in a company’s bonds. They perform this role for virtually all companies that issue bonds, whether in the United States or abroad. The existing scholarship on their duties focuses on the post-default scenario. In many countries, including the United States, the law then imposes a ‘prudent person’ standard. This Article, in contrast, examines an indenture trustee’s “pre-default” duties.

It is critical to try to define those duties because activist investors, including hedge funds and so-called “vulture fund” investors that purchase defaulted bonds at deep discounts, increasingly are making pre-default demands on indenture trustees, who must know how to respond. Also, the manner in which they respond can have widespread economic consequences because the bond market is huge—in 2018, approximately $43 trillion in the United States and $103 trillion worldwide.

Activist investors are also suing indenture trustees for losses on their bonds, alleging they should have taken pre-default actions to protect the bonds. To avoid the risk of liability, indenture trustees should know how they should discharge their pre-default duties.

The indenture trustee’s pre-default duties have not been seriously re-examined since enactment of the Trust Indenture Act of 1939, although the bond market has changed dramatically since then. Institutional investors now dominate; there are few individual retail investors. By virtue of their sophistication and the size of their bondholding, institutional investors face less of a collective action problem than retail investors had faced. Also, as mentioned, certain activist investors increasingly are engaging in high-risk strategic investing.

Whether or not due to these market changes, there are at least two views today of the indenture trustee’s pre-default role. By far the dominant view—and the view that comports with existing law and the plain language of indentures—is that indenture trustees have no pre-default fiduciary duties to investors. Rather, their duties are ministerial and limited to the usually administrative functions specified in the indenture. Since the 2007-08 financial crisis, however, some investors argue that indenture trustees—especially those of securitized bond issues, who act for the benefit of investors whose right to payment is limited to collections on specified financial assets (such as mortgage loans)—should have some pre-default fiduciary duties.

My Article analyzes what an indenture trustee’s pre-default duties should be, starting by considering the possible normative frameworks for legally imposing duties in a business context. I consider two potentially overlapping frameworks: to correct market failures, and to maximize efficiency. I also consider a formalistic rationale for legally imposing duties—because securitized bond issues involve purchased financial assets, they more closely resemble a traditional trust; and trustees of a traditional trust have fiduciary duties.

Based on its analysis, the Article concludes (among other things) that, pre-default, the indenture trustee’s duties should only be those specified in the indenture. The Article also applies that standard to the types of issues that may arise in lawsuits against indenture trustees.

For example, even prior to a formal default, one or more investors may demand that the indenture trustee take some enforcement or other remedial action to try to correct a problem. Compliance with that demand could be expensive, reducing the value of the estate for investors generally. Taking remedial action could therefore create a conflict if it would disproportionately benefit only certain investors. Absent instructions from the requisite investor threshold contractually required to direct the indenture trustee, the trustee should have the right to refuse to take a demanded action. In case of doubt, an indenture trustee could itself seek instructions. The Article also examines practical issues—and practical ways to resolve those issues—that might sometimes impair formation of the requisite investor threshold to direct the indenture trustee.

The full article is available here.

Simple Insolvency Detection for Publicly Traded Firms

By J.B. Heaton (J.B. Heaton, P.C.)

Solvency plays important substantial roles in both bankruptcy and corporate law. In practice, however, balance-sheet solvency testing is fraught with difficulties. Mechanically, the balance-sheet solvency test asks if the market value of assets exceeds the face value of debt.  As for assets, direct market values of assets are rarely if ever available (closed-end funds may be an exception, but these are hardly run-of-the-mill businesses). Analytical valuation tools—including discounted cash flow analysis, comparable company multiples, and comparable transaction analysis—require considerable subjective judgment and can lead to large valuation errors. As for debt, much debt that is on the balance sheet does not trade in the market, and it is often impossible even to identify all the contingent liabilities like pensions, guarantees, insurance liabilities, and obligations to involuntary creditors like tort claimants, all of which should be valued appropriately and included in determining the total face value of debt.

In a new paper forthcoming in Business Lawyer, I develop a simple balance-sheet solvency test for publicly traded firms. I derive the test from an elementary algebraic relation among the inputs to the balance-sheet solvency calculation: The solvency test requires only the assumption that the market value of assets equals the sum of the market value of the firm’s debt plus the market value of the firm’s equity. The test requires that at least one class of the firm’s debt is traded, and that the equity is traded as well. The result is a generated upper bound on the total amount of debt the firm can have and still be solvent.

The virtue of the method—apart from its ease of implementation—is that it makes possible the detection of balance-sheet insolvent firms notwithstanding the possibility that not all of the firm’s liabilities—including hard-to-quantify contingent liabilities—can be identified. As a result, the method allows for the detection of balance-sheet insolvent firms that otherwise might escape detection. This may assist in a wide variety of situations where it is necessary to analyze solvency.

The full article is available here.

What’s Wrong with Chapter 11?

By Charles J. Tabb (University of Illinois College of Law)

The time has come to cast a discerning eye at chapter 11, the United States corporate bankruptcy reorganization statute, and examine how it is currently broken and what fixes can be made to improve it.

This Article first identifies five core normative goals that chapter 11 should promote: (1) maximize the value of the debtor firm; (2) distribute the maximized value of the firm fairly and equitably; (3) save jobs; (4) minimize the ripple effect of the firm’s failure; and (5) ensure that in pursuing those normative goals, the cure is not worse than the disease.

The Article then examines five critical ways in which chapter 11 in practice fails to achieve the normative ideals: (1) traditional chapter 11 restructurings are largely a thing of the past, and have given way to quick all-asset sales of the company; (2) secured lenders control everything and get a disproportionate share of the firm’s value; (3) a small number of other creditors are able to apply leverage to obtain unfair and inequitable payments on their claims compared to other creditors; (4) venue forum shopping has triggered a race to the bottom; and (5) bankruptcy judges routinely ignore the statute as written and legislate judicially.

The Article concludes by identifying seven possible reforms that could help transform chapter 11 from the current nightmare to the normative ideal dream: (1) making sales once again just sales; (2) resurrecting the “perishability” or “emergency” test for sales; (3) limiting secured creditors to foreclosure value; (4) opening up DIP financing terms and eliminating draconian terms; (5) eliminating all preferential priority-altering payments; (6) curtailing venue choice and forum shopping; and (7) eradicating judicial legislation.

The full article is available here.

Disagreement and Capital Structure Complexity

By Kenneth Ayotte (University of California, Berkeley School of Law)

Complex capital structures are prevalent in many recent high-profile Chapter 11 bankruptcy cases.  One recent example is Toys ‘R’ Us, whose debt structure included dozens of subsidiary entities, with separate debt facilities against entities owning the intellectual property, the real estate, and international operations, among other asset groups.  Why do capital structures become fragmented and complex in this way, and what are the implications for bankruptcy law?

In my working paper, I suggest one reason why a firm’s owners may have the incentive to engineer fragmented capital structures, using the idea that investors may disagree about the values of the various assets that make up the firm.  Fragmenting the capital structure horizontally—that is, pledging different assets and asset groups to different creditor classes—allows the firm to sell asset-based claims that are targeted to the investors who value those assets most highly. This targeting is good for the firm’s owners, because it minimizes the firm’s overall cost of capital.

This complexity can become costly, however, when firms encounter financial distress.  The same disagreement-driven fragmentation that allows the company to borrow more cheaply up front can lead to costly valuation disputes in and around bankruptcy, since creditors place a higher valuation on their own collateral than do the other creditors.  This can lead to valuation disputes that are socially costly in terms of professional fees, delays, and lost opportunities.  An example of this is the Energy Future Holdings case.  Following it’s 2007 leveraged buyout, the capital structure was divided into two silos, with one silo of entities (called the “E” side) holding regulated power assets, and a separate silo of entities holding the non-regulated power assets (the “T” side), with separate creditor groups on each side.  The initial plan to avoid bankruptcy by converting E- and T-side debt into parent-level equity failed after more than a year of negotiations, as the two sides could not come to agreement about the relative value of the two sides.  The resulting bankruptcy took over four years to reach plan confirmation and generated over $500 million in professional fees, to the detriment of creditor recoveries.

The theory has several implications.  One is that disagreement about valuation can lead to inefficient liquidation of viable firms, as creditors may prefer to walk away with the collateral they value highly, rather than fight for that value in a reorganization where the other creditors (from their perspective) are clinging to inflated valuations of their own collateral.  These kinds of forces may have been at play in the Toys ‘R’ Us case.  The B-4 term lenders, including the hedge fund Solus Alternative Asset Management, believed they were better off monetizing their intellectual property collateral in a liquidation of Toys ‘R’ Us than backing a deal to keep existing stores open.  The recent cancellation of the auction of this collateral suggests that these lenders may have held optimistic beliefs than the marketplace about the value of these assets.

From an academic standpoint, the theory provides a new answer to a long-standing question in the literature: why do we need a corporate reorganization mechanism in the first place? Traditional answers to this question revolve around the need to solve illiquidity problems.  In the presence of disagreement, I suggest an alternative benefit.  A traditional Chapter 11 reorganization allows parties to walk away with securities backed by the assets they financed before bankruptcy, about which the creditors are likely to be more optimistic.  Thus, the creditors can continue “agreeing to disagree” about the values of their respective pieces, thus promoting settlement and avoiding socially costly valuation disputes.  This is not possible when the firm is sold as a going concern for cash, since cash has a commonly known value.

Finally, my model emphasizes that when capital structures are fragmented, bankruptcy costs can be driven by haggling and litigation over the value of the parties’ entitlements, even when the parties agree about what to do with the bankrupt firm.  This suggests that the time may be ripe for rethinking and improving the resolution of valuation disputes in bankruptcy.  In a related paper, published in University of Pennsylvania Law Review, Edward Morrison and I review valuation opinions in bankruptcy cases.

The full article is available here.

The Dark Side of Bank Resolution: Counterparty Risk through Bail-in

By Wolf-Georg Ringe and Jatine Patel (University of Hamburg – Institute of Law & Economics, University of Oxford)

Bail-in and its supplementary capital requirements have much touted potential. Beyond their promise to reign in financial institutions’ bail-out moral hazard, bail-in intends to stem systemic risk whilst maintaining “critical” banking functions. It seeks to do this by allocating responsibility for recapitalization of banks to their individual creditors, immediately upon resolution, and in a pre-defined manner, for each financial institution individually. Counterparties to banking capital are therefore intrinsic to the current regulatory framework.

In our recent paper, we show, however, that bail-in legislation may have had counterproductive effects. Our key finding is that the introduction of bail-in has led to increased interconnectedness among banks, which involves more rather than less systemic risk. Worse still, increased interconnectedness between banks may jeopardize the effectiveness of the bail-in regime altogether since resolution authorities may be reluctant to exercise bail-in powers in the face of highly interconnected and contagious banks.

Using a difference-in-differences methodology, we provide evidence for this from the introduction of bail-in powers at the Eurozone level on January 1, 2016 when it entered into force under the European legislation known as the Bank Recovery and Resolution Directive, and the corresponding Single Resolution Mechanism (as part of the Banking Union) became effective. Using data from the European Central Bank’s Securities Holdings Statistics, we demonstrate that beginning in early 2016, financial institutions’ investments in securities issued by other financial institutions has been following a markedly increasing rate. What is more, at the same time non-banks have continued to decrease their investments in the same issuances. Put differently, banks’ holdings of securities in each other increased following the introduction of bail-in legislation, while non-banks continued to divest their holdings of bank securities.

We interpret these findings as evidence of a relative cost advantage that financial institutions have in comparison with other investors when investing in banks’ securities. We know from prior literature that increased interconnectedness may stabilize the banking sector for small external shocks (Acemoglu et al. 2015). For large, systemic shocks, in contrast, bank interconnectedness may frustrate any bail-in decision due to the systemic risk it creates (Bernard, Capponi, and Stiglitz 2017).

We subsequently discuss the challenges in regulating this problem, noting that in addition to the incentive problems mentioned above, there are also extensive knowledge and incentive challenges. Those challenges are symptomatic of the same legal and economic difficulties expressed in the literature and evident in recent bail-in cases.

Whilst some aspects of the current regulatory framework, including the Basel III and the TLAC framework, and standardized information disclosure under IFRS 9, indirectly affect those knowledge and incentive issues, they insufficiently address the bail-in counterparty problem especially because those measures address pre-resolution systemic risk perceptions, and not post-resolution systemic risk. More crucially perhaps, they do not facilitate optimization, or the who should hold corollary.

Finally, we explore some potential regulatory supplements to the current framework that may assist in reducing the challenge of knowing who should hold banking issuances, particularly ensuring that markets are better informed and able to allocate banking securities to optimal holders in accordance with principles of portfolio management, as opposed to attempting to prescribe ideal holders. More analysis and further holistic research are required to understand better what combination of regulatory instruments would be appropriate.

The full article is available here.

Disruption and Credit Markets

By Bo Becker (Stockholm School of Economics) and Victoria Ivashina (Harvard Business School)

Corporate bond defaults have been on a long and powerful upward trajectory in the past few decades. The default rate of U.S. corporate bonds rose from 0.12 percent to 0.46 percent between the first and second halves of the period from 1970 to 2016—an increase of almost four times. The rating agency Moody’s reports that, of the ten years with the highest default rates since 1960, six occurred in the new millennium and none before 1990. In a recent working paper, we investigate the role of disruption in explaining this trend.

By disruption, we refer to the process whereby new firms replace old firms using innovations in their business models, operations, or new technology. This process causes incumbent firms to lose market share, suffer reduced profitability, and, as we demonstrate, default on debt obligations. Just to name a few of the many recent examples: single-location bookstores were disrupted by chain stores, which were in turn disrupted by online bookstores, and off-line travel agents were disrupted by online services.

In our study, we compare industries with high rates of arrival of new firms, measured as either venture capital investments in the sector over the last five years or as the fraction of public firms in the industry with an IPO date in the past five years. The two variables capture different stages of disruptors’ ascent. While one can easily think of several broad forces that have increased innovation and disruption over the past few decades, different industries have been affected at different speed and different depth. We exploit this variation to draw the connection between disruption and defaults.

Our measures of disruption positively predict future defaults on corporate bonds, controlling for a host of other factors (including time, industry, bond characteristics such as seniority and callability, and issuer characteristics such as credit rating). These bonds are largely issued by mature firms (startups rarely access the bond market). Not only are future defaults higher in industries with high rates of disruption, but the bond market prices this in: newly issued bonds in high-disruption industries have higher yields. These findings are surprising, as a reasonable expectation might be that firms in the same industry would generally suffer similar fates. We would then expect to see high rates of new firm creation coupled with low defaults on the debt (of incumbents). Instead, we find the opposite.

An active IPO market and elevated venture capital investment may help the inception and advancement of potential disruptors, but underlying causes may be found in technological shifts (information technology, mobile, and ,in an earlier era, perhaps electricity), deregulation (think airlines), and globalization (in our data, industries directly exposed to off-shoring are no more likely to see defaults; however, global markets may have an important role in scaling up the opportunities available for disruptive businesses).

The importance of disruption probably extends beyond creditors to other stakeholders of incumbent firms. The corporate bond market is useful for studying disruption because bonds are liquid securities with detailed, high-quality data. Furthermore, losses on corporate bonds are important because bonds are widely held. This is in contrast with the gains from disruption, which tend to be concentrated with entrepreneurs and venture capital investors.

Disrupting Secured Transactions: Should UCC Article 9 Be Revised to Reflect the Rise of the Internet of Things?

By Christopher G. Bradley (University of Kentucky College of Law)

The “Internet of Things” (IoT) refers to the networks formed by interconnected devices that can communicate, and be communicated with, remotely. The IoT has already affected our daily lives, as a crucial part of our smart phones, Fitbits, smart watches, car navigation units, and so on.  But even more, it has profoundly affected businesses of every sort.  Manufacturing, transportation, and utilities firms alone are estimated to have spent more than $347 billion on IoT technology in 2018. Companies have deployed IoT tools in order to automate operations, streamline supply chains, ease regulatory compliance, and facilitate safer and more reliable production.

The IoT also affects secured creditors’ ability to monitor their collateral. For instance, individual tags can be placed on objects as they are checked in and out of a facility; cameras and temperature sensors can assess warehouse or field conditions to protect against loss or theft; vehicles can be tracked at all times and even remotely disabled upon default.

I argue that just as the rise of the IoT represents a revolution in business practice, it should bring a similar one to UCC Article 9. The article argues that Article 9 should allow–and in fact require–creditors to stake their claims in tangible collateral directly rather than through the now-antiquated means of a filing system routed through the debtor’s name/identity.

The proposed system would require creditors to tag items as collateral, or to use an interactive map administered by the state filing office over the Internet, in order to perfect security interests in tangible collateral. After sketching the proposed system, the article considers some of its major costs and benefits.

The full article is available here.

Absolute Priority Redux: First-Day Orders and Pre-Plan Settlements in Chapter 11 Post-Jevic

By Bruce Grohsgal (Delaware Law School Widener University)

Bankruptcy’s absolute priority rule arose 150 years ago to prevent insiders from using their control over an enterprise – often coupled with hypothetical valuations, contrived sales, and collusion with other parties – to obtain a greater distribution or “control premium” from estate assets.  This premium came at the expense of parties who had a higher distributional priority but were not “in on the deal.”  The Supreme Court again considered this issue in Jevic in 2017, when it held that a chapter 11 case-ending settlement called a “structured dismissal” must comply with the same absolute priority rule that applies to the similarly case-ending confirmation of a chapter 11 cramdown plan.  The Court emphasized that insider control and collusion can endanger bankruptcy’s core principle of an orderly distribution in accordance with statutory priorities.

The Jevic Court explicitly left open, though, the extent to which a pre-plan settlement or court-ordered “first-day” distribution in chapter 11 may deviate from the absolute priority rule.  It suggested only that a court approving these pre-plan distributions must show some respect for – or a “proper solicitude” to – the statutory distributional priorities.

I propose in this paper that, for a proposed pre-plan, priority-skipping settlement with an insider, secured lender or other party who exercises some control over the debtor, the absolute priority rule is sufficiently respected when a bankruptcy court subjects to an auction the claim proposed to be settled.  If at the auction, a third party bids the same or a higher price for the claim absent the priority-skipping, then it will be clear that the initially proposed transaction included a control premium.  If instead a higher third-party bid is not obtained, it will be clear that the settling insider is not paying a discounted settlement price based on its control and that the priority-skipping has a legitimate basis that does not implicate the problem of insider control.  The auction, by displacing suspect hypothetical valuations, can address the precise mischief sought to be remedied by the absolute priority rule.

I further contend that a market test for a “first-day” distribution to a critical vendor, employee or other creditor that is challenged as priority-skipping will be limited to whether the debtor sought and failed to obtain in the market the same good, service, or credit from an alternative supplier on the same or better terms than those proposed in the first-day motion.  The reason for this is simple – a bankruptcy court will not be able in most cases to obtain, at the time of the first-day hearing, a market determination of case-ending distributions to creditors.  Any hypothetical valuation at a first-day hearing of the end-of-case distributions to creditors will be highly unreliable.  Because of these obstacles, I suggest that the question of whether a first-day payment will comport with end-of-case distributional priorities should be replaced with the question of whether the debtor sought and failed to obtain an alternative supply in the market on the same or better terms, and by a rebuttable presumption that preserving the going concern value of the chapter 11 debtor likely will benefit even the disfavored creditors.  This approach – which essentially adopts the occasionally maligned “doctrine of necessity” and rejects the Seventh Circuit’s Kmart rule – recognizes the disturbing weakness of a hypothetical determination, made at the first day hearing, of end-of-case distributions in a chapter 11 case.

The full article is available here.

Second Circuit Backs Foreign Clawback Claims in Madoff Bankruptcy Action

By Adam J. Goldberg, Christopher Harris, Robert J. Malionek, Kevin L. Mallen (Latham & Watkins)

In In re Picard, Tr. for Liquidation of Bernard L. Madoff Inv. Sec. LLC, No. 17-2992(L), 2019 WL 903978 (2d Cir. Feb. 25, 2019), the Second Circuit held that the trustee administering Bernie Madoff’s insolvent estate could use Section 550(a) of the Bankruptcy Code to claw back purely foreign transactions between foreign entities. The money at issue had been initially transferred by Madoff to foreign funds, then subsequently transferred by the foreign funds to the foreign defendants. The defendants argued that the Madoff trustee’s clawback claims were barred by the presumption against extraterritoriality and the principles of international comity.

While the Southern District of New York had focused its analysis on the subsequent transfers by the foreign funds to the foreign defendants, the Second Circuit focused on the initial transfer from Madoff to the foreign funds when determining whether the subsequent transfers could be recovered. The Second Circuit reasoned that since the initial transfers were from New York-based Madoff, the presumption against extraterritoriality and the principles of international comity did not bar the Madoff trustee’s attempts to recover these foreign subsequent transfers.  In so holding, the Second Circuit reversed the Southern District of New York’s prior ruling that such foreign transfers could not be recovered, and removed a protection for foreign investors who may not have anticipated that their investments — and their returns — could otherwise be subject to clawback under US law.

The full article is available here.

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