Senate Judiciary Committee Hearing on Bankruptcy for Banks and Proposed Chapter 14

On November 13, 2018, the Senate Judiciary Committee held a hearing on “Big Bank Bankruptcy: 10 Years After Lehman Brothers,” in connection with the proposed “Taxpayer Protection and Responsible Resolution Act” (“TPRRA”). The TPRRA would add a new chapter 14 to the Bankruptcy Code, providing a recapitalization mechanism for bank holding companies or some other financial companies.

This version of chapter 14 would implement the “Single Point of Entry” financial company resolution model in bankruptcy. (The SPOE model contemplates that only a financial company’s top-level holding company would go into bankruptcy proceedings, with losses borne by its creditors, while material subsidiaries continue to operate as going concerns. For more, see here.) The bill contemplates a proceeding where the bank’s holding company would have a large amount of its long-term debt turned into equity over a 48 hour (likely weekend) period. The firm’s subsidiaries would continue to operate, but would be transferred over to a new, debt-free bridge company. The old holding company’s shareholders and creditors would have their claims handled through a bankruptcy process. The bill also included a 48 hour automatic stay on Qualified Financial Contracts (QFCs), but effectively requires their assumption by the new bridge company.

In his opening remarks, Senator Grassley noted that several similar bank bankruptcy proposals have been incorporated into bills introduced into both the Senate and House over the past several Congresses. (For Roundtable coverage of the 2016 and 2017 FIBA bills, click here, here, here, and here.) A principal difference, stressed by Senator Coons in his opening statement, was that the current bill would not affect Title II of the Dodd-Frank Act, as some prior provisions would have. The view that a special chapter 14 should complement, rather than replace the FDIC’s Orderly Liquidation Authority (OLA) is consistent with the U.S. Department of the Treasury’s report on OLA, recommending against its repeal, released earlier this year. (For Roundtable coverage of the OLA, click here and here.)

The Hearing featured testimony by Donald Bernstein (Davis Polk), Professor Mark Roe (Harvard Law School), and Stephen Hessler (Kirkland & Ellis).

Video and testimonies available here.


For previous Roundtable posts on the resolution of financial institutions, see Howell Jackson & Stephanie Massman, “The Resolution of Distressed Financial Conglomerates“; Stephen Lubben & Arthur Wilmarth, “Too Big and Unable to Fail“; Mark Roe’s “Don’t Bank on Bankruptcy”; Mark Roe & Stephen Adams, “Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio”; David Skeel’s “Bankruptcy for Banks: A Tribute (and a Little Plea) for Jay Westbrook”; and, “Financial Scholars Submit Letter to Congress Opposing Repeal of Title II.”

(This post was authored by Ryan Rossner, J.D. ’19.)

Regulating Bankruptcy Bonuses

By Jared Ellias (University of California, Hastings)

In 2005, the perception that wealthy executives were being rewarded for failure led Congress to ban Chapter 11 firms from paying retention bonuses to senior managers. After the amendment became effective, Chapter 11 debtors could only pay executive bonuses through court-approved “Key Employee Incentive Plans,” which required managers to earn their pay by accomplishing specific performance goals, such as increasing revenue or moving the firm through the bankruptcy process.

In my article, I use newly collected data on the compensation practices of Chapter 11 debtors between 2002 and 2012 to examine how the reform changed bankruptcy practice. I find that relatively fewer firms used court-approved bonus plans after the reform, but the overall level of executive compensation appears to be similar. I hypothesize that three problems undermined the efficacy of the reform. First, the 2005 law asks bankruptcy judges to police the line between “incentive” bonuses and “retention” bonuses, which is extremely hard to do – judges are poorly equipped to assess the “challenging-ness” of a proposed performance goal. Second, creditors have limited incentives to police executive compensation themselves and help bankruptcy judges perform their inquiry, and the Department of Justice’s US Trustee program, while vigilant, lacks expertise in executive compensation. Third, gaps in the new regime make it easy for firms to bypass the 2005 law and pay managers without the judges’ permission. I support each of these hypotheses with empirical evidence. Further, there is also evidence that the reform significantly increased the litigation surrounding bonuses plans and, unsurprisingly, the attorneys’ fees associated with them. In many ways this paper examines what happens when Congress tries to change the balance of bargaining power between managers and creditors, and the result appears to be that firms found ways to get around a poorly written rule.

The full article is available here.

 

Bankruptcy for Banks: A Tribute (and Little Plea) to Jay Westbrook

By David A. Skeel, Jr. (University of Pennsylvania Law School)

Over the past several years, Congress has considered various versions of a legislative reform that would amend the Bankruptcy Code to facilitate the prompt reorganization of systemically important financial institutions (“SIFIs”). The reform would adapt the “Single Point of Entry” strategy devised for use under Title II of the Dodd Frank Act to bankruptcy. In each context, the assets, short term liabilities, and secured debt of the troubled SIFI would be transferred to a newly created bridge institution, leaving behind its stock and long-term debt. The newly recapitalized bridge institution would be fully solvent, and could contribute liquidity to the troubled subsidiaries as necessary. Although the bankruptcy for banks legislation appears to have strong support in Congress, its reception among bankruptcy scholars has been mixed.

In this short essay, I take the opportunity of a celebration of the work and influence of Jay Westbrook to explore his and his fellow critics’ opposition to bankruptcy for banks. I begin the essay by surveying Jay’s wide-ranging contributions to bankruptcy scholarship. Jay’s functional analysis has had a profound effect on scholars’ understanding of key issues in domestic bankruptcy law, and Jay has been the leading scholarly figure on cross-border insolvency. After surveying Jay’s influence, I turn to the topic at hand: bankruptcy for banks. Jay has been a strong critic of the proposed reforms, arguing among other things that financial institutions need to be resolved by regulators and an administrative process, not bankruptcy. After addressing these and other objections, I ask Jay if he might reconsider his opposition if the legislation were amended to respond to several of his primary concerns.

The essay is available here.

Secured Credit and Effective Entity Priority

By Christopher W. Frost (University of Kentucky – College of Law)

The historical and doctrinal development of secured transactions and bankruptcy law has created a priority system that is asset based. Secured creditor priority is tied to the value of specific assets that constitute the secured creditor’s collateral and not to the value of the debtor itself. And yet, in corporate bankruptcy cases, lenders and their attorneys often assert broad claims to the entire enterprise value of the entity – that is to the present value of the cash flows that the entity will generate as a going concern. The doctrinal basis for such claims is often unstated, however, and several commentators have criticized the breadth of those claims under existing laws.

This article responds to those views  and argues that secured creditors can establish a broad enough security interest to create an “effective entity priority.”  The argument is premised on the notion that the broad secured claim creates a closed system in which all of the assets acquired relate, and can be traced, to pre-bankruptcy collateral. The secured creditor’s priority therefore may extend to the value of the entity, rather than the value of specific assets within the entity. Although the doctrinal claim is plausible, the article notes that it can be difficult to maintain under the facts of particular cases. Thus the article suggests that changes to the Bankruptcy Code and the Uniform Commercial Code that recognize true entity priority may provide clarity and efficiency to the bankruptcy process.

The full article is available here. The article is forthcoming in the Connecticut Law Review.

Creditor Governance

By William R. McCumber (College of Business, Louisiana Tech University) and Tomas Jandik (Sam M. Walton College of Business, University of Arkansas)

A traditional view of creditors is that they are largely passive investors unless a borrower violates the terms of a loan agreement or misses a payment. However, like institutional shareholders, creditors hold concentrated positions in firm securities (loan shares), are sophisticated investors, and have access to senior management and non-public information. Since debt financing is much more common than equity financing, and because the great majority of credit agreements are honored, it is important to better understand how creditors advise and monitor portfolio (borrower) firms. We find that creditors play a significant role in corporate governance under normal circumstances, i.e. when firms are not in technical violation or default. Borrower firms are less likely than non-borrowers firms to file for bankruptcy in the intermediate future, and borrowers shift financial and investment decisions away from value-reducing policies and toward value-creating investments. Importantly, these changes are profitable for borrower firms since both cash flows and returns on assets improve at least three years after loan origination, which in turn decreases creditor portfolio risk. We also find that when creditors retain a larger proportion of the loan on their books, changes in borrower firm financials are more pronounced, providing evidence that creditors exert a greater governing force when more exposed to borrower risk.

The full article is available here.

A New Approach to Executory Contracts

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

Few bankruptcy topics have bedeviled courts—and busied commentators—as much as executory contracts. Perhaps the most nettlesome challenge is the problem of defining “executoriness,” which serves as the statutory gatekeeper to Section 365 of the Bankruptcy Code and its extraordinary powers. Elite lawyers, who are the closest approximation to chapter 11 repeat players, have no ex ante incentive to fix a definition; in part succumbing to a vividness bias, they want to exploit executoriness’s inherent ambiguity to select the definition perceived to be most advantageous in any given case ad hoc. From Westbrook to Countryman before, authors have struggled to find a coherent and normatively defensible definition of executoriness (including Westbrook’s call for its abolition) that would stop this gamesmanship, and even the American Bankruptcy Institute’s Review Commission has now entered the debate.

This article takes a new approach. It suggests abandoning the bootless task of finding the right test and concedes that executoriness is here to stay. This new approach focuses on the residuum of the “non-executory contract.” Using the policies, structure, and text of the Code, it argues that many of Section 365’s provisions can be synthetically replicated elsewhere. Doing so will blunt the strategic incentive to invest resources fighting the absence or presence of executoriness ab initio by scuttling the payoff. Concomitant gains will accrue to all.

The full article is available here.

The Secret Life of Priority: Corporate Reorganization After Jevic, 93 WASH L. REV. 631 (2018)

By Jonathan C. Lipson (Temple University – James E. Beasley School of Law)

The Supreme Court’s 2017 decision in Czyzewski v. Jevic Holding Corp. (In re Jevic) reaffirms that final distributions in chapter 11 cases must follow “absolute” priority absent the “consent” of priority creditors. The Court did not, however, define “consent” for this purpose, which is a problem, because consent can be hard to pinpoint in corporate reorganizations that involve hundreds or thousands of creditors and shareholders.

In this paper, I argue that, although the Jevic majority does not define consent, its reasoning reflects concerns about aspects of the reorganization process that may serve as proxies for it: stakeholder participation, outcome predictability, and procedural integrity.

First, I explain why “consent” is indeterminate in this context, inviting an inspection of process quality. Second, I assess Jevic’s process-value framework. Implementing Jevic’s values is not costless, so the Court’s commitment to them suggests that efficiency — the mantra of many scholars — is not the only or necessarily the most important value in reorganization. Third, I argue that these values conflict with the power that senior secured creditors have gained in recent years to control corporate reorganizations. Many worry that this power is the leading problem in corporate bankruptcy, producing needless expropriation and error. I also sketch opportunities that Jevic creates for scholars and practitioners who share these concerns.

Jevic reveals a secret: “priority” is not only about the order in which a corporate debtor pays its creditors, but also about the process by which it does so.

The full article is available here.

Non-Debtor Substantive Consolidation: Do Recent Cases Signal a Judicial Preference for State Law Claims?

By Charles W. Azano (Mintz Levin).

Jurisprudence varies on whether bankruptcy courts have the power to consolidate a bankruptcy debtor with a non-debtor. Even those courts that have permitted consolidation have done so with trepidation, calling the remedy “extreme” or “extraordinary,” and that the power is to be used “cautiously” or “sparingly.”

Two courts recently addressed whether it is possible for a non-debtor to be consolidated into the bankruptcy of an affiliated debtor, or whether such attempts are dead-on-arrival. First, the Eighth Circuit Court of Appeals in Official Committee of Unsecured Creditors v. Archdiocese of Saint Paul & Minneapolis (In re Archdiocese of Saint Paul & Minneapolis), held that because Section 303(a) of the Bankruptcy Code protected non-profit entities from involuntary bankruptcy filings, non-profit non-debtors could not be substantively consolidated into a debtor’s bankruptcy. Second, the United States Bankruptcy Court of the Northern District of Illinois, in Audette v. Jasemir (In re Concepts Am., Inc.), went even further and held that substantive consolidation of a non-debtor was barred under all circumstances in the Seventh Circuit. While both cases determined that the remedy of substantive consolidation was not available, they also each suggested that state law alter ego or piercing claims may provide the creditor an alternative remedy. This may just be a coincidence, or it may be a trend. In either event, it is fair to ask if there is a growing judicial preference for state law claims when a non-debtor is involved.

The full article is available here.

Bankruptcy Claims Trading

By Jared A. Ellias (University of California, Hastings)

Over the past twenty years, a robust secondary market has emerged in the debt of Chapter 11 firms. Critics worry that the trading associated with this market has undermined bankruptcy governance, by forcing managers to negotiate with shifting groups of activist investors in the Chapter 11 bargaining process. In my new Article, “Bankruptcy Claims Trading” I perform the first empirical study of trading in the financial claims of Chapter 11 debtors to learn more about how claims trading impacts the average Chapter 11 case. Using the entire record of trading in bond debt for all Chapter 11 debtors that filed for bankruptcy between 2002 and 2012, I find that nearly all Chapter 11 bonds trade very heavily throughout the bankruptcy process. However, I find that claims trading appears to be less important for bankruptcy governance than many critics fear. The activist groups that tend to participate in negotiations usually enter cases early and rarely change significantly. This suggests that bankruptcy claims trading is, on average, much more about passive investment and much less about activist entrance and exit.

The full article is available here.

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“.

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