Bankruptcy on the Side

By Kenneth Ayotte (University of California – Berkeley School of Law), Anthony J. Casey (University of Chicago Law School), David A. Skeel, Jr. (University of Pennsylvania Law School)

 

Side agreements—such as intercreditor and “bad boy” agreements—are increasingly at the center of major bankruptcy disputes. Litigation around these disputes can be costly and the results of that litigation can dramatically alter the landscape within which the stakeholders bargain over reorganization.

These agreements commonly include a promise by one party to remain silent by waiving some procedural right they would otherwise have under the Bankruptcy Code. Those waivers are invoked at crucial points in the reorganization process, including the approval of debtor-in-possession financing and plan confirmation.

In our new paper, Bankruptcy on the Side, we show that while side agreements have beneficial potential, the parties entering them often impose negative externalities on outsiders. A promise not to extend new financing, for example, can affect the debtor’s reorganization prospects. Similarly, a promise not to object to a reorganization plan can rob the court of information that might benefit the other classes of creditors.

The paper presents a simple model to derive a proposal that is consistent with the intent of the parties to the side agreement but also limits negative externalities. The core of the proposal is that where there is a nontrivial potential for value-destroying externalities, the court should limit a nonbreaching party’s remedy to its expectation damages. On the other hand, if the agreement is unlikely to cause externalities, a court should enforce the agreement according to its terms. Our proposal is different and superior to the approach taken by most courts, which invokes a narrow interpretative standard to invalidate side agreements. We focus instead on enforcing the provisions under normal interpretative doctrines while limiting the use of special remedies like specific performance and stipulated damages.

The insights of our paper also provide a new answer to thorny questions involved in choosing which courts should resolve disputes over intercreditor agreements, and in deciding whether forum selection clauses should be enforced. Specifically, the bankruptcy courts have no specialized expertise for cases where the plaintiff seeks expectation damages. In those cases, the court should defer to default venue rules and forum selection clauses. Where specific performance or stipulated damages are at issue, by contrast, our model suggests that the dispute should be resolved exclusively in bankruptcy proceedings.

 

Successor Liability in § 363 Sales

By Michael L. Cook of Schulte, Roth & Zabel LLP

Bankruptcy Code §363(f)(1) empowers a bankruptcy court to order a debtor’s assets sold “free and clear of any interest in such property.” Courts in the business bankruptcy context have been wrestling with successor liability, i.e., whether an asset buyer can be held liable for the debtor-seller’s liabilities. In 2009, the Second Circuit affirmed a bankruptcy court order barring creditors of the selling debtor from pursuing the asset buyer “for product defects in vehicles produced by” the debtor. In re Chrysler LLC, 576 F.3d 108, 123-24 (2d Cir. 2009), vacated as moot, 558 U.S. 1087 (2009) (held, successor liability claims are interests covered by a sale order under Code § 363(f)(1)).

Most recently, on July 13, 2016, the Second Circuit held that the bankruptcy court’s asset sale order in the General Motors reorganization case limiting specific pre-bankruptcy product liability claims required prior “actual or direct mail notice” to claimants when the debtor “knew or reasonably should have known about the claims.” In re Motors Liquidation Co., 2016 U.S. App. LEXIS 12848, *46-47 (2d Cir. July 13, 2016). Although the substance of the sale order may have been enforceable otherwise, “mere publication notice” to known or knowable claimants was insufficient. Had the complaining product liability claimants received adequate notice, reasoned the court, they “could have had some negotiating leverage [regarding the terms of any sale order] . . . and [a meaningful] opportunity to participate in the proceedings.” Id. at *61. The court noted a “trend…toward a more expansive reading of ‘interests in property’ which encompasses other obligations that may flow from ownership of the property.” Id., at 124, citing In re Trans World Airlines, Inc., 322 F. 3d 283, 285-90 (3d Cir. 2003).

The full memo is available here.

Bankruptcy Advisory: What Can Oil Pipelines Do As Shipper Bankruptcy Risk Increases?

By Filiberto Agusti, Caroline H.B. Gaudet, and Steven Reed, Steptoe & Johnson LLP

The expansion of North American petroleum production in the past 15 years triggered the construction of many pipelines. Construction was financed largely through long-term Transportation Services Agreements (TSAs) whereby shippers committed to transport minimum volumes on the pipelines at specified tariff rates or make shortfall payments. The recent sharp drop in the world price of crude oil has led to bankruptcies. This article reviews whether, in shipper reorganizations, bankruptcy courts have jurisdiction to approve the rejection of TSAs for which the Federal Energy Regulatory Commission (“FERC”) has approved the tariff rate structure.

No court has yet addressed this question, but there is guidance from cases addressing rejection of FERC-jurisdictional electric power agreements. The Fifth Circuit found that bankruptcy courts have jurisdiction to approve rejection where the reorganized debtor’s business purpose is to abandon the FERC-approved service altogether. In dicta, however, the Court noted that the bankruptcy court would have lacked jurisdiction to approve assumption of a modified contract without prior FERC approval of the modification. And in In re Calpine, the Bankruptcy Court for the Southern District of New York held that it lacked jurisdiction to approve rejection of a FERC-jurisdictional electric power agreement if the business purpose of the rejection was to obtain more favorable pricing for the estate. From a FERC standpoint, it is unclear whether a pipeline and a debtor shipper can modify a TSA to reduce pricing as a requirement for assumption.

The linchpin of FERC’s acceptance of specified TSA rates is that those rates must be offered through an “open season” to all potential shippers. A FERC proceeding may be necessary to clarify whether a pipeline has discretion to modify the TSA of a debtor shipper or if a post-open season modification reducing the shipper’s specified TSA rates would violate FERC’s non-discrimination requirements.

The full article is available here.

The Crude Downturn for Oil Companies

By John England, Andrew Slaughter, and Anshu Mittal of Deloitte LLP

The ups and downs in the crude oil and natural gas (O&G) industry over the past two years or so boil down to a 65 percent fall in oil prices, a $2.5 trillion loss in market value and a debt overhang of about $3 trillion. With persisting uncertainty about the timing of stabilization and recovery of oil prices, the financial stress in the industry is immediate and deteriorating.

In the United States alone, 35 crude oil and natural gas producers with cumulative debt of $18 billion filed for bankruptcy protection between mid-2014 and end-2015, and an additional eight have done so this year. The majority, however, are in Chapter 11 bankruptcy and continue to operate to maintain their production- and reserve-linked loans.

But stricter loan review guidelines by the Office of the Comptroller of the Currency (OCC), the banking regulator—for instance a borrower with debt/EBITDA ratio of more than four is now flagged as doubtful— and, could prompt banks to classify more and bigger O&G loans as “substandard and worse.” In fact, using similar financial and debt repayment metrics on 500 O&G producers globally, our analysis suggests a third of them are at a high risk of debt default and may file for bankruptcy protection, unless things take a dramatic turn for the better.

These stricter guidelines, along with the continued weakness in oil prices and expiration of hedges at favorable prices are choking the much-required cash supplies. U.S. shale producers are particularly vulnerable to the squeeze, as reduced funding immediately impacts their production due to the short investment cycle and high decline rates associated with shales. This impact has been evident in the past three months, with U.S. tight oil production having declined by about five percent this year.

In conclusion, 2016 will be a period of tough, new financial choices for the O&G industry, including the oilfield service providers and drillers. Staying solvent and navigating this downturn successfully will require technology-driven optimization solutions and tailoring of the operating model and, most importantly, innovative, flexible, and adaptive thinking in sourcing, managing, and deploying scarce capital. However, these conditions lay the foundation for a price rally and better years to come for those who can navigate these rocky waters.

The full article is available here: The Crude Downturn.

External and Internal Asset Partitioning: Corporations and Their Subsidiaries

By Henry Hansmann, Yale Law School, and Richard Squire, Fordham University School of Law

In our book chapter “External and Internal Asset Partitioning: Corporations and Their Subsidiaries,” forthcoming in The Oxford Handbook of Corporate Law and Governance, we analyze the economic consequences of external and internal asset partitioning, and we consider implications of our analysis for creditor remedies that disregard partitions between corporate entities. “Asset partitioning” is the use of standard-form legal entities, such as the business corporation, to set boundaries on creditor recovery rights. “External” partitioning refers to the legal boundaries between business firms and their equity investors, while “internal” partitioning refers to the legal boundaries among the constituent entities (parents and subsidiaries) within corporate groups.

The chapter begins by cataloguing the economic benefits and costs of corporate partitioning. The benefits identified include reduced equityholder monitoring costs, liquid shares, shareholder diversification, reduced creditor information costs, correction of debt overhang, liquidation protection, and bankruptcy simplification. The costs of corporate partitioning are accounting costs and the agency costs of debt. We compare the economics of external and internal partitioning, and we find that internal partitioning provides fewer potential benefits while often generating higher costs. Corporate subsidiaries do, however, also provide non-partitioning benefits such as tax advantages, regulatory compliance, and the preservation of transferable bundles of contracts.

The final part of the chapter considers whether cost-benefit analysis predicts how courts actually apply de-partitioning remedies, with particular emphasis on veil piercing and enterprise liability. We conclude that courts should employ the distinction between external and internal partitioning when applying creditor remedies that disregard corporate partitions, and we identify factors — in addition to whether a partition is internal or external — that courts should consider when deciding whether to de-partition. For example, we argue that the presence of guarantees which pierce corporate partitions on behalf of select creditors militates in favor of the use of de-partitioning remedies for general creditors.

The full chapter is available here: External and Internal Asset Partitioning: Corporations and Their Subsidiaries.

Business Bankruptcy and Restructuring: 2015/2016

By Harold S. Novikoff, et al., Wachtell, Lipton, Rosen & Katz

Prior to 2015, corporate defaults and bankruptcy filings were at relatively low levels, amid continuing low interest rates and well-performing credit markets.

In 2015, those trends began to reverse.  There were 75 chapter 11 filings in 2015 involving debt of $100 million or more, the highest number since 2010.  During the second half of the year, credit and commodity markets proved increasingly volatile.  In addition, near the end of the year, several investment funds specializing in high-yield debt suspended redemptions or announced liquidations or closings.

Looking forward, we expect many of the trends from 2015 to continue.  In particular, low commodity prices will continue to create a challenging environment in the oil and gas and related sectors.  Retailers will also face pressure, including from internet shopping.  Faced with market volatility and the high costs of bankruptcy, we expect distressed borrowers to continue pursuing out-of-court strategies, including exchange offers, bespoke financing arrangements and equity capital infusions.

In this memo, we discuss several important developments and themes from 2015, as well as expectations for the year ahead.  Among other things, the memo discusses issues regarding secured creditor cramdown, the Trust Indenture Act, Puerto Rico and extraterritorial reach of the Bankruptcy Code.

The full memo is available here.

WSJ Examiners — Insider Pay in Bankruptcy

The Wall Street Journal’s Bankruptcy Beat recently focused on the ever-controversial topic of executive pay. Reflecting on a number of recent bankruptcy cases that involved the “redaction” of key employee names or compensation figures, the question for the Examiners was this: when it comes to pre-bankruptcy insider pay, how much disclosure is enough?

As Brett Miller points out, the answer to this question will depend on who you are in relation to the bankruptcy process. He advocates balancing competing interests on a case-by-case basis.

Practitioners Sharon Levine, Shaunna Jones, and Richard Chesley point out the quid pro quo nature of enhanced disclosure, describing it as a cost that firms must pay in order to access the benefits of bankruptcy protection. As Ms. Jones puts it, the benefits of the bankruptcy process “are not without a price, and one cost is the requirement that the debtor be transparent about how it uses its assets”.

Ms. Levine, along with Lisa Donohue, voiced concerns that a lack of transparency breeds mistrust and will make negotiations more difficult, conflicting with the consensual objectives inherent in the Chapter 11 procedure. Anders Maxwell makes the analogous point that disclosures are needed to “more adequately inform an ongoing debate” on executive pay generally which, if “left unaddressed, has the potential to sap public confidence in business and markets.”

Mark Roe also considers the wider context of Chapter 11 practice and history, particularly in relation to Key Employee Retention Plans (“KERPs”) and fraudulent conveyances. Ultimately, he says, disclosure is “a matter for judicial decision, not executive discretion.” J. Scott Victor makes the further point that unilateral redaction “unfairly benefits large debtors while requiring other debtors to follow the rules.”

Businesspeople who commented—Jack Butler and Marc Leder—sounded a contrary note, pointing out that the debate focuses only on public disclosure, as parties in the case generally have access to the business’ financial information. Mr. Butler highlights the risk of harassment that executives might face, while Mr. Leder states, in concurrence with Perry Mandarino, that “compensation data without any context can cause outside observers . . . to leap to uninformed and incorrect assumptions”.

(This post was drafted by Samuel Parsons, L.L.M. ’16.)

The Trouble with Unneeded Bankruptcy Reform: The LSTA’s Response to the ABI Chapter 11 Commission Report

[Editors’ Note: The post below from the Loan Syndications and Trading Association (LSTA), summarizes their Report responding to the ABI Commission Report and Recommendation on the Reform of Chapter 11, released in December of 2014; for our previous post on the ABI report see here.]

The LSTA Report argues that:

  • The Commission Report is based on the “perception” that the system has failed. But that perception is not supported by reliable empirical evidence. The data that do exist generally support the conclusion that the system is functioning well.
  • The principal objective of current bankruptcy law is the maximization of value for all stakeholders. With few exceptions, it respects principles of non-bankruptcy law regarding the distribution of that value, as reflected in bankruptcy’s “absolute-priority” rule. The Commission Report breaks from those principles, arguing that market changes have led to distributions of value in bankruptcy that are “subjectively unfair,” and seeks to achieve results that it believes are fairer. But a clear, objective process that respects non-bankruptcy entitlements wherever possible is fair.
  • Many of the changes proposed by the Commission would reduce recoveries by secured lenders in the event of default. That would necessarily result in the increased cost, and reduced supply, of secured credit.

The LSTA Report reviews a number of specific proposals in the ABI Commission Report, including (i) calculating adequate protection based on a hypothetical foreclosure value; (ii) limitations on 363 sales and DIP loan provisions; (iii) “redemption option value”—which would require senior creditors in large bankruptcy cases to pay junior creditors even when the senior creditors have not been paid in full; and (iv) proposals for small and medium size enterprises. The LSTA concludes that these and other proposals would add cost and complexity to, and lengthen Chapter 11 cases.

For the full report, see here.

TCEH Bankruptcy: SDNY Transfers Delaware Trust Company v. Wilmington Trust N.A. Intercreditor Dispute to Delaware Bankruptcy Court, Reaffirming Broad View of Bankruptcy Jurisdiction

By Mark Ellenberg, Howard Hawkins, Ivan Loncar, Ellen Halstead, Michele Maman and Tom Curtin of Cadwalader Wickersham & Taft LLP

In Delaware Trust Company v. Wilmington Trust N.A. the United States District Court for the Southern District of New York found that a complaint based on an intercreditor agreement among secured creditors of Texas Competitive Electric Holdings LLC constituted a core proceeding.  Accordingly, the court denied a motion to remand the case to New York state court, where it had originally been filed, and also transferred the case to the US District Court for the District of Delaware.  The case was subsequently referred to the bankruptcy court presiding over the TCEH bankruptcy cases.  Plaintiff had alleged that the dispute, which involved allocation of adequate protection payments ordered by the Delaware Bankruptcy Court, was an intercreditor dispute that turned solely on the interpretation of a prepetition intercreditor agreement and, accordingly, should be decided in state court.  As such, the issue before the District Court was whether a New York court or the Delaware Bankruptcy Court should resolve the intercreditor dispute.

The District Court ruled that the dispute was core because the dispute would have no meaningful existence but for TCEH’s bankruptcy filing, as the ability to receive adequate protection derives solely from the Bankruptcy Code.  In addition, the Court found that the dispute was core because the intercreditor issue would likely arise again in the context of plan confirmation.   The decision is important because it reaffirms the often-challenged principle that contractual disputes solely among creditors may nonetheless qualify as “core” proceedings where, as here, the underlying dispute could only arise in the context of a bankruptcy proceeding.

For our full memo, please click here.

Bankruptcy in Groups

By William H. Beaver, Stanford University; Stefano Cascino, London School of Economics; Maria Correia, London Business School; and Maureen F. McNichols, Stanford University

Group bankruptcies tend to be large and affect a significant number of stakeholders. Business groups constitute a common way for ultimate owners to exercise control over a large number of companies while containing their risk exposure to different parts of the business through limited liability. In countries with underdeveloped financial infrastructures, business groups overcome difficulties in accessing external finance by reshuffling funds within the corporate structure.

In our study, we seek to understand how financial distress takes place within a business group. Using a large cross-country sample of group-affiliated firms, we show that group structure matters for parent and subsidiary bankruptcy prediction. Moreover, we show that the re-allocation of resources among group firms is likely to be a channel through which parent firms manage intra-group credit risk. Parents may be required to support financially distressed subsidiaries as a result of explicit or implicit agreements. Absent these agreements, parents might also have an incentive to support financially distressed subsidiaries as the bankruptcy of a subsidiary may impose severe costs (e.g., reputational damage, cross-default, direct liability under veil piercing). Intra-group support can also flow in the opposite direction as distressed parents may seek financial aid from healthy subsidiaries. The results of our study show that the association between parent and subsidiary default probabilities varies with the level of subsidiary integration within the group and country-level institutional quality. A shock to the parent probability of default is less likely to propagate to subsidiaries in countries with strong anti-self-dealing, investor protection, director liability and related-party transaction regulations.

Our findings are relevant for financial reporting regulators, auditors, investors and credit rating agencies, and speak to the regulatory debate on cross-border insolvencies.

The full article is available here.

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