Transplanting Chapter 11 of the US Bankruptcy Code into Singapore’s Restructuring and Insolvency Laws: Opportunities and Challenges

By Gerard McCormack (University of Leeds) and Wai Yee Wan (Singapore Management University – School of Law)

In 2017, Singapore introduced wide-ranging reforms to its insolvency and restructuring laws with a view to enhancing its attractiveness as an international centre for debt restructuring. A key theme of the reforms is the transplantation (with modification) of certain provisions from Chapter 11 of the US Bankruptcy Code including the automatic moratorium, cross-creditor cram-down, rescue financing and pre-packs. These provisions are engrafted into the existing scheme of arrangement framework, which in turn has its roots in the United Kingdom (UK).

In our paper, relying on the US experience and the reactions to similar reform proposals in the European Union (including the UK), we critically evaluate the effectiveness of the legal transplantation and discuss the possible unintended consequences of such transplantation.

We raise three issues. First, the new cross-class cram-down provisions could lead to valuation disputes and satellite litigation, such as whether the directors and scheme managers have properly discharged their duties. Second, the 2017 reforms shift power from the creditors to the management of the debtor company. This may prove to be disadvantageous to creditors in Singapore (and many other Asian countries) where the majority of the companies, including publicly listed companies, have concentrated shareholdings, and managers owe their existence to those who are in control. Finally, there remains the question whether the Singapore schemes will be recognised overseas, which will be important if the scheme proposes to modify debt obligations that are governed by non-Singapore law.

The full article is available here. The article is recently published in Journal of Corporate Law Studies.

 

How Specialized Courts Changed the Chinese Bankruptcy System

By Bo Li (Tsinghua University – PBC School of Finance) and Jacopo Ponticelli (Kellogg School of Management – Department of Finance)

In the last decade, China experienced a massive increase in corporate debt and, more recently, in corporate bankruptcies. Despite the mounting pressure on its insolvency resolution system, little is known about how bankruptcy works in China and the role played by the government.

China’s bankruptcy system experienced two recent changes: the reform of the bankruptcy code in 2007, and the introduction of specialized courts between 2007 and 2017. Before the introduction of specialized courts, bankruptcy cases were filed in local civil courts. Characterized by limited expertise and long delays, local courts tend to operate under the influence of local politicians, who have strong incentives to keep financially distressed state-owned companies alive to reduce unemployment and boost their political career. Thus, even though  the 2007 reform aligned Chinese bankruptcy law with those in the US and Europe, timely resolution of state-owned firms in financial distress remains a problem due to the influence of local governments.

Recently, China’s central government promoted the introduction of courts specialized in bankruptcy, which are modeled on US courts and run by insolvency professionals. In this paper, we study the impact of the introduction of specialized courts across Chinese provinces a on bankruptcy resolution and credit markets. The introduction of specialized courts led to an increase in the share of liquidations of state-owned firms and a faster speed of processing in court. In addition, state-owned firms operating in jurisdictions with specialized courts experienced a decrease in the size of new bank loans, lower access to new loans, and lower investment in physical capital relative to privately-owned firms.

The full article is available here.

 

Director Bankruptcy Experience and Corporate Risk Taking

By Radhakrishnan Gopalan (Washington University in St. Louis – John M. Olin Business School), Todd A. Gormley (Washington University in St. Louis), and Ankit Kalda (Indiana University – Kelley School of Business – Department of Finance)

In our paper, we evaluate the extent to which a director’s past life experience affects the policies their firms follow. The specific experience we focus on is corporate bankruptcy. We identify a set of directors that experience a corporate bankruptcy. We then evaluate the extent to which this bankruptcy experience of the director is associated with the subsequent policies of other firms that these individuals serve as directors.

A corporate bankruptcy can be either a liberating or a traumatic experience. If the bankruptcy allows the firm to shed excess debt and obtain a fresh start, it can be a liberating experience. On the other hand, if the bankruptcy is prolonged and destroys significant value, then it can be traumatic. An inefficient bankruptcy can also affect the future career prospects of the director as the market may partially blame them for the bankruptcy. Either way, a bankruptcy is likely to be a significant life experience and affect the director’s outlook towards risk taking.

We find that, on average, firms take on more risk if they have a director who has experienced bankruptcy in the past. Specifically, such firms finance themselves with more debt, are less likely to issue equity, more likely to take up riskier projects, as reflected in the variability of cash flows, and less likely to diversify their business through acquisitions. These shifts, however, are only present when the original bankruptcy was a less expensive affair. That is, when the previous bankruptcy was quick, resulted in a restructuring of the firm, and was accompanied by a smaller stock price decline. We also find that directors who are associated with such bankruptcies do not experience any adverse career outcomes.

Overall, our results highlight that, on average, a past corporate bankruptcy experience might actually increase a director’s willingness to take on risk in the future.

The full article is available here.

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.

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.

Bankruptcy Forum Shopping in Europe

By Wolf-Georg Ringe (University of Hamburg – Institute of Law & Economics; University of Oxford – Faculty of Law).

Over the past several years, European firms have been active in cross-border arbitrage to benefit from a more favorable bankruptcy regime. The European Insolvency Regulation (EIR), an instrument determining the competent courts and the applicable law in EU cross-border insolvency proceedings, has long sought to curb such efforts. A major reform which came into force in 2017 has the specific objective of further restricting abusive versions of forum shopping, in particular by introducing a three-month “suspension period” for forum shopping activities carried out shortly before the debtor files for insolvency.

In a recent article, I demonstrate that these efforts fail to achieve a satisfactory response to forum shopping. The key element of the reform, the suspension period, is both over-inclusive and under-inclusive in its scope of application and may, at best, be entirely without effect. The new rule will also create significant uncertainty and undermine effective ways of business restructuring.

Meanwhile, the reform does not address new variants of forum shopping, such as the use of the British “scheme of arrangement” by continental European firms. Such “procedural” forum shopping may be effected entirely without any physical relocation, as it does not come within the scope of application of the EIR.

The laudable goal of the EIR to improve the pricing of risks in cross-border insolvencies is jeopardized where the rules on jurisdiction are unclear or uncertain. The 2017 reform is a missed opportunity to improve the system by attaching substantive bankruptcy law and jurisdiction to a company’s registered office as the only clear and predictable connecting factor. Instead, the reform introduces new riddles and inconsistencies. Such steps will blur rather than improve the pricing of insolvency risk and thereby ultimately drive up the cost of capital.

The full article is available here.

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