By David H. Sweeney, Jason P. Rubin, and Laura P. Warrick (Akin Gump Strauss Hauer & Feld, LLP), with Practical Law Oil & Gas
Producers of hydrocarbons generally require some level of gathering, processing, and othermidstream services to monetize hydrocarbons. Midstream services are typically securedthrough contracts between the producers and the midstream providers. The fixed facilities thatare required to perform those midstream services require significant investment by themidstream providers and have capacity constraints. To ensure producers’ performance andprotect their investment, midstream providers often include in their contracts a dedication clausestyled as a “covenant running with the land”. This clause purports to dedicate the land orreserves to the midstream infrastructure and is intended to bind third parties, including estates in bankruptcy, as an interest in real property.
Decisions in recent Chapter 11 cases have challenged the notion that midstream servicescontracts containing purported covenants running with the land are not rejectable under section365 of the Bankruptcy Code. The result is that a debtor may be able to reject a midstreamcontract containing a covenant running with the land, repudiate future performance of its duties,and a midstream service provider may find its claims reduced to a pre-petition unsecured claim for monetary damages.
This article explores some recent case law regarding covenants running with the land inbankruptcy and offers practical suggestions for how producers and midstream providers mightnavigate the newly developing reality, including:
Conducting diligence on midstream contracts to identify red flags and address potentialissues before they become problems.
Addressing the shortcomings of covenants running with the land noted by bankruptcycourts.
Replacing covenants running with the land with a substitute, such as a presentlypossessory interest or a lien.
By Niklas Hüther (Indiana University) and Kristoph Kleiner (Indiana University)
”The bankruptcy system is supposed to work for everyone, but in many cases it works only for the powerful.” – House Judiciary Committee Chairman Jerrold Nadler, July 28th, 2021
Researchers have long recognized that judicial outcomes are subject to the biases of the ruling judge. To alleviate concerns of fairness, courts in both the U.S. and abroad claim to assign judges to individual court cases randomly. From a policy perspective, randomization promotes public confidence in the judicial process by limiting forum shopping and the individual influence of any individual judge. From an academic perspective, recent empirical research in economics and finance exploits the random assignment of judges to causally identify of a wide range of legal outcomes.
This paper revisits the claim of randomized judicial assignment in the context of U.S. Bankruptcy Court. Our research is motivated by legal scholarship arguing that debtors in recent cases are influencing judicial assignments (Levitin, 2021), as well as renewed interest in these issues from policy makers and the public (Merle and Bernstein, 2019; Randles 2020). Despite these arguments, there are reasons to believe assignment is random. For instance, after contacting all U.S. Bankruptcy Courts, Iverson et al. (2017) found that only one court (the Eastern District of Wisconsin) reports assigning cases to judges non-randomly. In addition, a range of research including Bernstein et al. (2019)provides convincing evidence that debtor characteristics fail to predict judicial assignments. Missing from this literature is any large-scale empirical evidence of non-random assignment.
Analyzing U.S. corporate bankruptcy filings between 2010 and 2020, we provide new evidence that assignment is not random, but predicted by the lending decisions of hedge funds. By focusing on investments made before the assignment of a bankruptcy judge, our technique is not suspect to standard critiques that predictability is merely an outcome of ex-post data mining; instead, in order for investors to systemically invest in firms that are later assigned a preferred judge, it must be possible to infer future judicial assignments. In addition, we focus on hedge funds, as they routinely influence a wide range of bankruptcy outcomes including emergence and debt restructurings. The prevalence of these investors allows us to explore a new channel of activism in the distress debt market: activist influence in judicial assignment process prior to filing.
In our setting, judges can decide whether to convert a Chapter 11 bankruptcy to a Chapter 7 liquidation; while secured creditors may have a preference for liquidation, unsecured creditors recover more under reorganization. Exploiting this distinction, we confirm unsecured hedge fund creditors (relative to secured hedge funds) are significantly less likely to be assigned a judge with a tendency to convert Chapter 11 cases. We also extend our analysis to an alternate bankruptcy outcome measure: the unsecured creditor recovery rate according to the confirmed plan. We find unsecured hedge funds are far more likely to be assigned a judge with a high past unsecured recovery rate.
We next test whether these estimates differ across the filings in our sample. First, we find that unsecured hedge fund claimants are assigned a preferable judge more commonly when the hedge fund invested shortly before the bankruptcy filing, suggesting hedge funds choose to invest explicitly to influence the filing. Second, we show the effects are greatest when the hedge fund is on the board of directors of the debtor at the time of filing, providing further support for the role of communication between debtor and creditor.
Finally, we conduct three robustness tests. First, we find no evidence that a judge’s future conversion rate (after controlling for the past conversion rate) is predicted by hedge fund investment, suggesting hedge funds are explicitly influencing judicial assignment based on information regarding past information. Second, focusing on the subset of districts that explicitly state random assignment within their district, we continue to find hedge fund investments predict assignment. Third, we include district-office-year fixed effects in our analysis and continue to find a relationship between hedge fund investments and assignment.
Moving forward, we believe there are two potential policies that can alleviate these issues. The first, and simplest, is for policy makers to develop a truly randomized process. Alternatively, policy makers can instead increase the number of bankruptcy judges, leading to lower predictability even if assignment is not fully randomized. Policy makers intent on a fairer judicial system should consider both proposals.
By Francesca Prenestini (Bocconi University, Milan)
Most legal systems follow one of two rules for regulating the capacity of an issuer to renegotiate the terms of the bond loan to avoid insolvency or to accommodate changing capital needs. The first rule requires the individual consent of every bondholder while the second one permits the proposed agreement to be approved upon a majority decision which also binds dissenting bondholders.
This article analyzes the desirability of adopting a regulatory approach that allows a binding vote of bondholders on amendments of the core terms of the loan and other restructuring measures, including the conversion of bonds into shares. In doing so, this article examines the drawbacks of the prohibitive approach, which requires consent from all bondholders, with particular regard to the judicial cases and business practices of two major legal systems (the U.S. and Italy).
In the U.S., the Marblegate and Caesars cases have reignited the debate on out-of-bankruptcy restructurings of bond issues. In 2015, the U.S. District Court for the Southern District of New York reaffirmed that coercive exit consent transactions which force bondholders into questionable restructurings are prohibited by § 316(b) of the Trust Indenture Act of 1939 (“TIA”). Then, in January 2017, the U.S. Court of Appeal for the Second Circuit adopted a narrower interpretation, holding that § 316(b) only prohibits formal non-consensual modifications of an indenture’s core payment terms.
The district court’s interpretation, though broad, is more coherent with the text, the legislative history, and the purpose of the TIA. Section 316(b) provides that the individual right of each bondholder to receive payment of the principal of and interest on their indenture security on the due dates cannot (with a few minor exceptions) be impaired without the bondholder’s consent. This section was enacted to protect bondholders from insider abuses by giving individual bondholders the power to veto proposed amendments in an out-of-court restructuring. However, this individual veto power often precludes even fair renegotiation agreements between the issuer and the bondholders.
Under Italian law, the meeting of bondholders may approve “amendments of the terms of the loan” by majority vote. Nevertheless, in the light of quite restrictive interpretations of such a rule, those modifications may not change the structural characteristics of the bond loan.
This article suggests that governments should adopt rules that allow a majority bondholders’ vote to accept out-of-bankruptcy restructurings of bond issues. Currently two different solutions may be implemented in the U.S. and Italy: in the U.S., until § 316(b) can be reformed, the Securities and Exchange Commission could exercise its power to grant exemptions to authorize transactions and agreements otherwise banned; and in Italy, in the absence of a statutory prohibition, the contract governing the loan could include a provision allowing the meeting of bondholders to vote upon amendments of the core terms of the loan and other restructuring measures, such as the conversion of bonds into shares.
This article first examines the two different approaches to bond loans restructuring in various legal systems and in the context of sovereign debt, and considers why allowing a binding vote of the bondholders in workouts is so important given the rationales for and against this rule. Then it focuses on the U.S. legal system, and discusses the statutory provision that bans the majority rule, how the jurisprudence and business practices have evolved, and recent proposals for reform. The article also considers the Italian system, its rules and business practices, and how to overcome its limits. In the end, this article suggests an alternative rule and proposes interim solutions to the problem while awaiting statutory reform.
By Amelia S. Ricketts (Harvard Law School) and Jin Lee (Harvard Law School)
On February 8, 2022, the Senate Subcommittee on Federal Courts, Oversight, Agency Action, and Federal Rights held a hearing on the process through which corporations allegedly side-step accountability through divisive mergers undertaken immediately prior to bankruptcy, commonly known as the “Texas Two-Step.”
Companies have used the Two-Step when they have incurred significant liabilities in mass tort cases. The company first changes its state of incorporation to Texas or Delaware. It then carries out a divisive merger, splitting into GoodCo and BadCo. GoodCo retains all of the company assets and the non-tort liabilities, while BadCo retains the mass tort liabilities. BadCo then files for bankruptcy, while GoodCo continues business in the ordinary course. BadCo requests that the automatic stay be extended to GoodCo, preventing tort victims from seeking relief from GoodCo.
Typically, as part of the divisive merger, GoodCo and BadCo execute a funding agreement whereby GoodCo agrees to fund any victims’ trust established in bankruptcy, but usually specifying an amount far below the potential liability. One witness argued that these agreements should assuage concerns about divisive merger bankruptcies, while others argued that they did not offer tort victims real recourse.
Certain witnesses objected to using the Texas Two-Step to obtain the benefits of bankruptcy without the burdens and urged legislative reform to prevent divisive merger bankruptcies. Others argued that the current bankruptcy protections, such as bad faith dismissal and fraudulent transfer law, were sufficient to guard against abuse. However, courts are generally reluctant to dismiss a case for bad faith. Moreover, fraudulent transfer law’s usefulness is also uncertain, because the Texas state law treats the divisive merger transaction as though no transfer has occurred. The witnesses also discussed Johnson & Johnson’s use of the Two-Step as an example and test case for existing protections against abuse.
Financially distressed companies often seek refuge in federal bankruptcy court to auction valuable assets and pay creditor claims. Mass tort defendants – including Purdue Pharma, Johnson & Johnson, Boy Scouts of America, and USA Gymnastics – introduce new complexities to customary chapter 11 dynamics. Many mass tort defendants engage in criminality that inflicts widescale harm. These debtors fuel public scorn and earn a scarlet letter that can ultimately destroy the value of an otherwise profitable business. Scarlet-lettered companies could file for bankruptcy and quickly sell their assets to fund victims’ settlement trusts. This Article argues, however, that this traditional resolution option would eviscerate victim recoveries. Harsh public scrutiny has diminished the value of the resources necessary to satisfy claims, creating a discount that must be borne by victims.
My public benefit proposal charts a new course. Instead of accepting fire sale prices and an underfunded settlement trust, the scarlet-lettered company emerges from bankruptcy as a corporation for the public benefit. This modified reorganization offers victims the greatest recovery. The continued operation preserves value during a transition period, after which the going concern can be sold efficiently. Further, assets that have been tainted by corporate criminality are cleansed behind a philanthropy shield and sold to capture the value rebound. The victims’ collective is the owner of the new company and can participate in a shareholder windfall if the reorganized company experiences strong post-bankruptcy performance.
At the forefront of a new trend in aggregate litigation, this Article proposes a public benefit alternative to traditional resolution mechanisms. This approach delivers utility that will support application in a variety of contexts, assuming certain governance safeguards are maintained. In our new age of greater personal and corporate accountability, more scarlet-lettered companies will emerge and ultimately land in bankruptcy. The need to address the disposition of tainted assets will be paramount in compensating mass tort victims trying to reassemble fractured pieces. This Article explains a new phenomenon and reconceptualizes resolution dynamics in a way that will have policy implications that transcend aggregate litigation.
The full article will be available at 117 Nw. U. L. Rev. ___ (forthcoming 2022) and can be accessed here.
By Aras Canipek (University of Konstanz), Axel H. Kind (University of Konstanz), and Sabine Wende (University of Cologne – Faculty of Management, Economics and Social Sciences)
Stronger creditor rights reduce credit costs and thus may allow firms to increase leverage and investments, but also increase distress costs and thus may prompt firms to lower leverage and undertake risk-reducing but unprofitable investments. Using a German bankruptcy reform, we find evidence on average consistent with the latter hypothesis. We also hypothesize and find evidence that the effect of creditor rights on corporate leverage and investments depends on the firm type, as it influences the effect creditor rights have on credit costs and distress costs and thus which effect dominates. For example, our findings suggest that stronger creditor rights are costly for large firms, for which the effect of creditor rights on distress costs should outweigh the effect on credit costs, but beneficial for small firms, for which the effect on credit costs should outweigh the effect on distress costs. Our understanding not only reconciles the mixed empirical evidence of existing studies, but also has important implications for optimal bankruptcy design. In particular, our findings are contrary to a widely held opinion that bankruptcy law should be uniform and balance the effect of creditor rights on credit costs and distress costs. Rather, they point to a menu of procedures in which a debtor-friendly and creditor-friendly procedure co-exist and thus allow different types of firms to utilize the procedure that suits them best. If such a menu is not possible, our analysis suggests that countries should choose a debtor-friendly or creditor-friendly procedure, depending on the most important firm type in the country.
Despite being pivotal in corporate debt restructuring, viability, an intricate notion with double meaning and double role, has not been systematically examined in Europe. Against this background, and especially given that the new European directive on restructuring and insolvency (the “Directive”) is currently under transposition and restructuring law is making its first steps as a harmonized field across Europe, my recent paper, published in Norton Journal of Bankruptcy Law and Practice, undertakes a doctrinal, comparative [USA, UK] and economic analysis of law examination of viability with the aim of putting forward suggestions that will make viability the linchpin of the Directive, thus optimizing its filtration effect as defined below.
In doing so, the paper first analyses and distinguishes the two different meanings of viability, namely financial viability and economic viability, and clarifies what the precise role of law is within the viability-related discourse. Such role consists in providing indicators of viability and incorporating appropriate “filtering mechanisms”, a term of art introduced by the paper, which refers to mechanisms filtering non-viable debtors out of the restructuring procedure, hence contributing towards satisfaction of restructuring’s overall goal of saving viable debtors only.
The way in which such filtering mechanisms are triggered depends on who plays the role of the “ultimate viability assessor” within a restructuring framework, for example an Insolvency Practitioner (“IP”) or a court. Depending on this, the paper distinguishes between IP-centered and Non-IP – centered models of viability assessment and identifies the Directive as standing closer to the Non-IP – centered one.
What the paper suggests though, is that, what ultimately matters is the appropriateness of filtering mechanisms in any chosen model of viability assessment. Such mechanisms can be most characteristically found under Chapter 11, Title 11 of US Bankruptcy Code and are the conversion/dismissal of a Chapter 11 case and stay relief under section 362. The paper examines them extensively and demonstrates how the existence or inexistence of viability in its double meaning, constitutes the “litmus test” for the triggering of Chapter 11’s filtering mechanisms.
In light of these comparative findings, the paper finally turns to the European directive and identifies its filtering mechanisms. The paper subsequently, and most importantly, makes suggestions on how the filtration effect of the Directive’s existing mechanisms can be optimized through appropriate interpretation, transposition, judicial practice or future reform. Through these suggestions, it is aspired that first, the Directive will properly reflect the notion of viability and consequently achieve an effective filtering of viable debtors from non-viable ones, and second, viability will ultimately become the primary point of focus and linchpin of European corporate debt restructuring overall.
The paper, entitled “Viability Assessment in Corporate Debt Restructuring: Optimizing the Filtration Effect of the European Directive on Restructuring and Insolvency” is available here.
By Daniel J. Bussel (Professor of Law, UCLA School of Law)
Neither the “American Rule” (each party pays its own attorney) nor the “English Rule” (loser pays both parties’ attorneys) is the baseline principle in insolvency cases. Most major parties do not bear their own attorney’s fees, win or lose. Fee-shifting is pervasive; the bankruptcy court is directly involved in reviewing the fees; sometimes it’s almost impossible to figure who actually foots the bills. This is true in US courts, which still generally purport to follow the “American Rule,” and courts in the UK, which generally purport to follow the “English Rule.” In both countries, theory notwithstanding, equitable principles, born in England’s ancient chancery courts, permit discretionary fee-shifting in light of the collective nature of insolvency proceedings.
Unfortunately, some US courts, including the Supreme Court, disregarding this history and practice, anomalously cling to the American Rule, creating perverse incentives that disrupt the efficient functioning of the reorganization process. Two leading examples are the Supreme Court’s decisions in Baker & Bottsand Midland Funding, both critiqued in my paper, Fee-Shifting in Bankruptcy. In Baker & Botts, the American Rule denies full compensation to the prevailing debtor’s attorney from any source, disincentivizing the pursuit of meritorious estate claims. In Midland Funding, the American Rule rewards strategic manipulation by the holder of meritless claims, disincentivizing clearly valid objections.
Abandoning the American Rule and authorizing a discretionary version of the English Rule as the default rule in bankruptcy for recovery of attorney’s fees is no radical step. Empirical work is limited, but supports the conclusion that shifting from the American Rule to a discretionary version of the English Rule will have only a modest impact. In bankruptcy cases, an enormous amount of explicit and implicit fee shifting already occurs. The bankruptcy courts have a well-developed set of procedures for regulating and allowing reasonable attorney’s fees. They are well-positioned to exercise discretion in awarding attorney’s fees to control bullying and holdout tactics calculated to confer leverage by pressing weak claims and imposing costs on others.
Several factors can appropriately guide court discretion to award fees in insolvency cases, including:
Whether the prevailing party or its adversary has a right to recover fees in nonbankruptcy litigation over the same issues.
Whether the bankruptcy code expressly contemplates recovery of fees as a component of damages.
The amount of fees and whether the stakes justify them.
The strength of the prevailing party’s merits case.
Whether the nonprevailing party played the part of bully, holdout, or squeaky wheel.
Whether a systemic asymmetry exists between the parties allowing one party to implicitly shift fees whether it prevails or not and regardless of the court’s fee award.
Whether the prevailing party’s success in litigation will economically benefit others similarly situated or creditors generally.
Whether a fee award will advance the public interest in equitable administration of bankruptcy cases.
The extent to which a given fee award may be so onerous to the non-prevailing party that it would unreasonably deter access to the courts.
Vexatious and unreasonable conduct by either (or both) of the litigants.
The extent to which the prevailing party incurred fees for considerations apart from the case at bar because of its status as a repeat player.
The extent to which the party seeking recovery of fees practically prevailed in the litigation.
Whether the prevailing party is a natural person, a minor private party, a major party, the bankruptcy estate, or a governmental entity.
Whether the non-prevailing party is a natural person, a minor private party, a major party, the bankruptcy estate, or a governmental entity.
Assessing the practical economic incidence of fees initially borne by the estate.
The UK, starting from the English Rule, has created a discretionary fee-shifting regime in insolvency cases resembling the discretionary approach advocated here. The English cases exhibit a continuing push-pull among (i) the desire to socialize costs of reorganizations that benefit third parties; (ii) concern about unduly discouraging participation by all affected constituents; and (iii) the problems posed by hold-outs, bullies and excessive litigiousness. See Matter of Virgin Active Holdings Ltd (Snowden, J.). The realities of insolvency practice are impelling both the English and American systems towards court-supervised discretionary fee-shifting.
The damage done by the American Rule is limited by how pervasive fee-shifting already is in bankruptcy. Fully embracing discretionary fee-shifting in favor of prevailing parties, however, is low-hanging fruit we can promptly gather in to facilitate sound administration of insolvent estates.
The COVID pandemic put unprecedented pressure on all economies around the world. Many predicted that this economic dislocation would lead to an unprecedented number of corporate bankruptcies. This did not happen. The American government and other governments responded with extraordinary measures. While these measures allowed companies to ride out the worst of the pandemic, they did have consequences. Many large companies were left with unprecedentedly large amounts of debt on their balance sheets.
Perhaps a robust economy will allow companies to grow their way out from under their debt burden. But perhaps not. To prepare for the possible future increase in large companies filing for bankruptcy, Congress should act now to build up a bankruptcy infrastructure sufficient to handle an influx in cases. Specifically, Congress should require that every circuit create a “business bankruptcy panel” designed to administer the Chapter 11 filing of large companies. As is well-known, three bankruptcy districts currently serve as dominant venues for large cases – the District of Delaware, the Southern District of New York and the Southern District of Texas. It is by no means clear that these three courts could handle a significant increase in caseloads. Creating expertise across the country would help prepare the system for any future rise in cases. A secondary benefit of this reform is that it may also ameliorate some of the concerns that have been raised over the years by the dominance of a small number of venues for large corporate cases.
Corporate debtors can decide if, when and how to file for chapter 11. Recently, there is a great deal of concern about their ability to decide where. In a series of two articles for the ABI Journal, I explain as debtor’s counsel the practice of responsible forum shopping and argues that it is, on balance, a social good.
Motivated by recently introduced legislation that would force domestic debtors to file chapter 11 only in the jurisdiction of their headquarters, Part I warns that mandating a single venue for a corporate debtor will impede legitimate restructurings and hurt companies and workers. There are important reasons why a distressed domestic corporation may need to file away from its headquarters: examples from my own experience include the need to preserve critical corporate contractual assets and to protect rank-and-file employee severance.
Since U.S. bankruptcy law necessarily varies from place to place around the country, someone has to decide what particular version of bankruptcy law should apply to each case given its unique factual context and reorganization purpose. As with many other chapter 11 decisions, the board of directors of the debtor is the least worst alternative.
Of course, there are some legitimate concerns with the current system of modified venue choice. But the venue reform legislation proposed in Congress is too blunt of an instrument. It is uninformed by experience in the trenches reorganizing distressed business and, if passed, would hurt some of the people it aims to help. Part I appears in the September issue of the ABI Journal, available here.
Part II of the series addresses international forum shopping—specifically the use of chapter 11 by non-U.S. debtors with minimal U.S. contracts—appears in the October issue of the ABI Journal.