Bankruptcy’s Cathedral: Property Rules, Liability Rules, and Distress

By Vincent S.J. Buccola (University of Pennsylvania – The Wharton School)

What good can a corporate bankruptcy regime do in the modern economy? The question bears asking because the environment in which distressed companies find themselves is so markedly different from the environment of just twenty years ago—to say nothing of the days of the equity receiverships, of sections 77 and 77B, of Chapters X and XI. The most important changes are well known: increased depth and liquidity of financial markets and, especially, increased capacity of financial contracting to say ex ante how distress will be resolved ex post. Recent efforts to take stock of contemporary bankruptcy practice, most notably the ABI’s Chapter 11 reform project, grapple implicitly with the significance of a changing environment. But by leaving the matter implicit, they underscore a lacuna about what the law’s marginal contribution to the economic order might be.

In a forthcoming article, Bankruptcy’s Cathedral, I hazard a general answer and elaborate its implications for a few prominent uses of bankruptcy in today’s practice.

The characteristic function of bankruptcy law, I say, is to recharacterize the mode in which an investor’s relationship to a distressed firm is governed. In particular, bankruptcy frequently toggles the protection of an investor’s economic interests from a property rule, in the Calabresi and Melamed sense, to a liability rule. It swaps out the investor’s unilateral right upon default to withdraw her investment, when such a right would ordinarily prevail, in favor of a judicially mediated procedure designed to give her the official value of her right. The automatic stay furnishes an example. It extinguishes a secured creditor’s power to repossess and sell collateral, and supplies instead a right only to what the bankruptcy judge determines to be “adequate protection” of its interest in the collateral.

This toggling function can be useful, Property rules are often more efficient during a company’s financial health than during distress. A state-contingent meta rule that switches between the two thus might be optimal. But what about financial contracting? Why can’t investors stipulate state-contingent meta rules if indeed they can maximize surplus by doing so? The short answer is that in some cases contract is sufficient, but in other cases legal or practical impediments are insuperable. The marginal contribution of bankruptcy law, then, is to supply toggling rules where investors cannot practically do so on their own.

One implication of my approach is to index the justifiable scope of bankruptcy to contingent facts about the efficacy of financial contracting. In environments where it is difficult for investors to specify state-contingent toggling rules, whether because of legal prohibition or practical impossibility, the compass for bankruptcy law is wider. As contract becomes more efficacious, bankruptcy’s brief grows correspondingly shorter.

This normative schema can be used to assess one-by-one the many actual interventions of bankruptcy laws. I scrutinize three uses of bankruptcy that are important in today’s practice: to confirm prepackaged plans, to effect going-concern sales, and to take advantage of the automatic stay. I find plausible justifications for a legal institution to bind holdout creditors and to extinguish in rem claims against a debtor’s assets. The automatic stay, on the other hand, is harder to justify. (The curious must read within to find out why.) More generally, though, my approach shows how one can weigh the contributions of a bankruptcy regime against its redundant or even counterproductive in light of contracting innovations.

The complete article is available for download here.

Bankruptcy Sales: Is A Public Auction Required to Assure That Property Is Sold for The Highest and Best Price?

By Vicki R. Harding (Vicki R. Harding, PLLC)

A buyer negotiating acquisition of commercial real estate from a Chapter 7 trustee or a Chapter 11 debtor-in-possession will almost always hear the mantra: “I have a fiduciary duty to maximize value for the benefit of the bankruptcy estate” – which the seller insists means the property must be sold through a public auction. The potential buyer may be designated as the stalking horse (e.g. its offer will be treated as an opening bid), and it may have input on the bidding procedures (bidder qualifications, minimum overbid, purchase price payment terms, etc.). But at the end of the day it runs a risk that after investing time and money in pursuing the acquisition someone else may be selected as having made a “higher and better” offer.

However, that is not always the case.  In re 160 Royal Palm, LLC, 600 B.R. 119 (S.D. Fla. 2019) presents an interesting case study. As discussed in Bankruptcy Sales: Highest Is Not Always Best, the bankruptcy court allowed a debtor to withdraw property from a previously authorized public auction and to proceed with a private sale to a designated buyer, subject only to an overbid by the stalking horse from the public auction. The court approved the private sale over the objection of a third party that claimed that in a public auction it would bid at least $1 million more than the private sale purchase price.

The full article is available here.

Rent Extraction by Super-Priority Lenders

By B. Espen Eckbo (Tuck School of Business at Dartmouth), Kai Li (Sauder School of Business at University of British Columbia) and Wei Wang (Smith School of Business at Queen’s University)

After filing for Chapter 11 bankruptcy, it takes large firms on average 16 months to restructure debt obligations and emerge as a going concern. With little cash on hand at filing, many firms need an infusion of new debt capital in order to fund continued operations while in bankruptcy. The standard debt instrument for this purpose is a debtor-in-possession (DIP) loan. Clearly, for a lender to be willing to supply a DIP loan, the loan must be fully collateralized and grant the lender extensive control rights. With an unprecedented large sample of DIP loan packages over the period 2002-2014 – totaling $120 billion in constant 2017 dollars – we first show that DIP loan contracts are fully collateralized, highly restrictive instruments. Our main research question is whether the interest rate on DIP loans reflects the actual risk of the firm defaulting on its DIP loan obligation. Our evidence on actual loan defaults strongly indicates that DIP loans are nearly risk-free, with only a single economic default (without full recovery) going back to 1988 (a default rate of 0.13% or lower). Nevertheless, loan spreads (the interest rate in excess of the London Inter-bank Offered Rate or LIBOR) average 604 basis points (bps), which exceeds even the average spread of even high-risk (“junk”) bonds. While desperate borrowers are willing to pay supra-competitive DIP loan prices, the central question is why competition among lenders fails to bring down DIP-loan spreads.

To answer this question, we first show that prepetition lenders dominate the supply of DIP loans (more than 70% of the cases). This is hardly surprising since, under §364(d) of the Bankruptcy Code, granting collateral to the DIP lender requires “priming” the lien of prepetition lenders, the debtor must obtain their consent. Moreover, a prepetition lender may “roll up” portions of the existing debt into the DIP loan package, which lowers the risk of the prepetition loan as well. By blocking the debtor’s access to DIP loans from new lenders, prepetition DIP-loan providers are in a strong monopolistic bargaining position vis-à-vis the debtor – resulting in opportunities for rent extraction. However, when collateralizing the DIP loan does not require priming prepetition lenders, the debtor may turn to new lenders such as hedge funds (HF) or private equity funds (PE). In these cases, it is reasonable to expect competition among the prospective DIP-loan providers to lower spreads. However, we find the opposite: While there is no evidence that DIP loans provided by new lenders face a greater risk of default, loans spreads are significantly higher.

It is possible that, notwithstanding the strong contractual protection afforded by DIP loans, there may be unobservable heterogeneity in the risk of firms seeking DIP loans that only a skilled DIP-loan provider is able to detect ex ante. If so, a high loan spread may be viewed as a return to the loan provider’s unique screening ability. We investigate this possibility by comparing spreads and fees in DIP loans on leveraged loans (“junk” debt). Presumably, the much longer maturities of leveraged loans (on average five years), combined with their much lower control rights and degree of collateralization, renders leveraged loans more risky than DIP loans. In fact, using Moody’s rating information, the typical spread on a B-rated leveraged loan has an expected default rate that is much higher than what we estimate for our DIP loan sample. Therefore, we expect leveraged loans that are supplied by sophisticated financial institutions to have higher spreads. Instead, we find the opposite: DIP-loan spreads are 236 bps higher than leveraged loans matched on size, industry and year of issuance, 255 bps (152 bps) higher than leveraged loans by the same firm within three years (one year) of filing.

Last, but not least, we show that junior claimholders (unsecured creditor committees and suppliers) file objections to the DIP-loan terms in as much as over 60% of the cases in our sample. Moreover, spreads are 80+ bps higher when objections occur, suggesting that high spreads are a concern. However, reading case files, we do not find a single case where the court lowered the loan spread (or fee). Although both the spirit and the letter of §364 require the terms of DIP-loans to be “fair, reasonable and adequate”, courts appear not to act as a backstop for what our data strongly suggest is significant extraction of economic rents by DIP-loan providers.

The full article is available here.

The New Bargaining Theory of Corporate Bankruptcy and Chapter 11’s Renegotiation Framework

By Anthony J. Casey (University of Chicago Law School)

The prevailing theory of corporate bankruptcy law states that its purpose is to vindicate or mimic the agreement that creditors would have reached if they had bargained with each other to write their own rules. That idea – the Creditors’ Bargain theory – has held a central place in the minds of lawyers, judges, and scholars for almost forty years. At the same time, Creditors’ Bargain theorists have struggled to explain what actually prevents creditors from bargaining with each other and how efficient rules that interfere with creditors’ bargained-for rights fit into the theory.

Meanwhile, in other areas of the law, scholars have long recognized the limits of hypothetical contract theories. Notably, scholars have shown that when parties have limited or asymmetric information and incentives to bargain strategically, their contracts will be incomplete in ways that the law cannot remedy with a hypothetical contract. Bankruptcy scholars have never squarely addressed this challenge.

Taking aim at these issues, my article, The New Bargaining Theory of Corporate Bankruptcy and Chapter 11’s Renegotiation Framework, proposes a new law-and-economics theory of corporate bankruptcy. Financial distress routinely presents uncertainty that is not contractible. By its very nature – given the number of parties engaged in strategic bargaining and the number of contingencies – financial distress poses questions that are impossible to predict, define, and negotiate in an ex ante contract. As a result, relationships involving a distressed firm are governed by incomplete contracts that allow parties to hold each other up.

Corporate bankruptcy law’s purpose is to solve this hold-up problem. The problem is familiar in law, but its frequency in the distress context invites a special bankruptcy solution. The noncontractible uncertainty associated with financial distress is a recurring characteristic across all firms. Because every relationship of this type is incomplete and requires judicial intervention upon the occurrence of the same event, a uniform bankruptcy system that deals with those relationships will produce consistency, efficiency, and market predictability.

In Chapter 11 that uniform system takes the form of a structured renegotiation framework. Because of the high level of ex ante uncertainty, the system relies mostly on procedural protection rather than specific substantive prescriptions. The framework allows parties to renegotiate their relationships within a system that imposes prices and burdens on the bargaining process and then subjects the results to high-level judicial oversight. The specifics of this framework are targeted at reducing the worst and most likely instances of hold up that block renegotiation efforts.

Bankruptcy, then, is not about mimicking a hypothetical ex ante bargain. It is about facilitating an actual ex post bargain. The normative claim of my article is that bankruptcy law’s core purpose is to solve the hold-up problem. The descriptive claim is that the ex post renegotiation framework is the fundamental attribute of Chapter 11. The remaining normative question is whether Chapter 11 succeeds at its purpose. This New Bargaining Theory of corporate bankruptcy can help identify the metrics by which to answer that question.

The full article is available here.

Reprofiling Today for a Sustainable Tomorrow: A Unilateral Italian Debt Restructuring

By Emma Cervantes, Victoria Dodev, Shane Ellement, Isabelle Sawhney (Duke University, School of Law)

Italy has €2.4 trillion of debt – an unsustainable level in pressing need of a restructuring. However, traditional avenues for sovereign restructurings cannot be utilized because Italy’s situation is complicated by several factors. First, the massive outstanding bond stock and diversity of bondholders makes a traditional consensual restructuring impractical. Additionally, about 68% of outstanding bonds are held by Italian parties, making any restructuring harmful to the domestic economy. To further add to this complicated situation, the ESM Treaty purports to impose additional restraints on Italy’s ability to restructure through the addition of CACs to approximately 60% of Italy’s bond stock.

Fortunately, there is a loophole in Italy’s bonds that can resolve these problems: Italy can unilaterally extend its maturities without bondholder consent. This power stems from the fact that Italy’s domestic government securities are issued as decrees under the relatively unknown 2003 Consolidated Act, which explicitly grants Italy the power to unilaterally extend bond maturities. Accordingly, 98% of its outstanding bond stock, about €2 trillion, can be restructured without bondholder consent. This strategy could result in the largest sovereign debt restructuring in history being done unilaterally.

This proposal demonstrates that the inclusion of CACs in some of its bonds does not foreclose the use of Italy’s Article 3 power. The proposal also describes the mechanics by which Italy would exercise its right to extend maturities. Unilaterally extending maturities does not require any retroactive utilization of the local law advantage. Nor does it expose Italy to significant legal risks in its domestic courts or under European treaties and conventions.

The full article is available here.

A Sovereign Debt Restructuring Framework for the Euro Area

By Sebastian Grund, Mikael Stenström (European Central Bank)

Our new paper discusses the legal framework for sovereign debt restructuring in the euro area – both de lege lata and de lege ferenda. Sovereign debt restructurings remain exceptional events that come with profound implications for financial stability and monetary policy transmission. However, they may be necessary as part of a financial assistance program to a euro area Member State, as was the case for Greece in 2012. Indeed, the European Stability Mechanism (ESM), the euro area’s lender of last resort to sovereigns, may only lend to countries with sustainable debts. Thus, if debt is assessed as unsustainable, an orderly debt restructuring may be warranted to allow for financial assistance by the ESM.

This paper seeks to contribute to the ongoing policy discussion on how to enhance the functioning of the Economic and Monetary Union (EMU) by exploring the legal aspects of sovereign debt restructuring in the euro area. Drawing upon the International Monetary Fund’s framework for debt restructuring, it analyses whether and how the procedures for sovereign debt restructuring in the euro area can be made more orderly, fair, and predictable by establishing a European Sovereign Debt Restructuring Framework (ESDRF).

We conclude that policymakers may consider the inclusion of enhanced Collective Action Clauses (CACs) as well as certain technical amendment clauses with a view at avoiding holdout inefficiencies. Indeed, the first version of the euro area CAC deviated from the international standard, as it did not allow for full aggregation of bondholder votes across all series. Thus, the euro area always faced a residual risk of holdouts blocking individual bond series, as was for instance the case for certain English-law bonds during the Greek debt restructuring of 2012. Besides CACs, we discuss the potential immunisation of ESM funds from holdout litigation as well as (temporary) stays on debt enforcement actions by opportune investors during restructuring negotiations, also taking account of recent innovations in the context of the Puerto Rican debt restructuring.  Finally, we review broader statutory changes to the current framework. Specifically, two options for a sovereign debt dispute resolution mechanism are discussed: (i) a separate chamber at the Court of Justice of the European Union (CJEU) and (ii) a sovereign debt arbitration mechanism. The rationale behind the establishment of such tribunals would be to centralise dispute settlement in the context of sovereign debt restructurings, thereby forestalling negative externalities from fragmented judicial decisions on bondholder claims.

The paper makes no judgement on the economic or political feasibility and necessity for such changes, but seeks to contribute to the debate by shedding light on the legal aspects to be taken into account in the context of completing Europe’s Economic and Monetary Union.

The full article is available here.

Reorganizing Health Care Bankruptcy

By Laura Coordes (Sandra Day O’Connor College of Law)

Many health care providers are experiencing financial distress, and if the predicted wave of health care bankruptcies materializes, the entire U.S. economy could suffer. Unfortunately, health care providers are part of a growing group of “bankruptcy misfits,” in the sense that bankruptcy does not work for them the way it works for other businesses. This is so for two primary reasons. First, the Bankruptcy Code is insufficiently specific with respect to health care debtors. Second, the Code lacks an organizing principle to allow the court to reconcile the competing players and interests in a health care bankruptcy case.

Previous attempts to address these issues have not succeeded. Notably, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 scattered reforms across the Code, making bankruptcy more complicated for health care debtors. As a result, some have argued that these debtors are better off using bankruptcy alternatives such as state receiverships to address their debts.

In Reorganizing Health Care Bankruptcy, I assert that despite their bankruptcy misfit status, health care providers can realize distinct benefits from bankruptcy relief. To be effective, however, this relief must respond to health care providers’ unique needs. Creating separate Bankruptcy Code subchapters for health care business bankruptcies would allow Congress to clarify many aspects of health care bankruptcy and enable the development of specific procedures and a distinct organizing principle unique to health care provider bankruptcies. Although this proposal contemplates a significant structural change to the Bankruptcy Code, the Article explains why this change is warranted as part of the Code’s necessary evolution.

The full article is available here.

Involuntary Bankruptcy: Limited Remedy and Strong Sanctions for Abuse

By Michael L. Cook (Schulte Roth & Zabel LLP)

Involuntary bankruptcy cases are relatively rare. According to the Second Circuit “far fewer [cases] are initiated as involuntary petitions by creditors, much less a single creditor,” citing statistics from the Administrative Office of the United States Courts. In re Murray, 900.

F.3d 53, 59 (2d Cir. 2018) (less than 1/10 of 1% of all bankruptcies). The numbers suggest that involuntary bankruptcy is a limited creditors’ remedy, causing at least 5 courts of appeals to pen strong opinions in the past 4 years that define the limits of this remedy and describe the sanctions available to an aggrieved debtor.

This article shows why courts have declined to allow bankruptcy courts to become collection agencies for a single creditor when available state law remedies are adequate. The courts have also not shied away from sanctions and damage awards to discourage the filing of improper involuntary bankruptcy petitions. The Third Circuit even held that “bad faith provides an independent basis for dismissing an involuntary petition,” despite the creditors’ having met all of the “statutory requirements,” stressing the “equitable nature of bankruptcy…” In re Forever Green Athletic Fields Inc., 804 F.3d 328, 334 (3d Cir. 2015).

The article also discusses a well-reasoned bankruptcy court decision sanctioning creditors who had “abuse[d]. . . the power given to [them] to file an involuntary bankruptcy petition.” In re Anmuth Holdings LLC, 2019 WL 1421169, *1 (Bankr. E.D.N.Y. Mar. 27, 2019). In that case, after trial, the court awarded not only attorneys’ fees and costs of about $115,000, but also punitive damages of $600,000, noting the petitioning creditors’ “egregious bad faith conduct,” their “lack of remorse and threats of future involuntary petitions,” plus their “knowingly false statements.”

Involuntary bankruptcy, when used as part of a collective process for all creditors, can insure the orderly and fair distribution of a debtor’s estate. But it is hardly a mechanism for resolving a two-party dispute. Whatever an involuntary bankruptcy petition may be, it is always a risky, limited remedy.

The full article is available here.

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.

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