Finding Acceptance: Using Strategic Impairment to Satisfy 1129(a)(10)

by David L. Curry, Jr. and Ryan A. O’Connor (Okin Adams LLP; Houston, Texas)

Section 1129(a)(10) of the Bankruptcy Code – requiring acceptance of a proposed plan from at least one impaired voting class – can often pose a unique challenge for single asset real estate debtors. Finding Acceptance: Using Strategic Impairment to Satisfy 1129(a)(10) (the “Article”), explores the potential use of “strategic” or “artificial” impairment as a means of achieving plan confirmation in contested cases where consensual restructuring of the secured creditor’s claim is not obtainable.  Whether such artificial impairment is permissible remains an open question, but the Article notes a growing majority of courts finding that impairment need not be economically driven. Yet, while artificial impairment may not be prohibited by § 1129(a)(10), courts have found that plans relying upon such may be subject to heightened scrutiny under § 1129(a)(3)’s good faith requirements. Thus, the Article goes on to contrast two recent circuit court opinions – Western Real Estate Equities, L.L.C. v. Vill. At Camp Bowie I, L.P. (In re Vill. at Camp Bowie I, L.P.), 710 F.3d 239, 244 (5th Cir. 2013) and Vill. Green I, GP v. Fannie Mae (In re Vill. Green I, GP), 811 F.3d 816 (6th Cir. 2016) – and their opposing outcomes in an effort to understand what factors a court may consider when determining whether a plan has been proposed in good-faith.  Ultimately, the Article concludes that while strategic impairment of insiders or other closely related parties may give rise to an inference of bad faith, the impairment of unrelated, minor creditors should be permissible.

The full article is available to download here.

David L. Curry, Jr. is a partner, and Ryan A. O’Connor is an associate, in the Houston office of Okin Adams LLP. The views expressed in this article are those of the authors, and not Okin Adams.

 

Chapter 11 Bankruptcy and Loan Covenant Strictness

By Garence Staraci (Yale University, School of Management) and Meradj Pouraghdam (Institut d’Etudes Politiques de Paris (Sciences Po))

In syndicated loan contracts, a borrower’s failure to comply with a covenant restriction triggers a default, and as such the lender’s right to terminate the loan (or foreclose on assets which are serving as collateral). The likelihood that such a covenant violation would occur depends on the loan covenant strictness, which measures how stringent covenant restrictions are on the borrower. Rationales for creditors to demand strict covenants include the pricing of default risk and the allocation of bargaining power in more frequently triggered renegotiations.

In this paper, we propose a new determinant of covenant strictness: the degree of creditor friendliness in Chapter 11 bankruptcy practices. This new determinant dictates that the more debtor(creditor)-friendly the bankruptcy practice is, the more creditors will seek to increase(decrease) their level of loan monitoring outside of bankruptcy through an adjustment in covenant strictness. Borrowers would agree on stricter covenants in exchange for a lower loan spread, and vice-versa. We demonstrate that covenants are not only included in order to shift the governance from debtors to creditors once they are breached, but to also potentially address the concern creditors might have about how the bankruptcy law is practiced if the borrowing firm goes bankrupt.

This paper finally relates to the recent recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, which has investigated the creditor friendliness of the corporate bankruptcy practice. Our results imply that any amendment to the Code that would limit the creditors’ rights during bankruptcy would have an impact on the pricing of syndicated debt through a modification of the covenant structure of loan contracts.

The full paper is available here.

Understanding the Scope of the § 546(e) Securities Safe Harbor Through the Concept of the “Transfer” Sought to Be Avoided

By Ralph Brubaker (University of Illinois College of Law)

Bankruptcy Code § 546(e) contains a safe harbor that prevents avoidance of a securities settlement payment. To date, pleas for sane limits on the scope of the § 546(e) safe harbor have focused upon what kinds of transactions should be considered a “settlement payment.” That language, however, is not the primary means by which § 546(e) both reveals its manifest object and correspondingly limits its reach thereto. Section 546(e) rationally constrains its scope via the statutory specification (the meaning of which the Supreme Court will consider in the pending case of Merit Management Group v. FTI Consulting) that the safe harbor only applies (because it need only apply) if the “transfer” sought to be avoided was allegedly “made by or to (or for the benefit of)” a protected securities market intermediary, such as a stockbroker or a financial institution.

Ascertaining the meaning and function of that determinative scope language requires an understanding of (1) the concept of a “transfer” as the fundamental analytical transaction unit throughout the Code’s avoidance provisions, and (2) the relationship between that avoidable “transfer” concept and the inextricably interrelated concepts of who that “transfer” is “made by or to (or for the benefit of).” By its express terms, § 546(e) only shields a challenged “transfer” from avoidance if (1) that transfer was “made by” a debtor-transferor who was a qualifying intermediary, “or” (2) a party with potential liability—because the challenged transfer allegedly was made “to or for the benefit of” that party—was a protected intermediary.

The full article is available for download here.


The roundtable previously posted a roundup of law perspectives on the Seventh Circuit’s decision in FTI Consulting, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016). The Supreme Court granted certiorari to review that decision on May 1, 2017. Petitioner Merit Management Group, LP has filed its opening brief, and amicus curiae briefs have been filed by Opportunity Partners, L.P. and Various Former Tribune and Lyondell Shareholders. Argument has been scheduled for November 6, 2017.

Sovereign Debt Restructuring and English Governing Law

By Steven L. Schwarcz (Duke University School of Law)

This Roundtable post is based on the author’s forthcoming article, Sovereign Debt Restructuring and English Governing Law, scheduled for publication in a symposium issue of the Brooklyn Journal of Corporate, Financial and Commercial Law (available at http://ssrn.com/abstract=2952776).

Unsustainable sovereign debt is a serious problem for nations as well as their citizens and creditors. It also is a threat to global financial stability. The existing “collective action clause” contractual approach to restructuring that debt is inadequate. At the same time, a multilateral framework, such as a convention or treaty, is not currently politically feasible. Recent research shows a drastic rise in sovereign debt litigation by holdout creditors, suggesting the urgency of finding solutions.

This article proposes a novel legal framework, focusing on governing law, for restructuring unsustainable sovereign debt. Because a significant percentage of sovereign debt is governed by English law, the UK Parliament has a unique opportunity to modify that law to include the legislative equivalent of perfect aggregate-voting collective action clauses in all English-law governed sovereign debt contracts. That not only would facilitate the fair and equitable restructuring of unsustainable sovereign debt; it also should ensure the continuing legitimacy and attractiveness of English law as the governing law for future sovereign debt contracts.

The article also proposes and examines the text of a model law that Parliament could consider as a basis for its legislation. Additionally, the article explains why, even absent Parliamentary enactment, a model-law approach could contribute to the incremental development of sovereign-debt-restructuring norms.

The full paper is available here

Roundup: Recent Op-Eds on Bankruptcy for Banks

The House of Representatives’ passage first of the Financial Institution Bankruptcy Act (FIBA) and then of the Financial CHOICE Act last Thursday has made bankruptcy for banks and the fate of Dodd-Frank’s Orderly Liquidation Authority (OLA) a live issue again. Both FIBA and the CHOICE Act would add a “subchapter V” to chapter 11 to resolve financial conglomerates in bankruptcy. Unlike FIBA, however, the CHOICE Act would also repeal the OLA, leaving bankruptcy as the only option for handling the failure of a financial conglomerate.

Several academics, former regulators, and practitioners, including several contributors to the Bankruptcy Roundtable, have recently published op-eds weighing arguments for and against replacing the OLA with bankruptcy. Support for adding tools to the Bankruptcy Code is widespread. Commentators differ, however, on whether bankruptcy, by itself, can address the systemic risk concerns that prompted the creation of the OLA and on whether it would be useful to have a bankruptcy procedure more robust than subchapter V.

Stephen Lubben contends that without a mechanism for providing liquidity to financial institutions—the usual providers of funding for companies in chapter 11—the Bankruptcy Code cannot effectively handle a widespread financial crisis. Mark Roe emphasizes that economic stability requires having the OLA and related structures to allow subchapter V to succeed (through regulatory coordination with international authorities and supervision over financial institutions to ensure that they have the capital structures to facilitate a subchapter V resolution). The OLA is also needed in case a subchapter V reorganization fails, as subchapter V is not a general bankruptcy authorization but, instead, a mechanism to use the 48-hour “single-point-of-entry” restructuring strategy in bankruptcy. This point renews some of the arguments Roe and David Skeel expressed earlier on ways subchapter V should be strengthened, such as by the addition of a regulatory trigger and a means to deal with an inability to complete the resolution within 48 hours.

Finally, Sheila Bair and Paul Volcker argue that having the OLA as a backstop for a failed bankruptcy makes government bailouts less likely, as the OLA provides regulators with the tools to wind down a failed financial institution in an orderly fashion. In contrast, Stephen Hessler argues that the Bankruptcy Code, amended along the lines of subchapter V, would promote both market discipline and financial stability. A bankruptcy judge applying well established precedents and rules in a subchapter V case would combat moral hazard more effectively than the OLA, which grants regulators significant discretion to treat similarly situated creditors differently.

(By Rebecca Green, Harvard Law School, J.D. 2017.)


Recent Roundtable coverage of this subject includes posts on a letter submitted to Congress by academics and the Trump administration’s direction to the Treasury to issue a report on the OLA.

Do the Financial Institution Bankruptcy Act and the CHOICE Act Undermine an Effective Restructuring of a Failing Financial Institution?

By Bruce Grohsgal (Delaware Law School, Widener University)

The House recently passed the Financial Institution Bankruptcy Act of 2017 (FIBA). FIBA’s provisions are incorporated into the Financial CHOICE Act of 2017, passed by the House last week, which would repeal Dodd-Frank’s receiverships for failing financial institutions that pose risk to the financial system. The Senate may soon consider both bills.

FIBA creates a subchapter V of chapter 11 for financial institutions. Only the holding company will file. In the first 48 hours of the case, it will transfer certain assets—consisting primarily of its equity in its subsidiaries and its derivatives—to a newly-formed bridge company. It will leave behind pre-designated “bail-in debt,” mostly unsecured term obligations owed to 401ks and pensions and shorter term unsecured trade debt.

In my view, however, FIBA is unlikely to result in an effective restructuring. First, because of FIBA’s 48-hour deadline, individual determinations likely will not be made with respect to the hundreds of thousands, if not millions of repo, derivatives, and other qualified financial contracts. Instead, the entire book of financial contracts—the “bad” along with the “good”—likely will be transferred to the bridge company. The bankruptcy court’s jurisdiction over the bridge company and its property—and the restructuring—ends on the transfers.

Second, the bridge company must assume 100% of the debt secured by any property transferred—without any write down, even if the property is worth less than the claim—and all liabilities owed on the derivatives and repo transferred. These statutory provisions may weaken the bridge company’s balance sheet and imperil its ability to obtain financing.

Though the Federal Reserve’s total loss-absorbing capacity (TLAC) rule includes “clean holding company” requirements to facilitate restructuring, the rule does not adequately address these balance sheet ills that FIBA creates. The clean holding company requirements apply only to eight U.S. global systemically important banks, and do not reach dozens of $50+ billion banks or nearly 5,000 other FIBA-eligible financial institutions. Moreover, TLAC does not prohibit secured borrowing even by those eight bank holding companies, though undersecured borrowings by those eight banks may be limited by TLAC’s regulatory capital requirements. But at a time of declining asset values and a ramp-up to a subchapter V filing, it is likely that many previously fully secured loans will have become undersecured. FIBA will require the bridge bank to either assume the unsecured portion of the debt or lose the collateral to the lender.

FIBA’s bankruptcy proceeding makes a run by the bridge company’s derivatives and repo counterparties more likely. If the bridge company’s balance sheet is weakened by the wholesale assumption of qualified financial contracts and by the assumption of debt above asset value, then the bridge company’s ability to obtain new financing may be diminished. Actions against the bridge company and its assets are not stayed under FIBA. As a result, when repo lenders and other counterparties require post-transfer haircuts and margin payments, and the bridge company is unable to obtain new funding, the run on repo and derivatives will continue.


The text of FIBA is available here. My testimony on FIBA before the House Judiciary’s subcommittee is available here. The text of The Financial CHOICE Act of 2017 is available here. The “clean holding company” requirements of TLAC are at 12 CFR § 252.64, and the TLAC final rule release is available here.

Creditor Rights and Corporate Debt Structure Around the World

By Kose John (New York University & Temple University), Mahsa S. Kaviani (Temple University), Lawrence Kryzanowski (Concordia University), and Hosein Maleki (Temple University)

In this study, we document that the strength of creditor protection influences corporate debt structures. Using data from 46 countries, we find that managers choose more concentrated debt structures and use more bank debt relative to other debt types in countries with better creditor rights protection. The choice of more concentrated debt structures in the face stronger creditor rights is made for two main reasons.

First, more concentrated debt structures increase the probability that a firm can successfully renegotiate distressed debt with its creditors. Therefore, concentrated debt structures can reduce expected bankruptcy costs.

Second, better creditor protection reduces the creditors’ monitoring incentives. The managers can form more concentrated debt structures to boost the monitoring incentives of creditors when creditor rights are strong. This monitoring is beneficial for the firm, as it results in higher firm value by reducing the problem of risk shifting (investment in high-risk, negative net present value projects by managers when a firm has risky debt outstanding).

We confirm our cross-country findings in a difference-in-difference analysis of corporate debt structure’s response to creditor rights reforms in Brazil, France, Italy, and Spain. The results are robust to various controls, alternative dependent variables, endogeneity concerns, and alternative estimation methods. Our sample consists of 25,700 unique firms and spans from 2001 to 2014.

The full article is available here.

Recent Developments in Bankruptcy Law, April 2017

By Richard Levin (Jenner & Block LLP)

The bankruptcy courts and their appellate courts continue to explore issues of interest to practitioners and academics. This quarterly summary of recent developments in bankruptcy law covers cases reported during the first quarter of 2017.

Cases of note include the Supreme Court’s decision in Czyzewski v. Jevic Holding Corp., prohibiting a structured dismissal that includes priority-skipping distributions over the objection of holders of claims in the skipped class.

Two bankruptcy courts used various powers to impose harsh sanctions on two different banks for even harsher misbehavior. In re Sundquist imposed actual damages of $1 million and punitive damages of $45 million against Bank of America for a sustained campaign of stay violations, harassment, misinformation, and recalcitrance against homeowners who suffered serious medical and emotional damages as a result. In characterizing the bank’s action, the court began its opinion, “Franz Kafka lives.” Following a new concept in imposing punitive damages, the court directed $40 million of the award to various nonprofit institutions rather than to the homeowners. In In re Kraz, LLC, the court imposed actual and consequential contract damages for a bank’s repeated tendering of a false estoppel certificate (payoff demand) but denied punitive damages for lack of a tort to which to attach them.

In other cases of note, the Ninth Circuit clarified what is included in the section 502(b)(6) landlord damages cap (In re Kupfer) and refused to apply the automatic stay’s police or regulatory power exception to a Private Attorney General Act action (Porter v. Nabors Drilling), the Eleventh Circuit found “related to” jurisdiction in an action against a trustee for conspiracy to obstruct justice by hiring the judge’s fiancé but no appellate jurisdiction over a bankruptcy court’s report and recommendation (Wortley v. Bakst), and the New York district court applied the Rule of Explicitness in a non-bankruptcy priority dispute (U.S. Bank v. TD Bank),

The full memo is available here.

The New Bond Workouts

By William W. Bratton (University of Pennsylvania Law School)

Bond workouts are a dysfunctional method of debt restructuring, ridden with opportunistic and coercive behavior by bondholders and bond issuers. Yet since 2008 bond workouts have quietly started to work. A cognizable portion of the restructuring market has shifted from bankruptcy courts to out-of-court workouts by way of exchange offers made only to large institutional investors. The new workouts feature a battery of strong-arm tactics by bond issuers, and aggrieved bondholders have complained in court. A fracas followed in courts of the Second Circuit, where a new, broad reading of the primary law governing workouts, section 316(b) of the Trust Indenture Act of 1939 (“TIA”), was mooted in the Southern District of New York, only to be rejected by a Second Circuit panel.

In “The New Bond Workouts,” Adam Levitin and I exploit the bond market’s reaction to the recent volatility in the law to reassess the desirability of section 316(b). Section 316(b), which prohibits majority-vote amendments of bond payment terms and forces bond issuers seeking to restructure to resort to untoward exchange offers, has attracted intense criticism, with calls for its amendment or repeal. Yet section 316(b)’s staunch defenders argue that mom-and-pop bondholders need protection against sharp-elbowed issuer tactics.

Many of the empirical assumptions made in the debate no longer hold true. Markets have learned to live with section 316(b)’s limitations. Workouts generally succeed, so there is no serious transaction cost problem stemming from the TIA; when a company goes straight into bankruptcy, there tend to be independent motivations. But workout by majority amendment will not systematically disadvantage bondholders.  Indeed, the recent turn to secured creditor control of bankruptcy proceedings makes workouts all the more attractive to them, as their claims tend to be unsecured. Accordingly, we cautiously argue for the repeal of section 316(b). Section 316(b) no longer does much work, even as it prevents bondholders and bond issuers from realizing their preferences regarding modes of restructuring and voting rules. The contractual particulars are best left to the market. Still, markets are imperfect, and a free-contracting regime may result in abuses. Accordingly, repeal of section 316(b) should be accompanied by the resuscitation of the long forgotten intercreditor good faith duties, which present a more fact-sensitive way to police overreaching in bond workouts than section 316(b).

The full paper is available here.


For previous Roundtable posts on Marblegate, section 316(b), and bond workouts, see “Second Circuit Rules on § 316(b) in Marblegate“; Liu, “Exit Consents in Debt Restructurings“; Roe, “The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table.”

Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond

Lawyers from Davis Polk, Drinker Biddle, and Wilmer Hale recently held a panel discussion entitled “Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond.” Jude Gorman of Reorg Research moderated.

The panelists considered the future of out-of-court restructurings and refinancings in light of the Second Circuit’s recent Marblegate decision, the latest development in the litigation between Marblegate Asset Management and Education Management Corp. The panelists discussed several issues surrounding section 316(b) of the Trust Indenture Act (“TIA”), including its underlying policy rationale, how the statute might serve capital markets most effectively, the practical application of 316(b) after the Second Circuit’s decision, and the likelihood of near-term changes to the legal context for out-of-court restructurings. Of particular note, James Millar, of Drinker Biddle, discussed how guarantees of bonds may be treated independently from the underlying bond under the TIA and, hence, subject to 316(b). George Shuster, of WilmerHale, noted that the decision could lead unhappy bondholders to pursue involuntary chapter 11 cases or fraudulent transfer actions. Byron Rooney, of Davis Polk, discussed how the lower court decision in Marblegate had disrupted opinion practice. Finally, Mark Roe emphasized that the SEC has broad authority to issue exemptions, presumably prospectively and generally, as well as on a case-by-case basis; although the SEC has used this authority only occasionally, in theory, bond market players unhappy with the impact of 316(b) could seek conditional exemptions.

Reorg Research’s summary of the session is available here.

(This post comes from Paavani Garg, J.D. ’18.)

 

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