Municipal Borrowing Costs and State Policies for Distressed Municipalities

By Pengjie Gao (University of Notre Dame), Chang Lee (University of Illinois at Chicago), and Dermot Murphy (University of Illinois at Chicago)

Recent high-profile municipal default cases in Detroit, Puerto Rico, and various cities in California have underscored the importance of state laws for dealing with default proceedings, or even preventing default from occurring in the first place. However, the effects of these laws, or lack thereof, on municipal borrowing costs remain unclear. Does unconditional state support for distressed local municipalities lead to lower local borrowing costs? If so, are there tradeoffs?

The authors address these questions by examining differences in distress-related laws and statutes across states. Some states have proactive policies in place that activate when their local municipality is exhibiting signs of fiscal distress (“Proactive states”). Meanwhile, other states allow unconditional access to the Chapter 9 bankruptcy procedure, with no laws in place for dealing with distressed municipalities (“Chapter 9 states”).

The authors find that these differences significantly affect local borrowing costs. In particular, Proactive states have lower borrowing costs and significantly lower yield reactions following default. Furthermore, Proactive state yields are less sensitive to economic conditions because of the implicit insurance that becomes particularly valuable when economic conditions are weak. There is also a significant contagion effect in Chapter 9 states that does not exist in Proactive states, in that a default in a Chapter 9 state is more likely to lead to higher yields for other bonds located in that state. However, the authors also provide evidence that borrowing costs at the state level are somewhat higher in Proactive states because of the partial transfer of local credit risk to the state.

The full article is available here.

FTI Roundup

The Seventh Circuit held last July in FTI Consulting, Inc. v. Merit Management Group, LP, 2016 BL 243677 (7th Cir. July 28, 2016), that § 546(e) of the Bankruptcy Code is not a safe harbor for “transfers that are simply conducted through financial institutions.” This decision deepens a circuit split on this issue. While the Second, Third, Sixth, Eighth, and Tenth Circuits have held that the plain language of § 546(e) protects transfers through financial institutions as settlement payments, the Seventh Circuit’s interpretation agrees with the Eleventh Circuit’s older decision in In re Munford, 98 F.3d 604, 610 (11th Cir. 1996). The legislative purpose of § 546(e) was to prevent the insolvency of one financial institution from causing systemic harm to the market as a whole. However, its text also has deep implications for leveraged buyouts that might render target corporations insolvent because payments to selling shareholders almost invariably pass through brokers and clearinghouses that are covered by the safe harbor.

Several law firms have now written memos on the FTI decision. Schiff Harden postulates that debtors will be more likely to forum shop when filing for bankruptcy when they have recently undergone a leveraged buyout. Jones Day makes clear that shareholders selling into a leveraged buyout face differing levels of risk depending on which forums the corporation could legally avail itself of in a bankruptcy proceeding. And Dechert argues that FTI Consulting will result in different treatment for parties selling identical securities in leveraged buyouts: financial institutions, stockbrokers, and the like will remain protected by the safe harbor when they are beneficial owners of stock, but other shareholders will be subject to avoidance action.

Tinkering with Ipso Facto Provisions Could Send Them Sailing out of Safe Harbors

By Maurice Horwitz (Weil, Gotshal & Manges)

Recently, the United States Bankruptcy Court for the Western District of Louisiana considered whether a bankruptcy termination provision in a forward contract continues to be safe harbored under section 556 if its enforcement is conditioned on other factors – in this case, the debtor’s failure to perform under the contract.  Consistent with prior case law, the court held that termination is only safe harbored if it is based solely on a condition specified in 365(e)(1) (i.e., the financial condition of the debtor, bankruptcy, or the appointment of a trustee).

The contract in Louisiana Pellets contained a standard ipso facto provision that permitted either party to terminate the agreement upon commencement of a bankruptcy case by the other party.  But the debtor’s counterparty could only invoke the provision if the debtor was also in breach of its obligations under the agreement.  The counterparty alleged that both requirements of the ipso facto provision – bankruptcy and breach – had been satisfied, and sought to terminate.

The court held that because the ipso facto provision contained an additional condition to enforcement (the debtor’s breach), it no longer fell within the 556 safe harbor.  Thus, even if both conditions were satisfied (bankruptcy and breach), the automatic stay applied and the termination clause could not be exercised absent relief from the automatic stay.

The lesson of Louisiana Pellets is that ipso facto provisions in financial contracts should be drafted carefully so that their enforcement depends solely on one of the conditions specified in Section 365(e)(1) of the Bankruptcy Code.

The full article is available here.

How Absolute is the Absolute Priority Rule in Bankruptcy? The Case for Structured Dismissals

By Bruce Grohsgal (Widener University School of Law)

A structured dismissal in a chapter 11 bankruptcy case is a court-approved settlement of certain claims by or against the debtor followed by the dismissal of the case. Courts have held that a bankruptcy court cannot approve a settlement unless it complies with the absolute priority rule, paying senior claims in full before any distribution to junior stakeholders.

The Supreme Court will consider structured dismissals this fall in In re Jevic Holding Corp. The question before the Court is: “Whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme.”

The argument that a structured dismissal always must follow the absolute priority rule, even when a chapter 11 plan is not confirmable, overstates the current statutory reach of the rule. The rule reached its zenith by judicial launch in 1939 in Case v. Los Angeles Lumber, when the Supreme Court construed the statutory term “fair and equitable” to be synonymous with “absolute priority.” Congress has circumscribed the rule repeatedly since: in 1952 under the Bankruptcy Act, in 1978 with enactment of the Code, and in 1986 and 2005.

As a result of these enactments, the absolute priority rule is a special, limited rule that does not pervade the current Code. Indeed, the very reorganization plan—a consensual chapter 11 plan—that the Supreme Court held was not confirmable in Los Angeles Lumber would be confirmable under the current Code.

My article, forthcoming and available here, concludes that Congress has authorized the bankruptcy court to approve a structured dismissal in chapter 11 when it is in the best interest of creditors—such as when a plan is not confirmable—even if distributions do not follow the absolute priority rule. Accordingly, the Supreme Court should resolve the current circuit split by affirming Jevic.

Recent Developments in Bankruptcy Law

By Richard Levin of Jenner & Block

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 second quarter of 2016.

Cases of note include the Supreme Court’s invalidation of Puerto Rico’s homegrown restructuring statute and its surprising conclusion that an individual debtor’s debt to his corporation’s creditor might be nondischargeable for “obtain[ing] money or property” by “actual fraud” where the corporation transferred away property in an actual fraudulent transfer.

The Second Circuit upset GM’s 2009 bankruptcy sale by granting some ignition switch plaintiffs an exemption from the free and clear ruling because they didn’t have a chance to participate in sale process negotiations. The debate over whether the Code’s financial contracts safe harbor preempts creditors’ claims under state fraudulent transfer laws continues with a Delaware decision ruling against preemption.

A Delaware bankruptcy court (following a recent Illinois decision) invalidated an LLC agreement provision that allowed a creditor to veto a bankruptcy filing. In a boost for litigation funding, a Florida bankruptcy court found that communications with the funder might be subject to the common interest privilege.

And in a decision that should send shudders down the spine of every consumer bankruptcy lawyer, the Ninth Circuit BAP held that a chapter 7 trustee may reject a debtor’s prepaid retainer agreement with his lawyer to defend dischargeability litigation and recover “unused” fees.

The full memo is available here.

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We at the Bankruptcy Roundtable will take a break from posting for the next few weeks in August and hope that you too will be able to get away from your desk at work.  We’ll be back after Labor Day.

Supreme Court Resolves Circuit Split on Actual Fraud

By Richard Lear of Holland & Knight.

The Supreme Court held 7-1 in Husky Int’l Electronics v. Ritz that “actual fraud” under § 523(a)(2)(A) of the Bankruptcy Code does not require a false representation for a debt to be nondischargeable. In so holding, the Court resolved a split among the circuits.

Petitioner Husky International Electronics, Inc., argued that “actual fraud” under § 523(a)(2)(A) does not require a false representation, but instead encompasses other traditional forms of fraud, such as a fraudulent conveyance of property made to evade payment to creditors.

Acknowledging that “fraud” is difficult to define precisely, the Supreme Court nevertheless rejected the need to do so, stating that “[t]here is no need to adopt a definition for all times and all circumstances here because, from the beginning of English bankruptcy practice, courts and legislatures have used the term ‘fraud’ to describe a debtor’s transfer of assets that, like Ritz’s scheme, impairs a creditor’s ability to collect the debt.” The Supreme Court further recognized that the common law indicates that although fraudulent conveyances are “fraud,” fraudulent conveyances do not require a misrepresentation from a debtor to a creditor, because fraudulent conveyances are not “an inducement-based fraud.”

The full memo is available here.

Bankruptcy Court Disagrees with Second Circuit’s Holding in Tribune

By Lee Harrington of Nixon Peabody.

Recently, in In re Physiotherapy Holdings Inc., the Bankruptcy Court in Delaware held that section 546(e) of the Bankruptcy Code did not preempt various state fraudulent transfer actions because the allegedly fraudulent transfers implicated neither the rationale for that section nor preemption generally. The decision is at odds with recent case law, notably: (i) the Tribune litigation, in which the Second Circuit concluded that state law constructive fraudulent transfer claims involving payments in LBO transactions are prohibited under section 546(e); and (ii) a proceeding in which the Southern District of New York concluded that the interest payment at issue, which did not retire the underlying debt, were not “settlement payments” and was thus outside section 546(e).

Section 546(e) precludes certain bankruptcy avoidance actions involving settlement payments made by or to a financial institution and transfers made by or to a financial institution in connection with a securities contract. It is intended to prevent litigation that might have a destabilizing “ripple effect” on the financial markets and provides a defense to constructive fraudulent transfer actions against shareholders receiving LBO payments.

Physiotherapy found that section 546(e) was not intended to shield “LBO payments to stockholders at the very end of the asset transfer chain, where the stockholders are the ultimate beneficiaries of the constructively fraudulent transfers, and can give the money back . . . with no damage to anyone but themselves” without the attendant destabilizing “ripple effect.”

The full memo is available here.

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The Bankruptcy Roundtable has previously covered treatment of 546(e), most recently in our Tribune Fraudulent Conveyance Litigation Roundup.

Celebrating Six-Months!

The Bankruptcy Roundtable celebrates its six-month anniversary this week and would like to thank the 63 authors, including 36 attorneys from 14 law firms, 26 bankruptcy, finance, and economics academics, and a judge, who contributed 38 weekly posts in that time.  We would also like to thank the hundreds of lawyers, academics, and interested non-lawyers who subscribe to our emails, from the United States and around the world.

The Roundtable’s purpose is to encourage the exchange of ideas between academics and professionals on critical corporate bankruptcy issues, and we couldn’t do that without this network.  Thanks a lot to all.

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