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.)

 

Puerto Rico and the Netherworld of Sovereign Debt Restructuring

By G. Mitu Gulati (Duke Law School) and Robert K. Rasmussen (University of Southern California Gould School of Law)

Puerto Rico has incurred debt well beyond its ability to repay. It attempted to address its fiscal woes through legislation allowing the restructuring of some its debt. The Supreme Court put a stop to this effort, holding that Congress in the Bankruptcy Code barred the Commonwealth from enacting its own restructuring regime. Yet all agreed that the Bankruptcy Code did not provide anything in its place. Congress quickly passed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) in an attempt to address Puerto Rico’s fiscal ills by enacting a special proceeding to deal with Puerto Rico’s financial woes. The price Puerto Rico paid, however, was steep—the imposition of a control board to direct, in effect, the Commonwealth’s finances and any insolvency proceedings. In light of the conditions that gave rise to PROMESA, we explore whether, in the first place, Congress has the power to bar Puerto Rico from enacting a restructuring mechanism without offering an alternative. We submit that the answer is no. When it comes to a state, the Supreme Court has held the power to issue debt necessarily implies the power to restructure that debt. Congress can preempt that power so long as it puts something in its place. To preempt and leave nothing runs afoul of our federal system. The same reasoning, with even greater force, applies to Puerto Rico. The federal government entered into a compact with the citizens of Puerto Rico, granting them, among other things, the power to issue debt. Puerto Rico implicitly received the power to restructure this debt. Congress could offer a substitute to any regime that Puerto Rico might enact, but it cannot leave the Commonwealth without any means to address its fiscal affairs.

The full paper is available here.


For previous Roundtable coverage of Puerto Rico’s debt crisis, see “Puerto Rico Update: White House Weighs in with a Proposal,” “Puerto Rico Public Corporation Debt Enforcement and Recovery Act,” and “U.S. District Court Holds that Puerto Rico’s Recovery Act Is Unconstitutional.”

Jevic: Law Firm Perspectives

On March 22, the Supreme Court decided Czyzewski v. Jevic Holding Corp., holding that bankruptcy courts may not approve structured dismissals that provide for distributions that deviate from ordinary priority rules without the affected creditors’ consent. According to the Court, Chapter 11 contemplates three possibilities: (1) a confirmed plan; (2) conversion to Chapter 7; or (3) dismissal. Absent an affirmative indication of congressional intent, the Court was unwilling to endorse a departure from the Code’s priority scheme; thus, it rejected the Third Circuit’s “rare cases” exception allowing courts to disregard priority in structured dismissals for “sufficient reasons.”

Dechert warns the decision could short-circuit “creative solutions to difficult and unique issues” and impose a “real economic cost” on debtors, creditors, and the courts. PretiFlaherty speculates that Jevic might give additional leverage to priority claimholders who know that debtors and secured creditors now “have one less arrow in their quiver.” More generally, Winston & Strawn predicts bankruptcy professionals will “look to Jevic for insight” when developing exit strategies in difficult cases.

Foley & Lardner highlights the Court’s basic commitment to absolute priority, while noting the Court’s careful distinction between final distributions, which must follow absolute priority, and interim distributions, which may break from priority to serve the Code’s ultimate objectives.

DrinkerBiddle emphasizes that Jevic provides “support for employee wage orders, critical vendor orders, and roll-ups,” a “shot in the arm for the sub rosa plan doctrine,” and “fodder for objections to class-skipping gift plans.” Duane Morris agrees, noting that Jevic may be “cited in unexpected ways” in battles about gift plans, critical vendor payments, and the like.

Sheppard Mullin wonders how consent will be determined in structured dismissals and whether features of plan confirmation other than absolute priority — for instance, cramdown, the bests interest test, and bad faith — will be imported into the structured dismissal context as well.

(By David Beylik, Harvard Law School, J.D. 2018.)


The roundtable has posted previously on Jevic, including a report of the case by Melissa Jacoby & Jonathan Lipson. For opposing views on the case leading up to oral argument, see Melissa Jacoby & Jonathan Lipson on their amicus brief and Bruce Grohsgal making the case for structured dismissals. For other Roundtable posts related to priority, see Casey & Morrison, “Beyond Options”; Baird, “Priority Matters”; and Roe & Tung, “Breaking Bankruptcy Priority,” an article that the Jevic opinion referenced.

Language Matters: Third Circuit Finds Make-Whole Provision Enforceable After Bankruptcy Filing

By Craig A. Barbarosh, Karen B. Dine, Jerry L. Hall, and Margaret J. McQuade (Katten Muchin Rosenman LLP)

In November 2016, the Third Circuit rendered a decision in Delaware Trust Co. v. Energy Future Intermediate Holding Co., LLC, finding that the defendants, who voluntarily filed for bankruptcy, were still obligated to pay over $800M in expected interest owed to lenders. The case stemmed from the defendants’ attempt to refinance, during bankruptcy, certain first lien and second lien notes in the wake of declining interest rates. The defendants filed for bankruptcy to render the notes immediately due and payable pursuant to the indentures’ acceleration provision. The defendants assumed acceleration would allow them to avoid the “make-whole” obligation to noteholders that otherwise would be due upon an optional redemption (i.e., the net present value of future payments not yet accrued at the time of prepayment).

In holding that the defendants’ actions effectively constituted an “optional redemption” triggering their obligation to pay future interest to noteholders under the make-whole provision, the Third Circuit clarified the often-muddy interplay between indenture acceleration provisions and “make-whole” redemption provisions. Specifically, the Third Circuit held that: (1) an acceleration provision that is silent as to “make-whole” does not annul a make-whole provision; (2) in order to sever “make-whole” obligations, acceleration provisions must specifically reference “make-whole” obligations; (3) “redemption” does not equal “prepayment;” and (4) issuers have the burden to insist on clear language if they intend to sever make-whole obligations through acceleration.

The full article is available here.

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.

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