Disagreement and Capital Structure Complexity

By Kenneth Ayotte (University of California, Berkeley School of Law)

Complex capital structures are prevalent in many recent high-profile Chapter 11 bankruptcy cases.  One recent example is Toys ‘R’ Us, whose debt structure included dozens of subsidiary entities, with separate debt facilities against entities owning the intellectual property, the real estate, and international operations, among other asset groups.  Why do capital structures become fragmented and complex in this way, and what are the implications for bankruptcy law?

In my working paper, I suggest one reason why a firm’s owners may have the incentive to engineer fragmented capital structures, using the idea that investors may disagree about the values of the various assets that make up the firm.  Fragmenting the capital structure horizontally—that is, pledging different assets and asset groups to different creditor classes—allows the firm to sell asset-based claims that are targeted to the investors who value those assets most highly. This targeting is good for the firm’s owners, because it minimizes the firm’s overall cost of capital.

This complexity can become costly, however, when firms encounter financial distress.  The same disagreement-driven fragmentation that allows the company to borrow more cheaply up front can lead to costly valuation disputes in and around bankruptcy, since creditors place a higher valuation on their own collateral than do the other creditors.  This can lead to valuation disputes that are socially costly in terms of professional fees, delays, and lost opportunities.  An example of this is the Energy Future Holdings case.  Following it’s 2007 leveraged buyout, the capital structure was divided into two silos, with one silo of entities (called the “E” side) holding regulated power assets, and a separate silo of entities holding the non-regulated power assets (the “T” side), with separate creditor groups on each side.  The initial plan to avoid bankruptcy by converting E- and T-side debt into parent-level equity failed after more than a year of negotiations, as the two sides could not come to agreement about the relative value of the two sides.  The resulting bankruptcy took over four years to reach plan confirmation and generated over $500 million in professional fees, to the detriment of creditor recoveries.

The theory has several implications.  One is that disagreement about valuation can lead to inefficient liquidation of viable firms, as creditors may prefer to walk away with the collateral they value highly, rather than fight for that value in a reorganization where the other creditors (from their perspective) are clinging to inflated valuations of their own collateral.  These kinds of forces may have been at play in the Toys ‘R’ Us case.  The B-4 term lenders, including the hedge fund Solus Alternative Asset Management, believed they were better off monetizing their intellectual property collateral in a liquidation of Toys ‘R’ Us than backing a deal to keep existing stores open.  The recent cancellation of the auction of this collateral suggests that these lenders may have held optimistic beliefs than the marketplace about the value of these assets.

From an academic standpoint, the theory provides a new answer to a long-standing question in the literature: why do we need a corporate reorganization mechanism in the first place? Traditional answers to this question revolve around the need to solve illiquidity problems.  In the presence of disagreement, I suggest an alternative benefit.  A traditional Chapter 11 reorganization allows parties to walk away with securities backed by the assets they financed before bankruptcy, about which the creditors are likely to be more optimistic.  Thus, the creditors can continue “agreeing to disagree” about the values of their respective pieces, thus promoting settlement and avoiding socially costly valuation disputes.  This is not possible when the firm is sold as a going concern for cash, since cash has a commonly known value.

Finally, my model emphasizes that when capital structures are fragmented, bankruptcy costs can be driven by haggling and litigation over the value of the parties’ entitlements, even when the parties agree about what to do with the bankrupt firm.  This suggests that the time may be ripe for rethinking and improving the resolution of valuation disputes in bankruptcy.  In a related paper, published in University of Pennsylvania Law Review, Edward Morrison and I review valuation opinions in bankruptcy cases.

The full article is available here.

Financially Distressed Companies, Restructuring and Creditors’ Interests: What is a Director to Do?

By Andrew Keay (University of Leeds)

Out of court restructuring is a popular and, according to many, optimal way of resolving the circumstances of insolvent companies in the UK, and probably more so since the advent in the UK of the Enterprises Act 2002. One concern that some commentators have raised is the fact that the opportunities to engage in such restructuring are likely to be reduced given the way that the courts have approached claims that directors who have initiated restructuring strategies are liable for breach of duty in failing to take into account the interests of company creditors when their company is insolvent or near to it (as applied by section 172(3) of the Companies Act 2006 in the UK). Allied to this is the concern that if directors are not granted freedom to use their discretion in entering into a restructuring process companies might be placed into administration or liquidation when they have some prospect of continuing to trade and to do so profitably, because directors may choose to be risk averse in placing a company into administration or liquidation rather than take the risk of being held liable for breach of the duty if they attempt restructuring. This paper examines whether the aforementioned concerns are realistic, given the law, and, if they are, what directors should be doing to ensure that they do not breach the obligation in relation to creditors. These are important issues as little consideration has been given in the UK to the issue of liability of directors for breach of duty in the wake of a restructuring. The issues are considered in light of section 172(3) of the Companies Act 2006 which makes the director’s duty to promote the success of the company for the benefit of the shareholders (as under section 172(1) and providing for what is known as ‘enlightened shareholder value’) subject to any rule of law that requires directors to consider the interests of creditors. It is a rule of law in the UK (and in many Commonwealth countries and Ireland) that when their company is insolvent or in dire financial distress directors must take into account the interests of creditors.

The paper finds that while directors might be subject to liability in entering into restructuring attempts, this is only going to occur in limited cases and so there should not be particular concern over liability. This is because first of all courts will not hold directors liable if they acted in good faith and took into account the interests of creditors, and regarded these interests as paramount in their considerations. Even if the directors failed to take into account the interests of creditors or failed to make them paramount, they will not be liable where the court finds that the honest and intelligent director, taking into account creditors’ interests, would have entered into the restructuring in any event on the basis that it would benefit creditors. Obviously if directors restructure in such a way as to benefit themselves or specific creditors, or they have improper motives, then liability is more likely to ensue. But, where the directors have acted reasonably then they should be safe from challenge.

The full article is available here.

Piercing the Corporate Veil: Historical, Theoretical and Comparative Perspectives

By Cheng-Han Tan, Jiangyu Wang, Christian Hofmann (National University of Singapore Law School)

Corporate personality is not absolute and this paper aims to compare and critically examine the circumstances under which veil piercing takes place against the objectives of incorporation. The countries examined are a mix of common law and civil law countries, including China, England, Germany, Singapore and the United States. We note that English and German courts have in recent years adopted a more restrictive approach to veil piercing, with Singapore courts appearing to be sympathetic to the current English position. On the other hand, courts in the United States and especially China seem to accept a more expansive approach to piercing even while recognising its exceptional nature. One reason for this is because veil piercing has been used loosely in instances which seem inappropriate and where the matters could have been determined by other legal principles.

We suggest that this is sub-optimal and that a narrower approach to veil piercing is preferable. For one, the need to look beyond the corporation is usually only necessary where insolvency has intervened. Direct claims by creditors against shareholders or management therefore potentially risk undermining the collective insolvency framework within which creditors are to have their claims adjudicated. Another reason is that veil piercing potentially overlaps with other legal doctrines, particularly the law of torts. As tort law is principally engaged with the issue of when civil wrongdoing arises, it will often provide a superior framework for determining whether shareholders or management should be directly responsible for alleged wrongdoing to a creditor.

The full article is available here.


The Roundtable will be off for two weeks. We’ll be back early after the New Year.