A Functional Law and Economics Analysis of the Restructuring Directive from a French Law Perspective

Vasile Rotaru (Droit & Croissance / The Rules for Growth Institute)

From a functional law and economics perspective, the recent European restructuring directive (the ‘Directive’) brings both welcome innovations and multiple pitfalls. Its final text bears the traces of the divergent objectives and inspirations of its drafters. In a recent paper, I attempt to provide a thorough analysis of the different hidden ‘models’ and important measures of the Directive, as well as its unfortunate oversights.

The first part of the paper lays the theoretical foundations of the subsequent analysis. It has long been argued that insolvency law should pursue two objectives: (i) facilitating debtor’s ex ante access to finance; and (ii) ensuring an efficient ex post distribution of resources in the economy, by restructuring economically viable companies with bad capital structures and swiftly liquidating companies with an unsustainable business. Together, the two should result in wealth maximization, the default (but by no means only) criterion for assessing business law’s merits.

The paper takes a ‘functional’ approach, which is fueled by a deep skepticism towards any extensive cost-benefit analysis. It suggests that the ex ante focus should be on ensuring that a suitable epistemic framework is in place when the decision as to the redistribution of resources has to be taken. This implies incentivizing decision-makers to reliably reveal their preferences and bear the costs of their actions while diminishing coordination failures and potential conflicts of interests. Starting with this intuition, I attempt to reformulate the classical creditors’ bargain theory, underlining that so called ‘preventive’ proceedings are no exception.

In the second part of the paper, I rely on this theoretical framework to provide a critical analysis of the main measures of the Directive. I show that the apparent complexity of its final text (the contemplated proceedings could potentially take more than 70 forms) is owed to its drafters pursuing divergent objectives: economic efficiency or short-term preservation of businesses and jobs at all costs, with an unfortunate bias in favor of the latter (especially concerning SMEs).

Moreover, two coherent formal ‘models’ of proceedings are offered. The first is a unitary, public proceeding, with a potential general moratorium for up to four months. The second is a two-step proceeding—partially inspired by the current French model—that would start with an amicable phase devoid of wide publicity and would be accompanied by individual moratoria granted on a casuistic basis where they seem justified. The second, short and public ‘closing’ phase would be triggered in the specific circumstances where the restructuring plan has to be forced upon dissenting stakeholders. Once a decision has been made as to the objectives and formal model, most of the subsequent transposition options follow.

The Directive implies a devolution of decision-making powers to classes of affected stakeholders, although the court preserves a far too important role. Indeed, stakeholders are in the best position to identify and exploit any restructuring gain. It remains to be seen which criteria will be used to ensure that the interests of members of a class are aligned and no abusive behavior takes place. Where a plan is not approved by all classes of stakeholders, the Directive provides for a cross-class cram-down, where a majority of classes or at least one class of stakeholders who are ‘in the money’ must approve the plan. The latter option could potentially lead to abuses and uncertainties, given the meagre experience of European practitioners with valuations as a going concern. The cram-down can involve a debt-equity swap imposed both on shareholders, who should be treated as any other class of stakeholders and dissenting creditors. This possibility is not trivial, as it forces creditors to continue financing the business, and should be duly justified.

Unfortunately, the contemplated protections of stakeholders’ interests are somewhat underwhelming. For instance, instead of ensuring that all stakeholders share the restructuring gain in accordance with their respective ranks in the capital structure, the Directive provides for a confusing and dangerous ‘relative’ priority rule, which will likely render the negotiations unpredictable, or, alternatively, for an incomplete ‘absolute’ priority rule. Moreover, no protection is provided against debtor’s potentially abusive behavior before the opening of proceedings.

Finally, the paper offers some insights into the expected impact of its transposition into French law. In particular, its last part suggests that any transposition needs to aim at increasing the transparency and predictability of restructuring proceedings in order to foster secondary debt markets, and therefore to ensure that impatient creditors can easily be replaced by those interested in the restructuring gain.

The full article is available here.

Corporate Governance, Bankruptcy Waivers and Consolidation in Bankruptcy

By Daniel J. Bussel (UCLA School of Law)

Bankruptcy law—once the vanguard of enterprise liability —has increasingly tended to kowtow to formalities of corporate law standing in the way of effective reorganization.

In two areas in particular, corporate law is seen by some courts and commentators as imposing rigid and substantive limitations on bankruptcy rights.

First, although bankruptcy courts have long held that access to bankruptcy relief may not be waived in a contract, recent decisions have enforced state corporate law’s choice to defer to contractual governance arrangements baked into corporate charters that hinder or preclude an entity from filing for bankruptcy relief.

Second, influential appellate decisions have pushed bankruptcy courts to respect the legal boundaries between affiliated entities within a corporate group for substantive insolvency law purposes, even as those boundaries are routinely ignored for operational, financial, tax and regulatory purposes.

Professors Baird and Casey, expanding upon earlier work by Professor LoPucki, have noted and embraced this judicial trend toward respecting corporate law formalities.  They have coined the term “withdrawal rights” to describe the phenomenon of prebankruptcy contractual arrangements enforceable under state corporate law that operate to allow a particular creditor to opt-out of the bankruptcy process by segregating key operating assets in entities that are effectively precluded from obtaining bankruptcy relief without the creditor’s express consent.

In CORPORATE GOVERNANCE, BANKRUPTCY WAIVERS AND CONSOLIDATION IN BANKRUPTCY, I argue that these techniques, however clever, run smack into traditional and still vibrant bankruptcy doctrines that find contractual waivers of access to bankruptcy relief void as against public policy, and that permit consolidation of entities whose formal separateness is inconsistent with the actual and effective operation of the corporate enterprise under reorganization.

Thus “Golden Share” arrangements in which a creditor is issued a special class of equity (the Golden Share) and the debtor’s charter is amended to preclude bankruptcy filing absent the Golden Shareholder’s consent, fail as unenforceable contractual waivers of bankruptcy rights.

Moreover, constituents with claims against affiliated companies in bankruptcy proceedings that effectively operate as a unified enterprise should not be surprised when they are treated as a claimant against that unified enterprise, except to the extent that the bankruptcy equities themselves demand otherwise, and so long as the value of their rights in property are adequately protected, even if the formalities of entity separateness are otherwise respected.  The restrictive approach to substantive consolidation adopted by some appellate courts, notably the Third Circuit in Owens-Corning, that encourages reliance on formal entity separation, should be rejected.

Bankruptcy courts are destined to struggle with the problem of withdrawal rights forever. Powerful creditors have never fully accepted the concept that they can be compelled to participate in a collective proceeding in the event of the common debtor’s insolvency and have sought ways to opt out of those proceedings when it is to their advantage to do so. They show no signs of flagging in efforts to structure bankruptcy-remote relations through statutory exceptions and preferences, the creation of property rights in their favor, and contractual strictures. If they have the political strength to carve out express exemptions in the Bankruptcy Code, courts may have little flexibility to prevent the opt-out.

But absent a federal statutory exemption, to the extent that state law corporate formalities manipulated to the advantage of certain constituencies through special contractual arrangements become impediments to effective bankruptcy reorganizations, those formalities are quite properly overridden by bankruptcy law.  Bankruptcy law limits the efficacy of the “Golden Share” and other contractual arrangements incorporated into company charters, and the entity partition techniques observed by LoPucki, Baird and Casey (among others).  Those limits should be factored into market expectations surrounding asset securitization and other structuring techniques designed to avoid the ordinary operation of bankruptcy law upon a particular creditor’s claim. If they are properly factored in, it is difficult to believe that securitization of core assets of non-financial operating companies will remain a cost-effective alternative to more traditional financing arrangements. The market should place little value on a bankruptcy withdrawal right that is likely to prove illusory when it matters most.

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.

Restructuring Italy’s New York Law Bonds

By Andrea E. Kropp (Duke University School of Law)

Little attention has been paid to Italy’s bonds issued under New York law in discussions of Italy’s debt stock and how it will be restructured should the need arise. Because these New York law bonds have no collective action clauses and had been presumed to contain very creditor-friendly pari passu language, they appeared to be too difficult to restructure. As a result, it has been assumed that they would remain untouched, with an Italian debt restructuring impacting only local law bonds. No proposals had previously addressed how to restructure the New York law bonds because of this assumption. This article fills that gap by creating an actionable strategy to restructure the bonds and by demonstrating how the long-held presumption about the creditor-friendly pari passu language is flawed.

The article advocates for the use a set of exit amendments in an exchange offer effectuating the restructuring of the New York law bonds. These exit amendments will be used to secure execution and attachment immunity and to extend the period before creditors holding the non-exchanged bonds can accelerate. This set of exit amendments act to make the bonds quite unattractive to would-be holdout creditors. In addition, these creditors’ motivation to hold out is decreased even further because of the pari passu language in the indentures for the issuances. While the pari passu language in the bonds appeared to pose an insurmountable challenge to a restructuring, this presumption is grounded in a reading of the sales documents rather than the underlying Fiscal Agency Agreements that actually control the issuances. In contrast to the sales documents, the Fiscal Agency Agreements contain language that is much less creditor-friendly. Consequently, a recalcitrant creditor’s calculus in determining whether to hold out in a restructuring has changed significantly, making the exit amendment strategy a truly viable option.

The full article is available here.

Debt Restructuring and Notions of Fairness

By Sarah Paterson (London School of Economics & Political Science)

In a recent article, I argue that we have repeatedly failed to identify clearly our concerns for fairness in different types of debt restructuring situations, and that this has confused corporate bankruptcy policy debate.  To defend the article’s thesis, I build a theoretical frame by unpacking the principles and the procedural demands of fairness from diverse fields of scholarship such as moral and political philosophy, biological sciences, psychology, organisation theory, group theory and economics.  I apply this theoretical frame to three very different types of debt restructuring: a restructuring of a small or medium sized enterprise; a restructuring of a large corporate; and a restructuring of a financial institution in English law.  In each case, a fairly typical fact pattern is outlined to ground the analysis, and the quality and extent of the fairness concerns examined.

The analysis in the article concentrates exclusively on fairness.  It does not consider the trade-off between fairness and other objectives (such as cost reduction), or utilitarian objections (such as concern that a situation which differentiates between classes of stakeholder in its approach to the fairness of the case would make stakeholders worse off overall), or arguments that what we might consider to be questions of fairness should properly be reinterpreted as economic questions.  In short, its objective is not to argue that fairness should prevail over all other considerations, but rather to explore, as an initial question, the quality of fairness in each of the situations with which it is concerned.

S. Paterson, ‘Debt Restructuring and Notions of Fairness’ (2017) 80(4) Modern Law Review 600 available here.

Fifth Circuit Adopts Flexible Approach to Collateral Valuation in Cramdown Chapter 11 Cases

posted in: Cramdown and Priority, Valuation | 0

By Peter S. Saba (Jones Day).

In In re Houston Regional Sports Network, L.P., 886 F.3d 523 (5th Cir. 2018), the U.S. Court of Appeals for the Fifth Circuit held that bankruptcy courts have flexibility in selecting the date on which to value collateral, “so long as the bankruptcy court takes into account the purpose of the valuation and the proposed use or disposition of the collateral at issue.”  In so holding, the Fifth Circuit rejected the proposition that a bankruptcy court must value collateral as of either the bankruptcy petition date or the effective date of a cramdown chapter 11 plan.  However, because the bankruptcy court failed to consider the proposed use of the collateral in assigning it a value, the Fifth Circuit remanded the case below for additional findings.

In declining to establish a bright-line rule mandating the valuation date for a creditor’s collateral in cramdown chapter 11 cases, the Fifth Circuit’s ruling, informed by section 506(a), gives bankruptcy courts the flexibility to consider an appropriate valuation date based on the actual use or disposition of a creditor’s collateral and the purpose of the valuation.  The principal benefit of this approach is that it recognizes that any valuation in this context should consider developments in a chapter 11 case which may have an impact on value.  Even so, secured creditors should be aware that consideration of the proposed or actual use of collateral under a plan may in some cases mean that collateral may be assigned a lower value as of plan confirmation or effectiveness than as of the bankruptcy petition date.

The article is available here.

The Secret Life of Priority: Corporate Reorganization After Jevic, 93 WASH L. REV. 631 (2018)

By Jonathan C. Lipson (Temple University – James E. Beasley School of Law)

The Supreme Court’s 2017 decision in Czyzewski v. Jevic Holding Corp. (In re Jevic) reaffirms that final distributions in chapter 11 cases must follow “absolute” priority absent the “consent” of priority creditors. The Court did not, however, define “consent” for this purpose, which is a problem, because consent can be hard to pinpoint in corporate reorganizations that involve hundreds or thousands of creditors and shareholders.

In this paper, I argue that, although the Jevic majority does not define consent, its reasoning reflects concerns about aspects of the reorganization process that may serve as proxies for it: stakeholder participation, outcome predictability, and procedural integrity.

First, I explain why “consent” is indeterminate in this context, inviting an inspection of process quality. Second, I assess Jevic’s process-value framework. Implementing Jevic’s values is not costless, so the Court’s commitment to them suggests that efficiency — the mantra of many scholars — is not the only or necessarily the most important value in reorganization. Third, I argue that these values conflict with the power that senior secured creditors have gained in recent years to control corporate reorganizations. Many worry that this power is the leading problem in corporate bankruptcy, producing needless expropriation and error. I also sketch opportunities that Jevic creates for scholars and practitioners who share these concerns.

Jevic reveals a secret: “priority” is not only about the order in which a corporate debtor pays its creditors, but also about the process by which it does so.

The full article is available here.

The Ninth Circuit Affirms Creditors’ Ability to Block ‘Cramdown’ by Purchasing Claims

By George P. Angelich and Annie Y. Stoops (Arent Fox).

The Ninth Circuit affirmed the creditor’s ability to block “cramdown” by purchasing junior debt for the purpose of protecting its own existing claim.  In re Fagerdala USA-Lompoc, Inc., 891 F.3d 848 (9th Cir. 2018).  In reversing the bankruptcy court’s decision to designate claims for bad faith under 11 U.S.C. § 1126(e), the Ninth Circuit held that the creditor acting in its self-interest by purchasing unsecured claims to block “cramdown” did not constitute bad faith unless evidence showed the creditor acted with a motive ulterior to the purpose of protecting its economic interest in a bankruptcy proceeding.  Examples of “ulterior motive” included a creditor purchasing claims for the purpose of blocking litigation against it or a debtor arranging to have an insider purchase claims.

Fagerdala clarifies that creditors may purchase claims in defense of their economic interests in bankruptcy proceedings.  In holding that the bad faith inquiry under 11 U.S.C.  § 1126(e) requires evidence of an “ulterior motive,” the Ninth Circuit sets the stage for designation where a non-creditor or strategic investor purchases claims as an offensive move to gain an advantage over the Chapter 11 debtor.

The full article is available here.

Inequality and Equity in Bankruptcy Reorganization

Richard M. Hynes and Steven D. Walt (University of Virginia School of Law).

Courts have developed a series of controversial doctrines that allow a debtor to depart from bankruptcy’s standard priority rules.  In a recent decision, the Supreme Court signaled tolerance of one type of departure, the critical vendor payment, as long as it occurs early in the case and is what an economist would call a strict Pareto improvement: a payment that makes all creditors better off.  This essay demonstrates that Pareto improvements appear in the stated tests governing other departures, including roll-ups and substantive consolidations.  Some scholars, and a few courts, would apply much more permissive tests similar to economists’ Kaldor-Hicks standard and allow deviations as long as the winners gain more than the losers lose.  Still other courts would do away with these doctrines entirely and allow departures only with the consent of the disfavored.  Defending the judicial use of the Pareto standard in reorganizations, the essay further discusses some of the normative considerations in the choice between a Pareto standard, a Kaldor-Hicks standard, and an absolute prohibition.

The full article can be found here.

The Pari Passu Fallacy – Requiescat in Pace

Lee C. Buchheit (Cleary Gottlieb Steen & Hamilton LLP)

The pari passu fallacy, first uncloaked in 2000, posits that when a sovereign borrower promises to maintain the equal ranking of a debt with the borrower’s other senior indebtedness, it thereby implicitly promises to pay all of those debts on a ratable basis.  In its 18-year life span, the fallacy has caused considerable mischief in the sovereign debt market.  It even prompted a wholesale change in the drafting of the pari passu clause in sovereign bonds expressly to disavow the ratable payment interpretation of the provision.  Recent decisions of the US federal courts in New York have clarified the circumstances in which a sovereign borrower will be held to breach, and just as importantly when it will be held not to breach, a contractual pari passu undertaking.  These cases confirm that a sovereign borrower will not breach a pari passu covenant merely by paying one creditor while not paying another, equally ranking, lender.

The full paper can be found here.

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