Supreme Court to Resolve Circuit Split Over Structured Dismissals

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By Douglas Mintz, Robert Loeb and Monica Perrigino of Orrick, Herrington & Sutcliffe

The Supreme Court recently granted certiorari in Czyzewski v. Jevic Holding Corp. to decide whether a bankruptcy court may authorize the distribution of settlement proceeds through a “structured dismissal” in a way that violates the statutory priority scheme in the Bankruptcy Code.  Specifically, the Court must decide whether Section 507 of the Bankruptcy Code, which details the order of payment of certain priority claims, must be followed outside of a plan when distributing proceeds pursuant to a structured settlement of a bankruptcy case.

The Supreme Court’s decision should resolve an important circuit split.  There is a strong textual argument to permit such distributions and structured dismissals, given the lack of provisions in the Bankruptcy Code dictating that priorities apply to settlements (as opposed to plans).  A ruling in favor of structured dismissals would serve to channel cases away from chapter 11 plans and toward consensual settlements, thereby reducing administrative costs and facilitating quicker bankruptcy resolutions.  However, this could also lead to settlements that run counter to the expected results under the absolute priority rule.  The Supreme Court’s decision may also indirectly permit “gifting” payments outside the scope of a plan – as courts have generally limited gifts in the plan context.

The full article is available here.

Priority Matters

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By Douglas G. Baird, University of Chicago Law School

Chapter 11 of the Bankruptcy Code is organized around the absolute priority rule. This rule mandates the rank-ordering of claims. If one creditor has priority over another, this creditor must be paid in full before the junior creditor receives anything. Many have suggested various modifications to the absolute priority rule. The reasons vary and range from ensuring proper incentives to protecting nonadjusting creditors. The rule itself, however, remains the common starting place.

This paper uses relative priority, an entirely different priority system that flourished until the late 1930s, to show that using absolute priority even as a point of departure is suspect when firms are being reorganized. The essential difference between absolute and relative priority is the effect of bankruptcy on the exercise date of the call-option component of the junior investment instrument. Under absolute priority, the bankruptcy accelerates the exercise date; a regime of relative priority leaves it untouched.

Absolute priority is naturally suited for regimes in which the financially distressed firm is sold to the highest bidder. It is much less appropriate for a regime that puts a new capital structure in place without a market sale. In the absence of an actual sale, absolute priority requires some nonmarket valuation procedure. Such a valuation is costly and prone to error.

Chapter 11 attempts to minimize these costs by inducing the parties to bargain in the shadow of a judicial valuation, but rules are needed to police the strategic behavior that arises from the ability of parties to exploit information they have, but the judge does not.

Once one decides in favor of a reorganization rather than a market sale, the commitment to absolute priority is suspect. Instead of trying to find a bankruptcy mechanism that best vindicates the absolute priority rule, one is likely better off trying to identify the priority rule that minimizes the costs of bankruptcy itself. Asking which priority rule is most likely to lead to a successful plan at reasonable cost is a better point of departure than a debate over which priority rule provides the best set of ex ante incentives.

Looking at Chapter 11 from this perspective shows that much of the complexity and virtually all of the stress points of modern Chapter 11 arise from the uneasy fit between its priority regime (absolute instead of relative) and its procedure (negotiation in the shadow of a judicial valuation instead of a market sale). These forces are leading to the emergence of a hybrid system of priority that may be more efficient than one centered around absolute priority.

Read the full article here (forthcoming 165 U. Pa. L. Rev.).

Bankruptcy’s Quiet Revolution

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Douglas G. Baird, University of Chicago School of Law

 

Over the last few years, reorganization practice has undergone a massive change. A new device—the restructuring support agreement—has transformed Chapter 11 negotiations. This puts reorganization law at a crossroads. Chapter 11’s commitment to a nonmarket restructuring with a rigid priority system requires bankruptcy judges to police bargaining in bankruptcy, but the Bankruptcy Code gives relatively little explicit guidance about how they should do this policing.

In the past, the debtor initiated multiple rounds of negotiations in which everyone participated. Each party would push back against the claims of the other, and a consensus eventually emerged that left things roughly in equipoise. This has now changed. Instead of bargaining in which everyone participates, there is now a sequence of two-party bargains, beginning with the key players.

Changing the structure of negotiations in this fashion would not matter much if there were not much to bargain over. If bankruptcy’s substantive rules allowed for little variation in what each party received or if the debtor had an incentive to limit what each creditor group received, changing the rules would not change outcomes. But neither is the case, at least not any more.

Priority rights in bankruptcy are sufficiently uncertain that there are a broad range of confirmable plans in any case, each with radically different distributional consequences for the various creditor groups. And modern debtors are interested in a speedy and successful exit from Chapter 11. They are relatively indifferent to how rights in the firm are divided among competing creditors.

These changes have become manifest only in the last few years, and there is little wisdom about how the bankruptcy judge should respond. This essay suggests that long-established principles inform how bankruptcy judges should go about this task. In assessing whether a plan is “fair and equitable” and whether it has been filed in “good faith,” judges should focus not on how the plan apportions rights in the reorganized firm, but whether the process that has led to the plan ensures that everyone’s cards are on the table.

In particular, judges should ensure that restructuring support agreements do not interfere with the flow of information to the judge. Negotiations that lead to a confirmable plan should be problematic to the extent, but only to the extent, that they keep the judge in the dark and limit her ability to ensure that the plan complies with the terms of the Bankruptcy Code.

Click here to view the full article.

Bankruptcy Resolution and the Restoration of Priority of Claims

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Vedran Capkun, Associate Professor, Accounting and Management Control, HEC Paris

Lawrence Weiss, Professor of International Accounting, The Fletcher School, Tufts University

We present new evidence on the violation of priority of claims in bankruptcy and recovery rates for secured creditors, unsecured creditors, equity holders using a sample of firms that filed for Chapter 11 bankruptcy between 1993 and 2004. Our study reveals a number of new insights: First, we find a significant reduction in the violations of priority of claims compared to research on prior periods, with equity holders appearing to have lost their ability to extract concessions in violation to priority of claims. Second, the results are consistent with the hypothesis that unsecured creditors accept a violation to priority of their claims in order to obtain a faster resolution. Third, the results suggest that secured creditors are less likely, and unsecured creditors are more likely, to experience a violation to priority of their claims when secured creditors exercise increased control over the debtor (as proxied by debtor in possession financing). Finally, violations to secured creditors’ priority of claims are more likely when filings occur in Delaware and the Southern District of New York than elsewhere.

 

The full article is available here.

Fifth Circuit Affirms Secured Lender Surcharge

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By Michael L. Cook, Schulte Roth & Zabel LLP

The cost of maintaining a secured lender’s collateral is usually borne by the unencumbered assets of the debtor’s bankruptcy estate.  In other words, administrative expenses of the debtor’s estate (e.g., professional fees) cannot be recovered from the secured lender’s collateral because the trustee or Chapter 11 debtor-in-possession acts for the benefit of unsecured creditors, not the secured creditor.  Bankruptcy Code §506(c) provides an exception to the general rule, however, when the trustee incurs properly identified preservation expenses that primarily benefit the secured lender if the lender has either caused or consented to the accrual of these expenses.

The Fifth Circuit, on December 29, 2015, required a secured lender to “pay the [encumbered] property’s maintenance expenses incurred while the [bankruptcy] trustee was trying to sell the property.”  In re Domistyle, Inc., 811 F.3d 691 (5th Cir. 2015).  Explaining the Code’s “narrow” and “extraordinary” exception to the general rule meant to prevent a windfall to a secured creditor at the expense of unsecured creditors, the court rejected the lender’s argument that it had not benefited from the expenses paid by the trustee to preserve the property.  On the facts of the case, the court found that all of the surcharged expenses related only to preserving the property’s value and preparing it for sale – e.g., security expenses, lawn mowing and roof repairs.

This article briefly summarizes those appellate decisions explaining why courts usually deny surcharge requests.  It also describes the few cases permitting surcharge.

The full article can be found here.

United States Court of Appeals for the Second Circuit Holds That Claims Arising from Securities of a Debtor’s Affiliate Must Be Subordinated to Senior or Equal Claims of the Same Type as the Underlying Securities

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By Fredric Sosnick, Douglas P. Bartner, Joel Moss, Solomon J. Noh and Ned S. Schodek of  Shearman & Sterling LLP

 

Lehman Brothers Inc. (“LBI”) was lead underwriter for unsecured notes issued by Lehman Brothers Holdings Inc., LBI’s affiliate and parent. A Master Agreement Among Underwriters governed the relationship between LBI and the offering’s junior underwriters, and created among them a right of indemnification for liabilities resulting from securities fraud claims related to the offerings.

 

Following the bankruptcy of Lehman Holdings and the SIPA proceeding of LBI, investors filed securities fraud lawsuits alleging material misstatements and omissions in the offering documents, and asserted claims for contribution against LBI. The SIPA trustee objected, arguing that the claims were subject to mandatory subordination under § 510(b) of the Bankruptcy Code. The underwriters argued that because Lehman Holdings, not LBI, issued the securities, § 510(b) did not apply to the underwriters’ claims.

 

The Second Circuit held that claims arising from securities of a debtor’s affiliate must be subordinated to all claims senior or equal to claims of the same type as the underlying securities. As a result, the claims for contribution and reimbursement for losses incurred in the course of defending and settling securities fraud lawsuits brought by investors in securities issued by LBI’s affiliate were subordinated to the claims of LBI’s general unsecured creditors pursuant to § 510(b).

 

This Court of Appeals’ decision was based on precedent, textual support and legislative history, and it clarifies the appropriate classification of claims in the affiliate-securities context.

 

For the full memo is available here.

 

Cram-down interest rates in controversy

posted in: Cramdown and Priority, Valuation | 0

By Maxwell Tucker of Squire Patton Boggs

The correct method to determine the adequacy of the “cram-down” interest rate offered under a contested Chapter 11 plan remains subject to debate.  Most bankruptcy courts first cite the “prime plus” formula set forth in Till v. SCS Credit Corp., 541 U.S. 465 (2004)(plurality opinion), then refer to various risk factors that may require an upward adjustment from the prime rate.

The recent bankruptcy court opinion issued in In re Couture Hotel Corporation, found in my blog post linked here, provides an excellent roadmap for parties contesting cram-down interest rates.  The debtor’s Chapter 11 plan proposed to repay the loan with principal and interest amortized over thirty (30) years, and proposed that interest shall accrue at the rate of 4.25% interest per annum.  The lender objected to the plan, contending that an interest rate in excess of 10% was required.  Both parties offered expert testimony in support of their contentions.

For reasons explained in the opinion, the bankruptcy court disagreed with each expert’s testimony.  The sixty-two page Couture Hotel opinion, rich in fact findings, provides detailed reasons for the court’s rejection of the respective experts’ risk adjustments, while refraining from giving an advisory opinion as to what interest rate would be adequate.

Organized Labor and the Cost of Debt: Evidence from Union Votes

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Murillo Campello, Cornell University, National Bureau of Economic Research (NBER); Janet Gao, Indiana University – Kelley School of Business; Jiaping Qiu, McMaster University – Michael G. DeGroote School of Business; Yue Zhang, McMaster University

Despite their declining prominence, unions still shape human capital participation in corporate activity. Of the largest 100 industrial firms in the U.S. today, 33 have a unionized labor force, with most of their unions formed in the last 20 years. Unions are meant to enhance workers’ bargaining power in negotiating contracts governing benefits such as wages, health care, and pension funding. Arguably, these pecuniary benefits are less important than concerns such as job security and career development. Those non-contractual interests are most endangered when firms go bankrupt. To protect their members, unions have become active parties in legal proceedings under Chapter 11. Not surprisingly, their overriding goal in those proceedings has been that of securing job preservation.

Unionization assigns extraordinary rights to workers in bankruptcy. Critically, the shift to workers’ bargaining power can be detrimental to other corporate creditors. Building on these insights, our paper examines the effect of unionization on unsecured creditors by studying the price reactions of publicly-traded bonds to labor union elections. We do so using detailed election data from the National Labor Relations Board. Comparing closely-won and closely-lost union elections, we find that union wins lead to significant losses in bond values. Interestingly enough, they do not lead to poorer firm performance or higher default risk. We show that unionization is associated with longer proceedings in bankruptcy court, more bankruptcy emergences and refilings, and higher bankruptcy fees and expenses, all of which aggravate bondholders’ losses. Simply put, unionization bring losses to corporate creditors by way of increasing bankruptcy costs, but without increasing the likelihood that firms go into bankruptcy in the first place.

For the full article see here.

Bankruptcy in Groups

By William H. Beaver, Stanford University; Stefano Cascino, London School of Economics; Maria Correia, London Business School; and Maureen F. McNichols, Stanford University

Group bankruptcies tend to be large and affect a significant number of stakeholders. Business groups constitute a common way for ultimate owners to exercise control over a large number of companies while containing their risk exposure to different parts of the business through limited liability. In countries with underdeveloped financial infrastructures, business groups overcome difficulties in accessing external finance by reshuffling funds within the corporate structure.

In our study, we seek to understand how financial distress takes place within a business group. Using a large cross-country sample of group-affiliated firms, we show that group structure matters for parent and subsidiary bankruptcy prediction. Moreover, we show that the re-allocation of resources among group firms is likely to be a channel through which parent firms manage intra-group credit risk. Parents may be required to support financially distressed subsidiaries as a result of explicit or implicit agreements. Absent these agreements, parents might also have an incentive to support financially distressed subsidiaries as the bankruptcy of a subsidiary may impose severe costs (e.g., reputational damage, cross-default, direct liability under veil piercing). Intra-group support can also flow in the opposite direction as distressed parents may seek financial aid from healthy subsidiaries. The results of our study show that the association between parent and subsidiary default probabilities varies with the level of subsidiary integration within the group and country-level institutional quality. A shock to the parent probability of default is less likely to propagate to subsidiaries in countries with strong anti-self-dealing, investor protection, director liability and related-party transaction regulations.

Our findings are relevant for financial reporting regulators, auditors, investors and credit rating agencies, and speak to the regulatory debate on cross-border insolvencies.

The full article is available here.

Curbing the Exploitation of Passive Creditors in Chapter 11 Reorganization by Leveraging the Oversight Role of the United States Trustee

By Addison F. Pierce, American University – Washington College of Law

The Bankruptcy Reform Act of 1978 is beginning to show its age in ways similar to the forty-year-old code it replaced. In addition to being ill-suited to address changes in the underlying credit market, the current code is confronting the development of an entirely new marketplace — a market in claims trading. While some praise the enhanced liquidity, others take issue with the strains placed on the efficacy of bankruptcy.

Rather than engaging in the normative debate, this Comment seeks to redress a clear drawback to the current system: the harm endured by passive creditors. Unlike those economically empowered to participate in the reorganization process, the passive creditor lacks the economic ability and incentive to play an active role. This position leaves the passive creditor’s ability to collect on its claim solely in the hands of another: the creditors’ committee. While this committee may have provided adequate protection in 1978, the credit market and its participants are very different today. Some argue that this issue is systemic and can only be addressed by replacing the current code; however, this Comment argues that something can be done short of this massive task. The challenge is as follows: if too little is done, passive creditors will continue to be exploited and if too much is done the whole market could be damaged. Recognizing this challenge, this Comment proposes that passive creditors can be afforded adequate protection by leveraging the oversight power of the US Trustee to ensure the proper functioning of creditors’ committees. Moreover, the recommendation of this Comment would enhance protection for passive creditor while remaining market neutral.

For the full article, see 4 Am. U. Bus. L. Rev. 95 (2015), available here.

 

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