Financial Distress, Stock Returns, and the 1978 Bankruptcy Reform Act

posted in: Cramdown and Priority | 0

By Dirk Hackbarth, Boston University, Rainer Haselmann, Goethe University Frankfurt, and David Schoenherr, London Business School

The 1978 Bankruptcy Reform Act introduced Chapter 11, replacing two separate corporate reorganization chapters (Chapters X and XI). The reform significantly increased shareholders’ bargaining power in financial distress in the years following its passage, leading to a spike in absolute priority deviations in Chapter 11 and out-of-court reorganizations. We exploit this exogenous variation in the allocation of bargaining power between shareholders and debtholders to study the effect of weakening creditor rights on equity risk premia in distress. We find that, relative to safe stocks, distressed stocks’ valuation rose and their risk and return decreased after the reform. Additionally, distressed firms exhibit a higher cost of credit after the reform, confirming that changes in equity risk premia are driven by a shift in bargaining power from debt to equity.

The reform has a differential effect on distressed equity returns. Stocks of firms in which debtors already have relatively higher bargaining power vis-à-vis creditors before the reform, such as firms with a low fraction of tangible assets or with high inside ownership, are less affected by the reform. This strengthens the evidence that the effect of the reform on security prices is through the bargaining power channel, and suggests that part of the increase in shareholder bargaining power through the introduction of Chapter 11 is a substitute for firm-level characteristics that determine higher shareholder bargaining power. Overall, our results reveal that the design of the Bankruptcy Code affects not only the cost of debt but also the cost of equity, an aspect previously not examined in the literature.

For the full article see Review of Financial Studies, Volume 28, Issue 6, June 2015, pp. 1810-1847, available here.

The Bankruptcy Roundtable will be taking August off, but will return in September.

Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain

posted in: Cramdown and Priority | 0

Editor’s Note:  Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain, by Mark Roe and Fred Tung, was selected as one of the ten Best Corporate and Securities Articles of 2014. This “10-best” list reflects the choices of academic teachers in this area from more than 560 articles published last year. The article was the subject of a Bankruptcy Roundtable post on April 8, 2014 at its time of publication. It was the only bankruptcy-based article on the “10-best” list. That list can be found here.

By Mark Roe, Harvard Law School, and Frederick Tung, Boston University School of Law

Roe 124tungprofileIn “Breaking Bankruptcy Priority:  How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, we question the stability of bankruptcy’s priority structure. Bankruptcy scholarship has long conceptualized bankruptcy’s reallocation of value as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of statutory and agreed-to contractual priorities.

In “Breaking Priority,” we propose an alternative view. No hypothetical bargain among creditors is ever fully fixed because creditors continually seek to alter the priority rules, pursuing categorical rule changes to jump ahead of competing creditors. These moves are often successful, so creditors must continually adjust to other creditors’ successful jumps. Because priority is always up for grabs, bankruptcy should be reconceptualized as an ongoing rent-seeking contest, fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps.

We highlight a number of recent and historical priority jumps. We explain how priority jumping interacts with finance theory and how it should lead us to view bankruptcy as a dynamic process. Breaking priority, reestablishing it, and adapting to new priorities is part of the normal science of Chapter 11 reorganization, where bankruptcy lawyers and judges expend a large part of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.

The paper is available here.

Statutory Erosion of Secured Creditors’ Rights: Some Insights from the United Kingdom

By Adrian Walters, IIT Chicago-Kent School of Law

The prevailing wisdom is that Chapter 11 bankruptcy proceedings have been captured by secured creditors with the consequence that many Chapter 11s are little more than glorified nationwide federal foreclosures through which secured creditors exit by means of a section 363 sale.  Some scholars worry that secured creditor capture of Chapter 11 leads to asset deployment decisions that do not produce welfare-maximizing outcomes for creditors as a whole.

In an article forthcoming in the 2015 University of Illinois Law Review, I do not question this prevailing wisdom.  Instead, I seek to argue, by reference to experience in the United Kingdom, that if we are serious about curbing secured creditors’ control of bankruptcy proceedings through bankruptcy law reform, we have to acknowledge and understand the ways in which secured creditors respond to reforms that are adverse to their interests.

The article identifies four ways in which lenders may be expected to adjust to “adverse” bankruptcy reform: (i) meta bargaining; (ii) adjustments to pre-bankruptcy behaviour; (iii) transactional innovation; and (iv) shape shifting. The article then illustrates how lenders in England and Wales have successfully adjusted to sustained statutory attempts to undermine their bankruptcy priority by carving value out of their collateral, and to erode their control rights by abolishing their right to appoint an administrative receiver over floating charge collateral.

Click here to read more.

The New Corporate Web: Tailored Entity Partitions and Creditors’ Selective Enforcement

posted in: Cramdown and Priority | 0

By Anthony J. Casey, University of Chicago Law School

Casey, Anthony_0 (1)Firms often separate assets into distinct entities that have their own legal identity but are commonly owned and together form a large corporate group. While the law-and-economics literature has viewed these legal partitions as either all or nothing, firms have developed sophisticated legal mechanisms to create precisely tailored partitions. The result is a complex corporate web of interconnected legal affiliates.

For example, an asset that is placed in one legal entity may serve as collateral guaranteeing the debts of another legal entity within the corporate group. The assets of the two entities are separate for some purposes but integrated for others. Conventional theories of corporate groups cannot explain the tailored partitions in this corporate web. This article develops a new theory of selective enforcement to fill that gap.

When a debtor defaults on a loan, that default may signal a failure across the entire firm or it may signal a project-specific failure. Tailored partitions provide monitoring creditors with a valuable option to choose between project-specific and firm-wide enforcement depending on the information signal provided. Thus, firm-wide risks and failures can be addressed globally while the effects of project-specific risks and failures can be locally contained when necessary.

These concepts of selective enforcement and tailored partitions reveal important implications for theory and practice. They provide a cohesive justification for the web of entity partitioning and cross liabilities that characterize much of corporate structure today and inform the analysis of holding-company equity guarantees, fraudulent transfers, and ipso facto clauses.

The full version of this article is available here.

From Chrysler and General Motors to Detroit

By David A. Skeel, Jr., University of Pennsylvania Law School

dskeel

In the past five years, three of the most remarkable bankruptcy cases in American history have come out of Detroit: the bankruptcies of Chrysler and General Motors in 2009, and of Detroit itself in 2013. The principal objective of this Article is simply to show that the Grand Bargain at the heart of the Detroit bankruptcy is the direct offspring of the bankruptcy sale transactions that were used to restructure Chrysler and GM. The proponents of Detroit’s “Grand Bargain” never would have dreamed up the transaction were it not for the federal government-engineered carmaker bankruptcies. The Article’s second objective, based the comparison of the Detroit cases, is to make a very brief case for reform of bankruptcy sales.

Part I of the Article briefly surveys the increased use of bankruptcy sales and related shifts in Chapter 11 practice over the past several decades. Part II describes the Chrysler and General Motors bankruptcies, which built on but radically expanded the scope of a bankruptcy sale. Part III turns to the Detroit bankruptcy, focusing primarily on the “Grand Bargain,” while also exploring the city’s use of another recent bankruptcy strategy, known as “gifting.” The Article concludes, in a brief final part, that the Detroit cases have pushed recent bankruptcy innovations to their logical extremes — and beyond — exposing the need to update the oversight of bankruptcy sales.

The full version of this article is available here.

 

Momentive Ruling May Pave the Road for Below-Market “Takeback Paper” Cramdowns of Secured Creditors

posted in: Cramdown and Priority | 0

By Donald S. Bernstein, Davis Polk & Wardwell LLP

bernstein In a lengthy and widely discussed bench ruling delivered on August 26, 2014, Judge Robert D. Drain of the United States Bankruptcy Court for the Southern District of New York held that Momentive Performance Materials could satisfy the cramdown standard of Section 1129(b) of the Bankruptcy Code as to its oversecured creditors by distributing to them replacement notes paying a below-market interest rate, under the reasoning of the Supreme Court’s Till opinion. Rejecting arguments made by the objecting creditors that a market rate of interest was required, Judge Drain approved the use of a rate computed by reference to the prime rate, with an additional margin to compensate the creditors for the risk of non-payment, reasoning that the Bankruptcy Code does not require an interest rate that covers creditors’ costs or provides them with a profit. We note that, if followed, Judge Drain’s ruling may shift the leverage in future Chapter 11 cases in favor of debtors and unsecured creditors, potentially enabling them to satisfy secured creditors with long-term replacement notes at below-market rates, which could incentivize some debtors to avoid the use of market-rate takeout exit financing and potentially provide additional value for unsecured creditors at the expense of secured creditors.

For more analysis, navigate here for PDF download.

Post-Petition Interest: Not Very Predictable

posted in: Cramdown and Priority | 0

By Vicki Harding, Pepper Hamilton, LLP

hardingvIn a recent case a mortgagee battled the debtor over post-petition interest:  When did the lender become oversecured and thus entitled to interest?  Was it entitled to the default rate?  Should interest be compounded?

Some may be surprised to learn that a lender must do more than simply show that it is oversecured to receive its contract rate for the period between the petition date and confirmation.  Most courts hold that a bankruptcy court has at least limited discretion to use another rate.

Here the debtor filed a plan of reorganization that proposed to pay its senior lender in full with interest at 4.25% from the effective date of the plan, but did not include any post-petition, pre-effective date interest.

The lender argued that it was entitled to post-petition interest at the 14.5% contract default rate accruing from the petition date.  The debtor responded that the lender became oversecured only after a sale of its collateral and the default rate was unenforceable and inequitable.

Generally post-petition interest is not allowed, but there is an exception for oversecured creditors.  The 1st Circuit concluded that a bankruptcy court is not required to accept the contract rate, although there is a presumption that the contract rate (including default rate) applies if it is enforceable under state law and there are no equitable considerations leading to a different result. See here for a more detailed discussion of Prudential Ins. Co. of Am. v. SW Boston Hotel Venture, LLC (In re SW Boston Hotel Venture, LLC), 748 F.3d. 393 (1st Cir. 2014).

Leases and Executory Contracts in Chapter 11

posted in: Cramdown and Priority | 0

By Ken Ayotte, University of California at Berkeley Law School

Ayotte_Kenneth_medium_webThis paper offers the first empirical analysis of the timing and disposition decisions large Chapter 11 debtors make with respect to their leases and executory contracts in bankruptcy.  In particular, I analyze the effect of the revised 365(d)(4), which requires tenant-debtors to make decisions on their real estate leases within seven months unless the landlord grants an extension.

I find that the seven month deadline strongly accelerated real estate lease disposition decisions.  This suggests the existence of renegotiation frictions that prevent debtors from buying more time from their landlords.  The accelerated timeline, moreover, may have affected case outcomes.  Using a difference-in-differences methodology, I find that the probability of reorganization fell significantly more for lease-intensive debtors than for non-lease-intensive debtors after BAPCPA.

The paper also offers many new stylized facts.  For example, I find that most assignments occur in the context of a going-concern sale of the whole firm or business unit, rather than on an individual basis.  I also find that many debtors assume contracts early, rather than maximizing the “option value” of waiting.  Examining early assumptions in detail, I find evidence consistent with “implicit contracting” motives, whereby assuming early secures benefits for the debtor that the formal contract alone could not.

The full paper may be found here.

Creditor Conflict and the Efficiency of Corporate Reorganization

posted in: Cramdown and Priority | 0

By Mark Jenkins at University of Pennsylvania and David C. Smith at University of Virginia

While a rich set of theories make clear that incentive conflicts between senior and junior claimants in a company’s capital structure may lead to inefficient outcomes, empirical evidence on how often these conflicts do so has been limited. In this paper, we study the incentives of senior claimants to force inefficient liquidations, or liquidations in which a firm’s assets are sold for less than the firm’s value as a going concern. We develop a bargaining model that assumes senior creditors can exert strong control over whether a firm reorganizes or liquidates during the bankruptcy process. The estimable parameters of the model allow us to gauge the efficiency of bankruptcy outcomes using a large sample of U.S. corporate bankruptcy cases over the period 1989 to 2011.

The main result of the paper is an estimate of the value loss that results from inefficient liquidations in bankruptcy. We estimate these losses to be up to 0.28 percent of the going-concern value of the firm, on average, across all bankrupt firms in our sample. As predicted by theory, these losses are realized primarily by firms with asset values that are close to the face value of secured debt. Our estimate of efficiency losses is driven by several auxiliary findings, including estimates of the fraction of firms that are efficiently reorganized, the fraction of firms that are efficiently and inefficiently liquidated, and the average liquidation discount faced by firms in bankruptcy.

The full article can be found here.

Reports of Equity’s Death Have Been Greatly Exaggerated

posted in: Cramdown and Priority | 0

By Adam J. Levitin, Georgetown University Law Center

Mark Berman is veryLevitin Headshot kind to take notice of my article in his recent analysis of Law v. Siegel, posted on the HLS Bankruptcy Roundtable, here.  We agree on a great deal about the case and scope of equity practice.  A question persists about the scope of Law v. Siegel, though, and what it is proscribing when it reiterates the view that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.”  The question, then, is which non-Code practices are properly characterized as “equity”.  My own view is that very little of modern bankruptcy practice is in fact “equity.”

Law v. Siegel, for example, should not affect such important non-Code practices as judicial interpretation of Bankruptcy Code statutory terms or judicially-created doctrines like substantial consolidation, which are sometimes mistakenly listed among the bankruptcy court’s “equitable powers”.  As I wrote earlier, though, because such practices are interstitial and formed as broad principles, they are, in my view, better understood as part of a federal common law of bankruptcy, and distinguished from equitable powers, which are based on case-by-case specifics, as in Law v. Siegel.  As interstitial powers, these lie outside any widening or narrowing of bankruptcy court’s equitable powers.

Moreover, the uncertainties about when actual equitable practices contradict statutes will continue.  In cases of clear contradiction, the interpretive result will be easy. But cases where it is unclear whether a conflict truly exists will continue to invite negotiation between and among the parties because of the cost and uncertainty of litigation.  Despite the Supreme Court’s best efforts, consideration of the equities will likely remain a part of our bankruptcy system.

For a fuller treatment of this subject, please continue here.

1 2 3 4 5