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

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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.

 

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

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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

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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

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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.

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