Debt Recharacterization Under State Law

By James M. Wilton (Ropes & Gray, LLP)

The majority federal law test for recharacterization of insider debt in bankruptcy establishes a multi-factor test drawn from federal tax cases. The test is problematic and has been rejected by Fifth and Ninth Circuit Courts of Appeals in favor of a state law rule of decision. The U.S. Treasury, in fact, has moved away from use of multi-factor tests even in tax cases because they are unworkable and produce “inconsistent and unpredictable results.”

In an article published this month in The Business Lawyer, I predict that the U.S. Supreme Court will resolve the circuit split over debt recharacterization in favor of a state law rule of decision. The article is intended for transactional lawyers interested in structuring transactions to minimize debt recharacterization risk and for bankruptcy litigators interested in understanding the arguments both for and against application of a federal or a state law rule of decision. For the circuits that have endorsed a state law rule of decision for debt recharacterization, the article examines the appropriate test for determining choice of law and surveys the substantive state law of debt recharacterization in thirteen jurisdictions, including New York and Delaware.

The article concludes that debt recharacterization under state law allows equity sponsors and other corporate insiders to provide credit support to distressed businesses, with greater assurance that loans will be enforceable both under state law and in bankruptcy court.

The full article is available here.1


  1. ©2019. Published in The Business Lawyer, Vol. 74, Winter 2018-2019, by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association or the copyright holder.

How Specialized Courts Changed the Chinese Bankruptcy System

By Bo Li (Tsinghua University – PBC School of Finance) and Jacopo Ponticelli (Kellogg School of Management – Department of Finance)

In the last decade, China experienced a massive increase in corporate debt and, more recently, in corporate bankruptcies. Despite the mounting pressure on its insolvency resolution system, little is known about how bankruptcy works in China and the role played by the government.

China’s bankruptcy system experienced two recent changes: the reform of the bankruptcy code in 2007, and the introduction of specialized courts between 2007 and 2017. Before the introduction of specialized courts, bankruptcy cases were filed in local civil courts. Characterized by limited expertise and long delays, local courts tend to operate under the influence of local politicians, who have strong incentives to keep financially distressed state-owned companies alive to reduce unemployment and boost their political career. Thus, even though  the 2007 reform aligned Chinese bankruptcy law with those in the US and Europe, timely resolution of state-owned firms in financial distress remains a problem due to the influence of local governments.

Recently, China’s central government promoted the introduction of courts specialized in bankruptcy, which are modeled on US courts and run by insolvency professionals. In this paper, we study the impact of the introduction of specialized courts across Chinese provinces a on bankruptcy resolution and credit markets. The introduction of specialized courts led to an increase in the share of liquidations of state-owned firms and a faster speed of processing in court. In addition, state-owned firms operating in jurisdictions with specialized courts experienced a decrease in the size of new bank loans, lower access to new loans, and lower investment in physical capital relative to privately-owned firms.

The full article is available here.

 

Creditor Governance

By William R. McCumber (College of Business, Louisiana Tech University) and Tomas Jandik (Sam M. Walton College of Business, University of Arkansas)

A traditional view of creditors is that they are largely passive investors unless a borrower violates the terms of a loan agreement or misses a payment. However, like institutional shareholders, creditors hold concentrated positions in firm securities (loan shares), are sophisticated investors, and have access to senior management and non-public information. Since debt financing is much more common than equity financing, and because the great majority of credit agreements are honored, it is important to better understand how creditors advise and monitor portfolio (borrower) firms. We find that creditors play a significant role in corporate governance under normal circumstances, i.e. when firms are not in technical violation or default. Borrower firms are less likely than non-borrowers firms to file for bankruptcy in the intermediate future, and borrowers shift financial and investment decisions away from value-reducing policies and toward value-creating investments. Importantly, these changes are profitable for borrower firms since both cash flows and returns on assets improve at least three years after loan origination, which in turn decreases creditor portfolio risk. We also find that when creditors retain a larger proportion of the loan on their books, changes in borrower firm financials are more pronounced, providing evidence that creditors exert a greater governing force when more exposed to borrower risk.

The full article is available here.

Non-Debtor Substantive Consolidation: Do Recent Cases Signal a Judicial Preference for State Law Claims?

By Charles W. Azano (Mintz Levin).

Jurisprudence varies on whether bankruptcy courts have the power to consolidate a bankruptcy debtor with a non-debtor. Even those courts that have permitted consolidation have done so with trepidation, calling the remedy “extreme” or “extraordinary,” and that the power is to be used “cautiously” or “sparingly.”

Two courts recently addressed whether it is possible for a non-debtor to be consolidated into the bankruptcy of an affiliated debtor, or whether such attempts are dead-on-arrival. First, the Eighth Circuit Court of Appeals in Official Committee of Unsecured Creditors v. Archdiocese of Saint Paul & Minneapolis (In re Archdiocese of Saint Paul & Minneapolis), held that because Section 303(a) of the Bankruptcy Code protected non-profit entities from involuntary bankruptcy filings, non-profit non-debtors could not be substantively consolidated into a debtor’s bankruptcy. Second, the United States Bankruptcy Court of the Northern District of Illinois, in Audette v. Jasemir (In re Concepts Am., Inc.), went even further and held that substantive consolidation of a non-debtor was barred under all circumstances in the Seventh Circuit. While both cases determined that the remedy of substantive consolidation was not available, they also each suggested that state law alter ego or piercing claims may provide the creditor an alternative remedy. This may just be a coincidence, or it may be a trend. In either event, it is fair to ask if there is a growing judicial preference for state law claims when a non-debtor is involved.

The full article is available here.

Bankruptcy Law as a Balancing System – Lessons from a Comparative Analysis of the Interaction Between Labor and Bankruptcy Laws

By Omer Kimhi (Haifa University Faculty of Law) and Arno Doebert (Independent)

The rehabilitation of distressed corporations often requires the reduction of labor costs. In order to regain economic stability, distressed firms need to terminate employees or modify their employment conditions. When employees are protected by statutes or by collective bargaining agreements, however, such measures are not always possible. The employer’s freedom to manage its work force is limited, and it may fail to implement labor reforms necessary for the firm’s recovery.

In the paper, we examine the intersection between bankruptcy and labor laws from a comparative perspective. We study the labor and bankruptcy laws of three different jurisdictions, the Netherlands, France, and Germany, and find a so far unexplored trend. Jurisdictions with high employment protection levels relax their otherwise rigid labor rules through their bankruptcy system. Within bankruptcy, employers enjoy greater flexibility and thus are better situated to decrease their labor costs and to reorganize.

The paper explores this trend vis-à-vis the arguments brought up by the procedural approach to bankruptcy. It looks at the rationale of the bankruptcy-induced modifications to the labor laws, and the effects these changes have on the bankruptcy process. We show that although the modifications are designed to promote the preservation of firms as going concerns, forum-shopping problems may lead to the opposite outcome. The analysis contributes to the ongoing debate between the traditional and procedural approaches, and sheds light on the interpretation of section 1113 of the Bankruptcy Code as well.

The full article is available here.

 

 

 

Loan to Bond Substitution: An Empirical Analysis on the Functioning of the Substitution Channel for Eurozone Firms

By Francesco Ruggiero (University of Naples Federico II)

This paper contributes to the literature by enhancing the understanding of the link between bank debt and bond market debt in the Eurozone. This implication is particularly important for small firms that usually rely heavily on bank loans, and are likely to be excluded from the credit market during crises. In this paper, I find that firms based in the Eurozone can substitute bonds for loans in response to changing credit conditions. But the substitution is only partial, and firms will end up raising less funds than needed. Despite the bank centric feature of the European financial market that encourages firms to rely a lot on bank loans, bonds still serve as a substitute to loans. Firms in the Eurozone choose to substitute bonds for loans especially in periods in which the banking sector is in distress or the central bank implements policies to enhance credit.

The comparison with the U.S. firms (provided as benchmark) requires an in-depth analysis on the relative roles of the banking system and the financial market in Europe and the U.S. The divergence in results might indicate that policies enacted by the Fed in the U.S. might not be the best fit for European system. European Central Bank (“ECB”)  should thus tackle similar problems differently. In principle, the central bank’s expansive monetary policies should have affected bank lending positively as well. The reason why it did not work as expected along this transmission channel is that  the banks tend to hoard extra liquidity received from the ECB to deal with potential  sudden shortages in the future.

The full article is available here.

 

 

Courts As Institutional Reformers: Bankruptcy and Public Law Litigation

Kathleen G. Noonan (University of Pennsylvania), Jonathan C. Lipson (Temple University—Beasley School of Law), and William H. Simon (Columbia Law School)

Wags sometimes ask: What is chapter 11 good for?

In a new paper, we show that, among other things, it provides a template that both legitimates and explicates Public Law Litigation (PLL), civil class action suits against public agencies such as police departments and prison systems. These are among the most controversial disputes that courts face; often criticized, and widely misunderstood. Analogies to chapter 11 practice show how critics err, and how PLL works.

We make three basic points. First, we show that both bankruptcy and PLL, which share roots in the federal equity receivership, are judicial responses to collective action problems that other institutional mechanisms (e.g., markets or electoral politics) cannot or will not address.

Second, we show that courts in neither context “run” the organizations in question. In both types of case, management (of the debtor or agency) remains in possession and control, subject to judicial and stakeholder (e.g., creditor or plaintiff) oversight.

Third, chapter 11 and PLL both operate at the organizational level, through “restructuring.” For chapter 11, this will usually involve a plan of reorganization. The PLL analogue is a settlement agreement in a consent decree. Like plans, consent decrees typically reflect negotiated improvements in operations designed to increase the agency’s chances of success.

Critics of PLL sometimes claim that courts commandeer public instrumentalities, exceeding their expertise and authority. But this is no truer in PLL than it is in chapter 11 reorganization. Rather, judges in both spheres facilitate consensual resolutions that seek to balance stakeholder participation against managerial discretion.

This matters because the Trump Administration has vowed to “deconstruct the administrative state,” which implies a reduction in the amount and quality of public services. Increased PLL would be a plausible response.

If that happens, courts should focus not on whether they can supervise the restructuring of public agencies, but how to do so more effectively. We show that the chapter 11 system can provide helpful guidance.

The full article is available here.

Justice Scalia’s Bankruptcy Jurisprudence: The Right Judicial Philosophy for the Modern Bankruptcy Code?

By Megan McDermott (Lecturer, University of Wisconsin School of Law).

The late Justice Scalia is best known among mainstream audiences for his originalist approach to the Constitution, as well as his polarizing views on various civil rights issues. But anyone who has cracked open a bankruptcy casebook also knows Justice Scalia for his many contributions to the bankruptcy field — both through sturdy majority opinions in interpretive cases like Timbers, Nextwave, and Radlax, and through his biting dissents and concurrences in watershed decisions like Dewsnup and Stern.

My recent article, Justice Scalia’s Bankruptcy Jurisprudence: The Right Judicial Philosophy for the Modern Bankruptcy Code?, seeks to both quantify and qualify Justice Scalia’s contributions to bankruptcy law. I show that during his three decades on the Court, Justice Scalia wrote in more bankruptcy cases than any other justice (followed closely by Justices Stevens and Thomas).

I also identify four predominant themes that emerge from Justice Scalia’s bankruptcy oeuvre: (1) a holistic approach to the Bankruptcy Code; (2) a commitment to textualism, regardless of outcome; (3) disdain for legislative history; and (4) a desire for clear boundaries regarding the scope and authority of bankruptcy courts.

Finally, the article explores the impact of his jurisprudential legacy on the bankruptcy field. Of particular note are the ways in which Justice Scalia’s approach often favored ordinary consumers over creditor interests. I conclude that while Justice Scalia did not always live up to the ideals that he advocated, he nonetheless offered a unifying vision that fits well with both the purpose and the design of the Bankruptcy Code.

The full article is available here.