By Shana A. Elberg, Seth E. Jacobson, & George R. Howard (Skadden)
Today, U.S. borrowers are more indebted than ever before. Borrowers have become increasingly aggressive in using secured leverage, and in taking advantage of “cov-lite” loan documents to engage in creative (and sometimes controversial) transactions to transfer assets beyond the reach of existing secured lenders by way of distributions to shareholders or contributions to unrestricted subsidiaries and then utilize those assets to raise additional secured financing. While the debt levels and cov-lite structures of leveraged loans may create risks for many stakeholders, lenders under asset-based loan facilities (“ABL facilities”) should be well-positioned to weather any storm. ABL facilities typically offer lenders greater protections in a liquidation scenario. In addition, ABL facilities often are a critical lynchpin of debtor-in-possession financing facilities when borrowers are looking to effectuate comprehensive restructurings through chapter 11. There are several tools available to ABL lenders to protect their credit position in the event that a borrower finds itself in a distressed situation. Lenders should position themselves to understand and use the chapter 11 process to ensure their debt claims retain, and even gain, protections in bankruptcy.
On November 26, 2019, the Fifth Circuit granted a petition for rehearing en banc and issued a revised opinion in In re Ultra Petroleum Corp., No. 17-20793 (5th Cir. Nov. 26, 2019). The new opinion reaffirmed the court’s prior holding that the alternation of a claim by the Bankruptcy Code does not render a claim impaired under 11 U.S.C. § 1124(1), while withdrew the court’s earlier guidance that make-whole premium was the “economic equivalent of ‘interest’” together with its prior suggestion on setting the appropriate post-petition interest rate via reference to general post-judgment interest statute or bankruptcy court’s equitable discretion.
Noting that issues relating to make-whole premiums is a common dispute in modern bankruptcy, the Fifth Circuit retracted its dicta and emphasized in the revised opinion that specific facts are essential in determining the difficult question of whether any premiums are effectively unmatured interest. The court concluded that “[t]he bankruptcy court is often best equipped to understand these individual dynamics – at least in the first instance.”
Firms took notice of the issues remain unsolved and offered perspectives on implications of this case. Morgan Lewis specifically notes that the revised opinion did not alter the original opinion’s reversal of the bankruptcy court’s ruling that creditors who are unimpaired in a bankruptcy plan pursuant to section 1124(a)(1) must receive the full amount of their claim under state law. Weil finds the opinion “does not answer the question of whether, or when, a make-whole may be payable in the Fifth Circuit”, but acknowledges that the ruling is “viewed by some as a victory” for certain creditors. Cleary highlights that the court’s revised opinion “withdrew essentially all of the guidance it had offered in its prior opinion” which had cast doubt on the enforceability of make-whole claims in bankruptcy. “Given the legal and economic significance of the questions left to be resolved”, debtors and creditors alike are likely to watch closely how the questions will proceed at the bankruptcy court, says Mayer Brown.
In In re Energy Future Holdings Corp., 773 Fed. Appx. 89, 2019 WL 2535700 (3d Cir. June 19, 2019), a panel of the U.S. Court of Appeals for the Third Circuit ruled that adequate protection payments made during a bankruptcy case and distributions under a chapter 11 plan are not distributions of collateral for purposes of a “waterfall” provision in an intercreditor agreement. The ruling is a reminder that intercreditor agreements will apply only in accordance with their terms.Although the parties could have drafted the intercreditor agreement to apply to any consideration received from the debtor by the noteholders, they did not. Therefore, the intercreditor agreement did not apply to the adequate protection payments and plan distributions made to the noteholders.Creditors have recently learned similar lessons in other cases. Because the ruling was unpublished, the decision is not binding on courts in the Third Circuit.
Happily, ultimate resolution of the Blackjewel case later in autumn saw the employees made whole and the company investigated for fraud. But this solution was anything but assured before it was reached, and employees in any event suffered substantial harm in the form of disrupted family budgets and substantial uncertainty as to ultimate recovery for months – including, critically, just as a new school year was commencing for employee families’ children.
It would seem well advised, then, to put in place a more permanent and reliable process for cases like that of Blackjewel and its employees. What is needed is a solution that is uniformly applicable, reliable, and known in advance such that all concerned parties can bargain and plan ‘in the shadow’ of the regime. Our present arrangements are subject to vagaries of state law and state budgets that vary across state jurisdictional space and fiscal time. The obvious solution to the difficulties raised by such variance is to subject this realm, like that of bankruptcy itself, to federal legislation.
A bill I have recently drafted and advocated aims to ‘fit the bill’ in effect called-for by the Blackjewel affair. It does so by (a) assigning the Department of Labor (‘DOL’) a permanent representation role in future employer insolvencies; (b) federalizing the employer bonding requirements now found only in inconsistently administered state laws; (c) establishing an Employee Liquidity Support Fund to tide employees over while bankruptcy proceedings are pending; and (d) holding employing-firms’ executive officers personally liable for violations of the Act’s requirements.
The reason for DOL representation and oversight is to ensure that employees have a coherent and powerful representative ‘at the table’ during insolvency proceedings – one that is endowed with oversight authority not only during, but in advance of insolvencies.
The reason for federalizing employer bonding requirements is that states often vary over time in respect of the seriousness with which they administer such requirements, presumably in part for reasons sounding in lobbying pressures and ideology but also for reasons of basic capacity – large employers, after all, often are ‘bigger’ than the states that would supervise them.
The reason for establishing an Employee Liquidity Support Fund is presumably obvious. What made Blackjewel’s travails so hard on employees was precisely the fact that ultimate resolution was long in coming, while employee families’ daily living expenses couldn’t ‘wait.’ Against such a backdrop it makes sense for DOL to do for employees what our Federal Reserve does for financial institutions while insolvency and consolidation proceedings are underway – viz., provide tide-over funding.
Finally, the reason for holding executive officers personally liable for compliance with the Act’s requirements should be obvious as well. For again as in the case of financial institutions, so here the only surefire way of ‘incentivizing’ firms to comply is to incentivize those through whom all firms act – their executives, as the term ‘executive’ (derived from ‘execute’) itself suggests. Diffuse shareholders, who often lack power over corporate officers, and insider shareholders, who often have interests at odds with the interests of non-executive employees in any event, simply aren’t up to the task.
Employing firms, their executives and their owners have enjoyed multiple forms of state patronage for decades in our nation, while employees have in general enjoyed only sporadic assistance from public sector institutions and, less now than any time since the early 20th century, labor unions. This Act will help further a cause that’s increasingly now recognized once again to be both morally and economically compelling: That is the task of protecting the interests of our own productive citizenry – our labor force.
By Bruce Grohsgal (Delaware Law School Widener University)
Bankruptcy’s absolute priority rule arose 150 years ago to prevent insiders from using their control over an enterprise – often coupled with hypothetical valuations, contrived sales, and collusion with other parties – to obtain a greater distribution or “control premium” from estate assets. This premium came at the expense of parties who had a higher distributional priority but were not “in on the deal.” The Supreme Court again considered this issue in Jevic in 2017, when it held that a chapter 11 case-ending settlement called a “structured dismissal” must comply with the same absolute priority rule that applies to the similarly case-ending confirmation of a chapter 11 cramdown plan. The Court emphasized that insider control and collusion can endanger bankruptcy’s core principle of an orderly distribution in accordance with statutory priorities.
The Jevic Court explicitly left open, though, the extent to which a pre-plan settlement or court-ordered “first-day” distribution in chapter 11 may deviate from the absolute priority rule. It suggested only that a court approving these pre-plan distributions must show some respect for – or a “proper solicitude” to – the statutory distributional priorities.
I propose in this paper that, for a proposed pre-plan, priority-skipping settlement with an insider, secured lender or other party who exercises some control over the debtor, the absolute priority rule is sufficiently respected when a bankruptcy court subjects to an auction the claim proposed to be settled. If at the auction, a third party bids the same or a higher price for the claim absent the priority-skipping, then it will be clear that the initially proposed transaction included a control premium. If instead a higher third-party bid is not obtained, it will be clear that the settling insider is not paying a discounted settlement price based on its control and that the priority-skipping has a legitimate basis that does not implicate the problem of insider control. The auction, by displacing suspect hypothetical valuations, can address the precise mischief sought to be remedied by the absolute priority rule.
I further contend that a market test for a “first-day” distribution to a critical vendor, employee or other creditor that is challenged as priority-skipping will be limited to whether the debtor sought and failed to obtain in the market the same good, service, or credit from an alternative supplier on the same or better terms than those proposed in the first-day motion. The reason for this is simple – a bankruptcy court will not be able in most cases to obtain, at the time of the first-day hearing, a market determination of case-ending distributions to creditors. Any hypothetical valuation at a first-day hearing of the end-of-case distributions to creditors will be highly unreliable. Because of these obstacles, I suggest that the question of whether a first-day payment will comport with end-of-case distributional priorities should be replaced with the question of whether the debtor sought and failed to obtain an alternative supply in the market on the same or better terms, and by a rebuttable presumption that preserving the going concern value of the chapter 11 debtor likely will benefit even the disfavored creditors. This approach – which essentially adopts the occasionally maligned “doctrine of necessity” and rejects the Seventh Circuit’s Kmart rule – recognizes the disturbing weakness of a hypothetical determination, made at the first day hearing, of end-of-case distributions in a chapter 11 case.
By Ronit J. Berkovich, Andriana Georgallas and Aarti Gupta (Weil, Gotshal & Manges LLP).
In a recent decision, In re Orexigen Therapeutics, Inc., No. 18-10518 (KG) (Bankr. D. Del. Nov. 13, 2018), Judge Kevin Gross of the United States Bankruptcy Court for the District of Delaware analyzed setoff under section 553 of the Bankruptcy Code. Setoff is a contractual or equitable right that allows entities that owe each other money to apply their mutual debts against each other. Whether a party has a setoff right is a twofold inquiry. First, the party seeking setoff must acquire such right prepetition under applicable nonbankruptcy law. Second, once the party establishes its setoff right, the party must meet the requirements of section 553(a) of the Bankruptcy Code, namely: (1) the party seeking setoff must be a “creditor” and (2) that party must have a “mutual debt” where that party’s debt to the debtor arose prepetition and that party’s claim against the same debtor arose prepetition.
In In re Orexigen Therapeutics, Inc., Judge Gross held that the mutuality requirement must be strictly construed, declining to find mutuality in a triangular setoff between the debtor, a parent entity that owed the debtor money, and that entity’s subsidiary, which was a creditor. Specifically, Judge Gross held that there is no contractual exception to the mutuality requirement and that mutuality may not be satisfied under a third-party beneficiary theory.
By Donald S. Bernstein, Timothy Graulich, Marshall S. Huebner, Darren S. Klein, Brian M. Resnick, Christopher Robertson, Damian S. Schaible, Eli J. Vonnegut and Jacob Weiner (Davis Polk & Wardwell LLP).
In In re Ultra Petroleum Corp., No. 17-20793, 2019 WL 237365 (5th Cir. Jan. 17, 2019), the U.S. Court of Appeals for the Fifth Circuit issued a decision strongly suggesting that (i) make-whole premiums are not payable in bankruptcy to unsecured and undersecured creditors and (ii) unsecured creditors in solvent-debtor Chapter 11 cases are entitled to postpetition interest only at the federal judgment rate—not the higher full contract rate. The Fifth Circuit found “compelling” the debtors’ argument that a make-whole premium owed to certain unsecured noteholders under the prepetition notes purchase agreement should be disallowed as a claim for unmatured interest pursuant to section 502(b)(2) of the Bankruptcy Code, departing from the majority view. While distressed companies may rejoice in this decision, creditors—particularly unsecured and undersecured creditors—will need to reconsider the likelihood of collection of make-whole premiums for distressed companies that are able to file for bankruptcy protection in Texas, Louisiana, or Mississippi, and to evaluate the risk that courts in other circuits follow the Fifth Circuit’s reasoning. Importantly, the UltraPetroleum decision will likely create additional incentives for distressed companies to file for bankruptcy in the Fifth Circuit if potentially large make-whole premiums are payable to unsecured or undersecured creditors.
In addition, the Fifth Circuit’s guidance on rates of postpetition interest owed to unsecured creditors in solvent-debtor Chapter 11 cases may influence courts in other jurisdictions in solvent-debtor Chapter 11 cases.
The full article, which describes the make-whole analysis in the context of the recent Momentive and Energy Future Holdings decisions and the postpetition interest rate dispute, is available here.
By Christopher W. Frost (University of Kentucky – College of Law)
The historical and doctrinal development of secured transactions and bankruptcy law has created a priority system that is asset based. Secured creditor priority is tied to the value of specific assets that constitute the secured creditor’s collateral and not to the value of the debtor itself. And yet, in corporate bankruptcy cases, lenders and their attorneys often assert broad claims to the entire enterprise value of the entity – that is to the present value of the cash flows that the entity will generate as a going concern. The doctrinal basis for such claims is often unstated, however, and several commentators have criticized the breadth of those claims under existing laws.
This article responds to those views and argues that secured creditors can establish a broad enough security interest to create an “effective entity priority.” The argument is premised on the notion that the broad secured claim creates a closed system in which all of the assets acquired relate, and can be traced, to pre-bankruptcy collateral. The secured creditor’s priority therefore may extend to the value of the entity, rather than the value of specific assets within the entity. Although the doctrinal claim is plausible, the article notes that it can be difficult to maintain under the facts of particular cases. Thus the article suggests that changes to the Bankruptcy Code and the Uniform Commercial Code that recognize true entity priority may provide clarity and efficiency to the bankruptcy process.
The full article is available here. The article is forthcoming in the Connecticut Law Review.
By Charles Tabb and Tamar Dolcourt (Foley & Lardner LLP).
In July, the Seventh Circuit Court of Appeals issued a decision that appeared to upend the long-held understanding that an underwater secured creditor was entitled to all of the proceeds of a sale under Section 363 of the Bankruptcy Code. In our new article, we analyzed the decision in Illinois Department of Revenue v. Hanmi Bank in which the Seventh Circuit opened the door to a potential recovery for out-of-the-money junior creditors based on the theory that a free and clear sale under the Bankruptcy Code created a premium for the assets that the junior creditor may be entitled to share. Though Hanmi dealt explicitly with a state taxing authority and its particular rights under Illinois state law, there is nothing in the opinion which limits it to those facts or that type of creditor. Furthermore, even though the court ultimately valued the interest that the Illinois Department of Revenue was forced to give up through the free and clear sale at zero, that was simply a failure of proof in the particular case. We also consider the long-term ramifications of this opinion and its likely effect on future sales under Section 363, including the possibility of increased costs and delays of negotiating these sales with recalcitrant junior creditors.