By Jared A. Ellias (University of California, Hastings) & Robert Stark (Brown Rudnick LLP)
On the eve of the financial crisis, a series of Delaware court decisions added up to a radical change in law: Creditors would no longer have the kind of common law protections from opportunism that helped protect their bargain for the better part of two centuries. In this Article, we argue that Delaware’s shift materially altered the way large firms approach financial distress, which is now characterized by a level of chaos and rent-seeking unchecked by norms that formerly restrained managerial opportunism. We refer to the new status quo as “bankruptcy hardball.” It is now routine for distressed firms to engage in tactics that harm some creditors for the benefit of other stakeholders, often in violation of contractual promises and basic principles of corporate finance. The fundamental problem is that Delaware’s change in law was predicated on the faulty assumption that creditors are fully capable of protecting their bargain during periods of distress with contracts and bankruptcy law. We show through a series of case studies how the creditor’s bargain is, contrary to that undergirding assumption, often an easy target for opportunistic repudiation and, in turn, dashed expectations once distress sets in. We further argue that the Delaware courts paved the way for scorched earth distressed governance, but also that judges can help fix the problem.
The full article is available here.
By Robert K. Rasmussen (University of Southern California Gould School of Law)
It is common to observe that investors receive both cash flow rights and control rights against a borrower. The crucial differences between these two “rights” are rarely focused on. Cash flow rights are legal entitlements. Outside of bankruptcy, failure to pay entitles a lender to resort to a legal remedy against the borrower. Inside of bankruptcy, the Bankruptcy Code structures the way in which these legal entitlements will be adjusted. Control rights are different. They do not confer direct power over the business, nor do they provide lenders with a judicial remedy that allows them to assert control. Rather, they work indirectly. The Bankruptcy Code, in turn, pays scant attention to a lender’s control rights.
This disparate treatment stems from the lending contract. That agreement provides enforceable rights to cash and as we have seen in recent years – there is little limit to the creativity in dividing up cash flow rights. The same contract, however, does not place control in the hands of a lender, even on a contingent basis because legal doctrines threaten creditors who put their hands on the levers of power. Outside of bankruptcy, the lingering shadow of lender liability doctrine leads lawyers to counsel clients to avoid contracting for control upon a borrower’s default. Inside of bankruptcy, lenders that exercise what a court finds to be excessive control face the threat of having their claims equitably subordinated. In addition to these threats, it is far from clear that a bankruptcy court would enforce a contract that gave direct control to the debtor’s lenders should the debtor default. These restrictions on contracting, however, are questionable. Opening up the contract space for direct contracting on control could increase contracting surplus.
The full article is available here.
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 O. Cem Ozturk (Georgia Institute of Technology – Scheller College of Business), Pradeep K. Chintagunta (University of Chicago), & Sriram Venkataraman (University of North Carolina at Chapel Hill – Kenan-Flagler Business School)
We empirically study the effect of Chrysler’s Chapter 11 bankruptcy filing on the quantity sold by its competitors in the U.S. auto industry. The demand for competitors could increase as they may benefit from the distress of the bankrupt firm (competitive effect). On the other hand, competitors could experience lower sales if the bankruptcy increases consumer uncertainty about their own viability (contagion effect). A challenge to measuring the impact of bankruptcies is the coincident decline in economic conditions stemming from the Great Recession and the potential effect of the “cash for clunkers” program. To identify the effect of the bankruptcy filing, we employ a regression-discontinuity-in-time design based on a temporal discontinuity in treatment (i.e., bankruptcy filing), along with an extensive set of control variables. Such a design is facilitated by a unique data set at the dealer-model-day level which allows us to compare changes in unit sales in close temporal vicinity of the filing. We find that unit sales for an average competitor reduce by 28% following Chrysler’s bankruptcy filing.
Our results suggest that this negative demand spillover effect is driven by a heightened consumer uncertainty about the viability of the bankrupt firm’s rivals. For example, we show that the sales of competitors’ vehicles that compete within the same segments as the bankrupt firm’s vehicles or that provide lower value for money are affected more negatively in response to the Chrysler filing. We also observe more web search activity for Chrysler’s competitors after the filing.
The full article can be found here.
The Federal Reserve Bank of New York’s Liberty Street Economics Blog has run a series of five posts seeking to estimate the total value destroyed by the Lehman Brothers Holdings Inc.’s Chapter 11 and Lehman’s investment bank affiliate’s liquidation through separate Securities Investor Protection Act (SIPA) proceedings.
Erin Denison, Michael Fleming, and Asani Sarkar, of the Federal Reserve Bank of New York’s Research and Statistics Group, estimate the total value destruction for Lehman, its creditors, and stakeholders to be approximately between $46 billion to $63 billion (between 15 to 21 percent of Lehman’s pre-bankruptcy consolidated assets), excluding expenses from the SIPA proceedings (an additional $1.4 billion) and the costs of resolving Lehman’s foreign subsidiaries. These estimates also exclude boarder spillover effects on the economy caused by Lehman’s collapse.
Denison, Fleming, and Sarkar suggest the main drivers of value destruction include: professional fees and expenses ($5.9 billion for Chapter 11 proceedings with an additional $1.36 billion for SIPA proceedings); liquidity costs for creditors during the lengthy proceeding ($15 billion); and lost relationships between Lehman and its equity underwriting clients ($23 billion). They break down these estimates of the value destroyed through a series of four posts, analyzing the direct costs (expenses paid to third parties for services provided during bankruptcy) and the indirect costs (opportunity costs for the firm, its creditors, and its stakeholders).
The first post on Creditor Recovery in Lehman’s Bankruptcy can be found here. The second post on Lehman’s Bankruptcy Expenses can be found here. The third post on Customer and Customer and Employee Losses in Lehman’s Bankruptcy can be found here. The fourth post on Indirect Costs of Lehman’s Bankruptcy can be found here. The final summary post can be found here.
For previous Roundtable posts on the valuation and resolution of Lehman, see Steven Lubben, “Lehman’s Derivative Portfolio”; Mark J. Roe, and Stephen D. Adams, “Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio.”
(This post was authored by Ryan Rossner, J.D. ’19.)
By Edwin Fischer and Ines Wöckl (University of Graz)
Many debtholders, whether private households, companies, or states, are caught up in high-interest long-term loans. At the same time, economic developments in the Eurozone over the past few years have created a low-interest environment in which prepaying an existing loan and simultaneously refinancing into a new loan can be advantageous from the borrower’s point of view. By redeeming an existing loan before maturity and refinancing into a loan with a lower interest rate, the amount of interest owed to the lender can be reduced significantly. Intuitively debt restructuring seems advantageous whenever the nominal interest rate of the new loan is lower than that of the old loan. However, prepayment considerations are more complex since debt restructuring entails transaction costs. These include a possible penalty for the early redemption of the existing loan, called a prepayment penalty, as well as credit charges and a possible loan disbursement fee for taking out a new loan. We use the method of differential investment to analyze under which circumstances loan and bond prepayments make sense for debtholders. We provide an exact solution concept as well as an easy-to-use approximation for calculating the critical upper limits for the nominal interest rate of the new loan up to which prepayment and subsequent refinancing is optimal. The calculations address both fixed and variable rate loans and consider whether the debt agreement is repaid at maturity or in annuities.
The full article is available here.
By Andrew Verstein (Wake Forest University School of Law)
Are insolvent firms different from solvent firms with respect to insider trading law and policy? One difference is the level of regulation of trading in the residual claims of the firm. In solvent firms, the residual claims are equity securities, and equity securities are subject to the full ambit of trading restrictions. In insolvent firms, non-equity claims are typically residual claims that are subject to less stringent regulation precisely because they are not equity and they may not even be securities. As a result, insider trading regulations apply with lesser force to the most economically significant and informationally-sensitive interests in an insolvent company. Insolvency is therefore deregulatory.
While insolvency deregulates, it also expands the reach of other aspects of federal insider trading law. That is because bankruptcy law creates new roles and new duties. Since insider trading law hinges on duties, these new relationships expand the coverage of insider trading restrictions.
I consider these tradeoffs in a forthcoming article, and I offer two tentative conclusions.
First, we should not rush to close the “loopholes” in insider trading law that open with regards to the residual claims. Deregulating insider trading is a Faustian bargain—greater price accuracy at the risk of lesser liquidity, fairness, and managerial integrity—but we should be more willing to accept the bargain with respect to insolvent firms than solvent ones.
Second, we should be solicitous of efforts to shield members of creditors’ committees from extensive insider trading regulation because these creditors occupy a position without analogue in the solvent firm: they both receive and contribute material, nonpublic information. Traditional insider trading law theory may not have the resources to manage a two-way flow of information, requiring new and accommodating thought.
The full article is available here.
By Gerard McCormack (University of Leeds) and Wai Yee Wan (Singapore Management University – School of Law)
In 2017, Singapore introduced wide-ranging reforms to its insolvency and restructuring laws with a view to enhancing its attractiveness as an international centre for debt restructuring. A key theme of the reforms is the transplantation (with modification) of certain provisions from Chapter 11 of the US Bankruptcy Code including the automatic moratorium, cross-creditor cram-down, rescue financing and pre-packs. These provisions are engrafted into the existing scheme of arrangement framework, which in turn has its roots in the United Kingdom (UK).
In our paper, relying on the US experience and the reactions to similar reform proposals in the European Union (including the UK), we critically evaluate the effectiveness of the legal transplantation and discuss the possible unintended consequences of such transplantation.
We raise three issues. First, the new cross-class cram-down provisions could lead to valuation disputes and satellite litigation, such as whether the directors and scheme managers have properly discharged their duties. Second, the 2017 reforms shift power from the creditors to the management of the debtor company. This may prove to be disadvantageous to creditors in Singapore (and many other Asian countries) where the majority of the companies, including publicly listed companies, have concentrated shareholdings, and managers owe their existence to those who are in control. Finally, there remains the question whether the Singapore schemes will be recognised overseas, which will be important if the scheme proposes to modify debt obligations that are governed by non-Singapore law.
The full article is available here. The article is recently published in Journal of Corporate Law Studies.
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.
By Cheng-Han Tan, Jiangyu Wang, Christian Hofmann (National University of Singapore Law School)
Corporate personality is not absolute and this paper aims to compare and critically examine the circumstances under which veil piercing takes place against the objectives of incorporation. The countries examined are a mix of common law and civil law countries, including China, England, Germany, Singapore and the United States. We note that English and German courts have in recent years adopted a more restrictive approach to veil piercing, with Singapore courts appearing to be sympathetic to the current English position. On the other hand, courts in the United States and especially China seem to accept a more expansive approach to piercing even while recognising its exceptional nature. One reason for this is because veil piercing has been used loosely in instances which seem inappropriate and where the matters could have been determined by other legal principles.
We suggest that this is sub-optimal and that a narrower approach to veil piercing is preferable. For one, the need to look beyond the corporation is usually only necessary where insolvency has intervened. Direct claims by creditors against shareholders or management therefore potentially risk undermining the collective insolvency framework within which creditors are to have their claims adjudicated. Another reason is that veil piercing potentially overlaps with other legal doctrines, particularly the law of torts. As tort law is principally engaged with the issue of when civil wrongdoing arises, it will often provide a superior framework for determining whether shareholders or management should be directly responsible for alleged wrongdoing to a creditor.
The full article is available here.
The Roundtable will be off for two weeks. We’ll be back early after the New Year.