By Alan F. Denenberg, Joseph A. Hall, Michael Kaplan, Jeffrey M. Oakes, Richard D. Truesdell, Jr., and Sarah Ashfaq of Davis Polk & Wardwell LLP
Companies have long relied upon out-of-court restructurings to keep them afloat during times of financial distress. In Marblegate Asset Management v. Education Management Corp. (S.D.N.Y. 2014), the Southern District of New York found that a proposed out-of-court restructuring, objected to byminority creditors, likely violated provisions of the Trust Indenture Act of 1939 (TIA), a Depression-era federal statute intended to protect rights to payment under a TIA-qualified indenture, which governs debt securities offered in any U.S. public offering. Unlike earlier TIA cases, a critical element of the proposed restructuring in Marblegate was explicitly permitted by the governing indenture, and no consent of the objecting creditors was required by the indenture. Nonetheless, the Court read the TIA to give creditors a substantive right to protection against out-of-court restructurings that they did not consent to on an individual basis, although it ultimately did not grant the plaintiffs’ motion for a preliminary injunction. But the potential for a minority creditor to obstruct a company’s ability to restructure, especially in light of indenture provisions the creditor knowingly accepted at the time it purchased its securities, could have serious consequences. While the debtor company’s actions in Marblegate were certainly aggressive, the Court’s view, if adopted by other courts, could have the potential to create an overriding ability for any creditor to block a restructuring — even when permitted by the indenture — directly leading to more court-administered bankruptcies. If followed to that conclusion, the opinion would be a potentially material and unwelcome change to the legal landscape.
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By Lynn M. LoPucki and Joseph W. Doherty, UCLA School of Law
Of the large, public companies that seek to remain in business through bankruptcy reorganization, only 70% succeed. The assets of the other 30% are absorbed into other businesses. Survival is important both because it is efficient and because it preserves jobs, communities, supplier and customer relationships, and tax revenues. This Article reports the findings of the first comprehensive study of who survives. Eleven conditions best predict survival. All are concurrently statistically significant in our best regression model. 1. A company that even hints in the press release announcing its bankruptcy that it intends to sell its business is much more likely to fail. 2. Companies whose cases are assigned to more experienced judges are more likely to survive. 3. Companies headquartered in isolated geographical areas are more likely to fail. 4. Companies that file with higher leverage are more likely to survive. 5. If a creditor’s committee is routinely appointed, the company is more likely to fail. 6. Companies with DIP loans are more likely to survive. 7. Companies that prepackage or prenegotiate their plans are more likely to survive. 8. Companies are more likely to survive if pre-filing interest rates are low. 9. Larger companies are more likely to succeed if they are larger. 10. Manufacturers are more likely to survive. 11. Companies with positive pre-filing operating income are more likely to survive. System participants can improve survival rates by shifting cases to more experienced judges and perhaps also by greater attention to the decisions to appoint committees, prenegotiate plans, obtain DIP loans, and publicly seek alliances. The article is forthcoming in the UCLA Law Review, May, 2015. Click here to read further.
By Donald S. Bernstein, Davis Polk & Wardwell LLP
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.
By Eric G. Pearson, Foley & Lardner LLP
It’s an ancient principle of equity, drawn from Roman law: Equity relieves the vigilant, not those who sleep upon their rights. And it sums up quite well the Seventh Circuit’s recent decision in SEC v. First Choice Management Services, Nos. 14-1270 & 14-2284 (Sept. 11, 2014). First Choice did not involve equity (or even cite the maxim); it concerned an untimely motion to intervene. But the principle was the same, and it’s a good lesson for potential intervenors.
The court, in an opinion written by Judge Posner, affirmed the district court’s denial of a motion to intervene as untimely in a receivership proceeding. The intervenor knew that the receiver proposed to sell the property to which the intervenor had an adverse claim six months before seeking to intervene and had even been involved for over a decade in what the court described as “protracted negotiations” with the receiver to reclaim the property. But the intervenor never was a litigant and, the court held, “had no possible excuse for waiting for six months after [learning of the receiver’s adverse claim] before moving to intervene.” Instead, it had “wait[ed] till the last minute to try to throw a monkey wrench into the deal.”
The Seventh Circuit was unwilling to brook that sort of “dawdling,” which created only more work for the receiver, purchaser, and district court. It affirmed the denial of the motion and dismissed an independent appeal challenging the sale order. Please see a full copy of this article here.
By Efraim Benmelech, Nittai Bergman, Anna Milanez, & Vladimir Mukharlyamov
In “The Agglomeration of Bankruptcy,” Professor Benmelech and his coauthors examine the spread of bankruptcy by analyzing the ways in which bankrupt firms impose costs on nearby non-bankrupt competitors. The authors argue that the normally positive economies of agglomeration created by stores in close proximity to one another can become detrimental during downturns. When a store is in distress, proximity works to amplify the negative effects of distress. The result is that retail stores in distress impose costs, such as decreasing sales, on nearby peers, which can ultimately lead to store closures and ultimately bankruptcy.
The authors use a novel and detailed dataset of all national chain store locations and closures across the United States from 2005 to 2010. The authors show that stores located in proximity to those of national chains that are liquidated are more likely to close themselves. Importantly, this effect is stronger for stores in the same industry as the liquidating national chain as compared to stores in industries different from that of the liquidating chain. Further, the geographical effect of store closures on neighboring stores is more pronounced in financially weaker firms.
For the full article, navigate here.
This summary was drafted by Robert Niles (J.D./M.B.A. ’16)
The HLS Bankruptcy Roundtable will be off-line for the holidays. We will be back in January.
On December 1, 2014, the House of Representatives passed, with bipartisan support, H.R. 5421—the Financial Institution Bankruptcy Act of 2014 (FIBA), a bill that would amend the Bankruptcy Code to better allow for the resolution of systemically important financial institutions (SIFIs). FIBA (previously discussed in Roundtable posts here and here) is similar in many respects to the bankruptcy amendments proposed in another bill introduced in the Senate (previously covered here) and to the “chapter 14” proposal from the Hoover Institution, but there are some key differences among these proposals.
First of all, the Senate version would entirely repeal the Orderly Liquidation Authority (OLA), the current regulatory receivership alternative to traditional bankruptcy (and to some, the only current viable option) to resolve failed SIFIs. Both FIBA and the Hoover Institution’s version, however, would keep the OLA in place as an alternative.
Additionally, each proposal takes a different approach to the issue of federal funding in a SIFI resolution, which is provided in an OLA resolution. The Hoover Institution’s version does not explicitly provide for such federal funding, but it does contemplate it and condition it upon a showing that no private funding is available. FIBA is silent on the matter, and the Senate version explicitly prohibits it.
Lastly, both FIBA and the Senate proposal solely focus on facilitating a single-point-of-entry (SPOE) resolution of a SIFI, whereas the Hoover Institution’s proposal seeks to accommodate both an SPOE recapitalization and a conventional reorganization of a SIFI. An SPOE recapitalization would make debt and equity at the financial holding company take the brunt of losses, while substantially all of the holding company’s assets would be transferred to a new bridge institution and cash would be pushed down into shaky subsidiaries to prevent their bankruptcy. A conventional reorganization (or liquidation) of a SIFI would largely track traditional bankruptcy approaches, with the troubled subsidiaries entering bankruptcy.
These and other differences among the proposals are some of the most debated aspects in the SIFI resolution reform discussion. Moreover, which version (if any) ultimately passes through both houses of Congress and is signed by President Obama may set significant precedent in resolution regimes worldwide.
This post was composed by Stephanie Massman (J.D. ’15)
By Brad Eric Scheler, Steven Epstein, Robert C. Schwenkel, and Gail Weinsten of Fried, Frank, Harris, Shriver & Jacobson LLP
In the recent Delaware Chancery Court decision of Quadrant Structured Products Company, Ltd. v. Vertin (October 1, 2014), the Court clarified its approach to breach of fiduciary duty derivative actions brought by creditors against the directors of an insolvent corporation. Importantly, the Court applied business judgment rule deference to the non-independent directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy—even though the creditors bore the full risk of the strategy’s failing, while the corporation’s sole stockholder would benefit if the strategy succeeded. By contrast, the court viewed the directors’ decisions not to exercise their right to defer interest on the notes held by the controller and to pay above-market fees to an affiliate of the controller as having been “transfers of value” from the insolvent corporation to the controller, which were subject to entire fairness review.
This decision appears to stand for the proposition that, under all but the most egregious circumstances, the business judgment rule will apply to directors’ decisions that relate to efforts to maximize the value of an insolvent corporation. Thus, even decisions made by a non-independent board for a high-risk business plan that favors the sole equity holder over the creditors, as in Quadrant, will be subject to business judgment deference. The court also distinguished decisions involving direct transfers of value from the insolvent corporation to the controller, holding that these decisions would be subject to entire fairness review because the controller stood on both sides of such transactions.
See here for a more detailed discussion of this case.
By Richard M. Hynes and Steven D. Walt, University of Virginia School of Law
Some bankrupt municipalities have proposed plans of reorganization that offer substantially greater recoveries to their active workers and retirees than those offered to other creditors. Because these greater recoveries are not mandated by a priority enjoyed by the active workers and retirees, a judge can only approve such a plan if it does not “discriminate unfairly” against a class of disfavored creditors that votes against the plan. This Article describes the law defining the unfair discrimination standard, identifies the categories of circumstances in which discrimination between co-equal classes is permitted, and argues that the claims of retirees and active workers do not fall into any of these categories. The Article concludes that current law does not allow a judge to approve a reorganization plan that provides retirees and active workers with a greater recovery.
The full version of the article can be found here.
By Michael L. Cook, Schulte Roth & Zabel LLP
The Bankruptcy Code encourages lenders to make debtor-in-possession (“DIP”) loans to Chapter 11 debtors. Because of Bankruptcy Code § 364(e), an appeal from a financing order will ordinarily be moot when the lender acted “in good faith” unless the appellant obtains a stay pending appeal. It is hence noteworthy when appellate courts overturn DIP financing orders that were not stayed pending the appeal.
The Fifth Circuit, on September 3, 2014, vacated five bankruptcy court and district court DIP financing orders due to (1) the lender’s lack of good faith in relying on a third party’s shares of stock as collateral; and (2) the bankruptcy court’s lack of subject matter jurisdiction to authorize a lien on third party collateral subject to disputed ownership claims. In re TMT Procurement Corp., 2014 WL 4364894 (5th Cir. Sept. 3, 2014). On October 23, 2014 the Fifth Circuit denied the petition for panel rehearing.
The Fifth Circuit rejected the debtors’ argument that the appeals were moot because of the lower courts’ repeated findings that the lender had made the loan in good faith. TMT provides a new test regarding the Code’s “good faith” requirement for lenders, based on the lender’s knowledge of possible insider manipulation of the bankruptcy process. The court also found a lack of subject matter jurisdiction because the debtors’ insiders used the bankruptcy financing process to “interfere with” unrelated state court litigation against the debtors’ controlling shareholder.
The full version of the article was recently published in The Bankruptcy Strategist. It is available online here.
Last week, the Wall Street Journal’s Bankruptcy Beat posted several pieces on the causes and consequences of so-called “Chapter 22” repeat bankruptcy filings. In the first three posts of the series, bankruptcy experts offered a range of views on the topic.
In the first post, Harvey Miller, of Weil, Gotshal & Manges, said that increased recidivism in Chapter 11 filings was largely due to distressed debt and securities investors, who effectively gain control of the debtor and its plan formulation process and do all that is necessary to expedite the plan confirmation. Because nobody in this coordinated effort will challenge the plan’s feasibility and because the judge is not well placed to independently investigate, feasibility issues may go unaddressed.
Marshall Huebner, of Davis Polk & Wardwell LLP, in the second post, noted other factors that could trigger subsequent Chapter 11 filings, including a company’s underestimation of the broader industry’s decline, creditor pressure on the debtor to remain overleveraged, and a debtor’s inability to shed legacy liabilities.
In the third post, Mark Roe, professor at Harvard Law School reasoned that, regardless of the cause, recidivism is both not that common—less than 20% of Chapter 11 debtors—and not that bad of a trade-off if it stems from getting companies through the bankruptcy process quickly, as long as most of them recover and grow. Enforcing a strict zero-tolerance feasibility standard could do more damage to debtors by keeping them in bankruptcy longer.
Visit the Bankruptcy Beat website to see the rest of the experts’ views on Chapter 22 filings.
Visit the HLS Bankruptcy Roundtable’s prior coverage of Ed Altman’s study of the frequency and nature of Chapter 22 filings, posted in June, here.
This summary was drafted by Stephanie Massman (J.D. 2015)