By Aurelio Gurrea-Martínez (Singapore Management University)
Corporate insolvency law can serve as a powerful mechanism to promote economic growth. Ex ante, a well-functioning insolvency framework can facilitate entrepreneurship, innovation and access to finance. Ex post, corporate insolvency law can perform several functions, including the reorganization of viable companies in financial distress, the liquidation of non-viable businesses in a fair and efficient manner, and the maximization of the returns to creditors. Therefore, if having an efficient corporate insolvency framework is essential for any country, it becomes even more important for emerging economies due to their potential for growth and their greater financial needs.
Unfortunately, the academic literature has generally paid more attention to the regulation of corporate insolvency in developed countries. Thus, it has largely omitted the debate about the optimal design of insolvency law in jurisdictions that, in addition to requiring a more active policy debate, amount to 85% of the world’s population and 59% of the global GDP, since they include some of the world’s largest economies such as China, India, Brazil, Russia and Indonesia.
In my new article, ‘Insolvency Law in Emerging Markets’, I seek to fill this gap in the academic literature by analyzing the problems and features of insolvency law in emerging economies and suggesting a new framework for financially distressed companies in these countries. My paper argues that, even though, in an ideal scenario, any improvement of the insolvency framework in these countries should start by enhancing the judicial system and the sophistication of the insolvency profession, these reforms usually take time, resources and political will. In fact, due to a variety of factors, including corruption, lack of awareness about the importance of the insolvency system for the real economy, or lack of political incentives to engage in such complex reforms whose benefits will only be shown in the long run, they might never occur. For this reason, my paper suggests an insolvency framework for emerging economies taking into account the current market and institutional features of these countries. If these conditions change over time, or they do not exist in some particular emerging economies, my proposal would need to be adjusted accordingly.
My proposed corporate insolvency framework for emerging markets is based on three fundamental pillars. First, pre-insolvency proceedings and out-of-court restructuring should be promoted as a way to avoid an insolvency system that is usually value-destroying for both debtors and creditors. Second, insolvency proceedings should be reformed to respond more effectively to the problems and features existing in emerging markets, which generally include the prevalence of small companies and large controlled firms, as well as the existence of inefficient courts and unsophisticated insolvency practitioners. Finally, emerging economies should adopt a more contractual approach to deal with a situation of cross-border insolvency. Thus, by facilitating the choice of insolvency forum, debtors, creditors and society as a whole will be able to enjoy the benefits associated with having access to more sophisticated insolvency frameworks. Besides, since many debtors and creditors would be using foreign insolvency proceedings, this value-creating forum shopping may incentivize many Governments in emerging economies to invest the resources needed to improve the market and institutional environment existing in these countries, hopefully making the insolvency framework suggested in this article no longer needed.
The full article is available here.
For previous Roundtable posts on insolvency reforms in China and India, see Xiahong Chen, INSOL Europe/LexisNexis coronavirus (COVID-19) Tracker of Insolvency Reforms—China; Xiao Ma, China Continues to Issue New Rules Promoting Corporate Rescue Culture, Facilitation of Bankruptcy Proceedings; and Himani Singh, Pre-packaged Insolvency in India: Lessons from USA and UK.
By Paul M. Green and Mark G. Douglas (Jones Day)
Valuation is a critical and indispensable part of the bankruptcy process. How collateral and other estate assets (and even creditor claims) are valued will determine a wide range of issues, from a secured creditor’s right to adequate protection, postpetition interest, or relief from the automatic stay to a proposed chapter 11 plan’s satisfaction of the “best interests” test or whether a “cram-down” plan can be confirmed despite the objections of dissenting creditors. Depending on the context, bankruptcy courts rely on a wide variety of standards to value estate assets, including retail, wholesale, liquidation, forced sale, going-concern, or reorganization value. Certain assets, however, may be especially difficult to value because valuation depends on factors that may be difficult to quantify, such as the likelihood of success in litigating estate causes of action.
The U.S. Court of Appeals for the First Circuit recently addressed this issue in In re Montreal, Maine & Atlantic Railway, Ltd., 956 F.3d 1 (1st Cir. 2020) (“MMA Railway”). The First Circuit affirmed a ruling that a secured creditor failed to satisfy its burden of establishing that collateral in the form of indemnification claims settled by the estate had any value entitled to adequate protection. According to the court, with respect to a disputed claim, a showing of possible damages is not enough. Instead, the creditor must establish the likely validity of the claim and the likelihood of recovery.
MMA Railway is a cautionary tale for secured creditors. Creditors bear the ultimate burden of proof in establishing the value of their collateral under section 506(a) of the Bankruptcy Code—a determination that has important consequences in many contexts in a bankruptcy case. The First Circuit’s ruling highlights the importance of building a strong evidentiary record to support valuation. It also indicates that certain types of collateral (e.g., disputed litigation claims) are more difficult to value than others.
The full article is available here.
By Michael L. Cook (Schulte Roth & Zabel)
Federal courts regularly resolve consolidated corporate tax refund disputes in bankruptcy cases. In the current economic downturn, the ownership of a large tax refund paid to an affiliated group of corporate debtors can be significant. See, e.g., FDIC v. AmFin Corp., 757 F.3d 530, 532 (6th Cir. 2014) ($170 million refund). If a corporate debtor’s parent owns the refund, it is part of the parent’s bankruptcy estate, and the subsidiary may be an unsecured creditor for any claimed benefits. But if the debtor parent is an agent or trustee for its affiliates, the parent cannot use the refund to repay its creditors.
Corporate parents and their subsidiaries often file a consolidated tax return. That enables affiliates to offset their losses against each other so as to reduce the group’s overall tax liability. Because only the corporate parent may file a consolidated return, any refund is also paid to the parent, not to individual affiliates. Affiliated groups, therefore, usually enter into tax sharing or allocation agreements. These agreements – or their absence – have generated a spate of litigation.
The Circuit Courts of Appeals had been sharply split on how to resolve tax refund ownership issues until the U.S. Supreme Court resolved the issue this past February in Rodriguez v. FDIC (In re Western Bancorp, Inc.), 589 U.S. ___, 140 S. Ct. 713 (Feb. 25, 2020). Without deciding the merits, the Court remanded the case to the Tenth Circuit, directing it to apply state law to resolve the refund ownership dispute between the parent’s bankruptcy trustee and a subsidiary. The Supreme Court also rejected a purported federal default rule promulgated by the Ninth Circuit in 1973 that had been adopted by a few other Circuits, describing it as inappropriate federal “common lawmaking.” On May 26, 2020, following the Supreme Court’s remand, the Tenth Circuit, applied Colorado law, construed the relevant group tax sharing agreement, and held for the subsidiary bank, now in the hands of a FDIC receiver.
This article describes relevant issues litigated over the past fifty years. It also notes open issues that will continue to be litigated following the Rodriguez decision.
The full article is available here.
By Steven T. Kargman (Kargman Associates/International Restructuring Advisors)
As part of the overall global economic slowdown in the wake of the COVID-19 pandemic, many emerging market economies around the globe have suffered sharp economic downturns, particularly in light of the lockdowns of economies that were imposed in many of these countries. With the economic fallout from the COVID-19 pandemic in emerging economies, a number of these economies have been faced with a veritable perfect storm.
Specifically, many of these economies have been adversely affected by, among other things, a sharp drop in prices for commodities such as oil and various metals, the drying up of foreign tourism revenues in view of the disruption of international air travel and the closing of national borders, and the major decrease in remittances due to layoffs of overseas foreign workers. In addition, many major emerging market currencies have experienced significant depreciation vis-à-vis hard currencies such as the US dollar.
Moreover, emerging economies as a whole have also faced what economists term a “sudden stop”—i.e., a sudden outflow of foreign investment capital that had previously been flowing into these economies. Furthermore, the public finances of governments in the emerging markets have become strained as such governments have been forced to make expenditures on economic recovery programs as well as public health responses to the pandemic.
The article discusses the implications of the global economic slowdown associated with COVID-19 for restructuring activity in the emerging markets around the globe. In particular, the article examines how the economic slowdown may give rise to several different types of emerging market restructurings, namely, sovereign debt restructurings, corporate debt restructurings, and infrastructure project restructurings. It also examines how the economic slowdown in the emerging markets might affect restructuring-related matters involving state-owned enterprises (SOEs) and non-performing loans (NPLs) in national banking systems.
The article also considers special issues associated with China’s newly prominent role as the largest official creditor to the emerging markets and developing countries and China’s sponsorship of Belt and Road Initiative (BRI) projects around the world. Further, the article discusses other legal and policy issues that have become more salient in recent years in the context of emerging market restructurings, such as the role of holdouts in sovereign debt restructurings as well as the relevance in corporate debt restructurings in these jurisdictions of any potential gap that may exist between insolvency/restructuring law and practice.
The full article can be found here.
By Kenneth Ayotte (University of California Berkeley School of Law) and Jared A. Ellias (University of California Hastings College of the Law)
The lenders that fund Chapter 11 reorganizations exert significant influence over the bankruptcy process through the contract associated with the debtor-in-possession (“DIP”) loan. In this Article, we study a large sample of DIP loan contracts and document a trend: over the past three decades, DIP lenders have steadily increased their contractual control of Chapter 11. In fact, today’s DIP loan agreements routinely go so far as to dictate the very outcome of the restructuring process. When managers sell control over the bankruptcy case to a subset of the creditors in exchange for compensation, we call this transaction a “bankruptcy process sale.” We model two situations where process sales raise bankruptcy policy concerns: (1) when a senior creditor leverages the debtor’s need for financing to lock in a preferred outcome at the outset of the case (“plan protection”); and (2) when a senior creditor steers the case to protect its claim against litigation (“entitlement protection”). We show that both scenarios can lead to bankruptcy outcomes that fail to maximize the value of the firm for creditors as a whole. We study a new dataset that uses the text of 1.5 million court documents to identify creditor conflict over process sales, and our analysis offers evidence consistent with the predictions of the model.
The full article is available here.
By Tomas Richter (Clifford Chance) and Adrian Thery (Garrigues)
Under EU Directive 2019/1023 promulgated in June 2019, the 27 Member States of the European Union must enact rules supporting preventive restructurings of businesses threatened by insolvency. The restructuring frameworks to be enacted are in a large part modelled after the U.S. Chapter 11 yet they are not carbon copies of it. Also, the 27 Member States have widely differing insolvency laws against whose background the preventive restructuring frameworks must operate, and significantly diverging institutions by which they will have to be applied. The implementation tasks will be both varied and formidable.
However, certain threshold questions are very similar across jurisdictions when it comes to particular topics relevant to corporate restructurings. In the context of agreeing to and adopting a restructuring plan, some of the key questions arise in relation to classification of investors’ claims and interests, grouping these claims and interests into classes, voting in the classes, and obtaining an official approval of the restructuring plan after investors have expressed their opinions on it via the voting mechanism.
The purpose of this first guidance note, published by INSOL Europe, is to flag some of the key issues that national legislators will want to consider in this particular context when implementing the restructuring frameworks prescribed by Title II of the Directive, and, at least at times, also to respectfully suggest which approaches, in the authors’ humble opinions, might perhaps be explored more productively than others.
The full article is available here.
By Axel Krohn (Martin-Luther-University Halle-Wittenberg, Germany)
The European Directive on restructuring and insolvency (“Directive”), which came into force in July 2019, has triggered a series of interesting debates. The possibility for EU Member States to subject the cram-down from Article 11 to a “relative priority rule” (“EU RPR”) when implementing the Directive into national law has proven to be particularly controversial.
Despite a confusing conceptual overlap with approaches presented in the U.S., the European interpretation of “relative priority” breaks new ground. The rule stipulates that, under a restructuring plan, dissenting voting classes have to be treated merely more favorably than any junior class. Although the Directive allows national lawmakers to refrain from the EU RPR and introduce a familiar “absolute priority rule” (“APR”)—that is, that a dissenting class of creditors must be paid in full before junior parties may receive any distributions—the EU RPR has already found supporters in various jurisdictions and should therefore be thoroughly examined.
This article identifies one aspect of the cram-down that has received little attention to date. In addition to the EU RPR, the European legislature has introduced a new “best interest of creditors” test (“EU BIT”), which does not—as in 11 U.S.C. § 1129(a)(7)(ii)—use the value that a party could expect in a hypothetical liquidation as a comparator, but refers to the “next-best-alternative scenario.” Although the concept of combining the EU RPR and the EU BIT is coherent in theory and may even eliminate some misconceptions about the EU RPR, the interaction of the two cram-down elements is likely to raise problems in practice.
First, this article discusses the concepts of the two priority rules and traces the motives of the European legislature for introducing the EU RPR.
Three aspects in particular appear to have motivated the legislature in drawing up the rule. For one, the legislature wished to create more flexibility in plan negotiations and thus respond in particular to special needs in the restructuring of smaller businesses. The rule may bring advantages, especially when it is reasonable to enable existing shareholders to participate in the continued business by means of an equity interest. Second, with regard to some Member States, the desire has arisen to create an instrument to overcome structural blocking positions of certain preferential (priority) creditors, in particular tax authorities. Finally, there is a trend in Europe which sees in the Directive a procedure that enables a structured contractual renegotiation of debts and detaches itself from the “traditional laws of insolvency law,” including the APR.
This article then deals with the new EU BIT and examines its interaction with the EU RPR.
It is worth noting that the EU BIT plays a much more important role in an EU RPR cram-down than under an APR. By moving away from the traditional liquidation benchmark and instead linking to the “next-best-alternative scenario,” the test protects precisely the value that can be achieved from the perspective of a creditor outside insolvency without cooperating with other parties. The then remaining reorganization surplus, which is subject to the EU RPR, is that fraction of the going concern surplus which can only be achieved through the combined efforts of all parties involved, but which creditors cannot claim in an individual case of enforcement.
Despite this harmonious interaction in theory, doubts may be expressed as to whether the combination of the EU RPR and the EU BIT would work in practice. The new focus on the hypothetical next-best-alternative scenario value will likely lead to an additional stress point in plan negotiations. The EU RPR, which does not itself contain a clear guideline for the distribution of the remaining surplus, is then to be applied between two unclear values, namely the hypothetical next-best-alternative value and the presumed reorganization value. It is reasonable to assume that the resulting distributional uncertainty will cause new hold-up potential and render it difficult to realize consensual plans, especially in larger restructuring cases. Also, it seems likely that unsophisticated junior creditors will face difficulties in defending their rights adequately in view of the potentially unclear next-best-alternative scenario value, and that others will try to use this to their advantage in complex negotiations.
The full article is available here.
By Jared A. Ellias (University of California Hastings College of the Law)
When commentators describe American bankruptcy law as “the model to which European restructuring laws should aspire,” they are really speaking about an ‘American bankruptcy ecosystem’ of which law is only a significant part. The American bankruptcy ecosystem is best understood as a complex system inhabited by bankruptcy judges, law firms, investment bankers and activist investors. In this Report, I focus on one of the major components of this ecosystem: specialized investors that participate in the ‘bankruptcy claims trade.’ As I discuss, American bankruptcy courts today are best understood not as a place of shame and failure but rather as an integrated part of the capital markets, similar to the private equity firms of New York and the venture capital investors of Palo Alto. As this view of bankruptcy law took hold, investors, typically hedge funds, began to raise a large stock of capital to deploy in it. Importantly, while these investors were born of the bankruptcy bar’s development of institutions that situated bankruptcy courts within the capital markets, they have deployed their capital to accelerate it. This Report chronicles the rise of claims trading and the state of the academic literature on activist investing. In sum, the best interpretation of the available empirical evidence is that claims trading and activist investing have, at the very least, not harmed Chapter 11 or distressed corporations, and may have actually improved the capacity of the American bankruptcy system to reorganize distressed assets.
The Report is available here.
By Clayton Gillette (New York University School of Law)
Courts in municipal bankruptcy cases have confronted the inherent vagueness in the statutory tests for municipal “insolvency” by embracing a test of “service delivery insolvency.” That test is typically evaluated in terms of a significant reduction in the availability of city services. Focus on a municipality’s failure to deliver services certainly serves as a plausible proxy for fiscal health, since provision of services is a primary function of local governments and thus a function that a financially healthy municipality would satisfy. Initially, such a test appears to be viable, since it invites both temporal and interlocal comparison service levels as a measure of fiscal health. Nevertheless, this article indicates severe limitations of a service delivery insolvency test. Reductions in service may indicate efforts to recover fiscal health rather than indicating fiscal distress, because that distress was generated by overspending on services. In addition, focus on particular service reductions as a measure of insolvency creates perverse incentives for local officials who desire to obtain debt relief to diminish those services most susceptible to measurement. When determining eligibility for Chapter 9, two potential measures other than service delivery insolvency may serve as alternative or complementary proxies for the need to adjust municipal debt: population outflows and loss of agglomeration benefits.
Population outflows may serve as an alternative indicator of fiscal distress. A city that fails to provide services at a level commensurate with its tax prices may lose mobile residents, and population declines imply that the per capita debt of the municipality is increasing. But that measure does not necessarily distinguish among emigrants. If those who exit consumed more services than they paid for, then exit will not necessarily betoken fiscal distress.
Local fiscal health is often dependent on the capacity of the locality to obtain the benefits of agglomeration. As a result, and notwithstanding measurement difficulties, one promising proxy for fiscal distress entails identifying whether those who have exited would otherwise have contributed agglomeration benefits to the locality. Agglomeration effects are related to the benefits that individuals or firms receive from being located within a network of other individuals or firms, such as sharing of knowledge and information, reducing spatial mismatches between jobs and places of residence, and neighborhood effects which are necessary for the development of social capital. Agglomeration may affect decision making by prompting residents to remain when they might otherwise emigrate because they would lose network benefits in excess of the gains they would obtain from exit. Demonstrable declines in agglomeration benefits could, more than population declines or rough measures of service delivery insolvency alone, inform judgments about the potential sources of fiscal distress and the likelihood that debt adjustment would be appropriate. If population decline is largely attributable to exit by firms that tend to generate local agglomeration benefits, then continued and declining fiscal distress is more likely to occur without intervention than if population decline results from exit that creates less of a reduction of those benefits.
The full article is available here.
By Vincent S.J. Buccola (University of Pennsylvania – The Wharton School), Jameson K. Mah (Cyrus Capital Partners), Tai Yi Zhang (University of Pennsylvania – The Wharton School)
Bankruptcy scholars have worried about the potential for credit derivatives to frustrate sensible out-of-court reorganizations since such derivatives became widespread in the 2000s. The basic problem they saw was that derivative contracting could complicate dealmaking by disguising investors’ true interests vis-à-vis a distressed company. Most perniciously, derivatives could lead creditors to oppose value-maximizing restructuring plans that offer fair treatment—not just for the familiar purpose of furthering a holdout strategy, but with the very aim of opposing the general welfare. In particular, a creditor with a large derivative position betting against its debtor could actively use its rights as creditor to drive the debtor into a messy and value-destroying default.
Many debt-market observers are sure that a recent episode pitting the hedge fund Aurelius against Windstream was a case in point. That episode has only increased attention on the subject, and issuers are experimenting with contractual devices that purport to muffle the influence of net-short activists at the expense, presumably, of secondary-market liquidity.
Our recent article argues that commotion over net-short creditor activism is misplaced—indeed that such activism is implausible. The nub of our skepticism lies in the incentives and capacities of investors other than a hypothetical net-short activist to foil the activist’s plans. The objective of net-short tactics, according to the story’s logic, is to cause a liquidity crisis that will reduce a targeted company’s value and prompt default. This objective implies, however, as a matter of arithmetic, that others can make money supplying offsetting liquidity.
Our article explores some of the channels through which this responsive liquidity is most likely to flow. We conclude that in the ordinary case one should expect parties other than the would-be saboteur to undermine its plans. If we are right, then it is a puzzle why a sophisticated potential activist would think it could succeed. A net-short activist bets not just on debt prices falling, as all short investors do. It bets rather on its own ability to cause the prices to fall. But in placing such a bet, the activist must know it is daring rival investors to profit by punishing it. The whole approach seems misguided. Which brings us to Windstream. Why did Aurelius think it could prevail at sabotage? As the article explains, we don’t believe it did and don’t believe it tried. We can’t say for sure, because lack access to the fund’s books and records. But so do the many other commentators who have opined on the story.
To us, then, one of the most intriguing features net-short activism is its rhetorical appeal. We suggest that the appeal lies in a kind of mythological function—that net-short sabotage has, in particular, the cautionary form of a good urban legend.
The article is available here.