Post by Frederick Tung, Professor at Boston University School of Law
In “Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, Mark Roe and I question the stability of bankruptcy’s priority structure and suggest a new conceptualization of bankruptcy reorganization that challenges the long-standing creditors’ bargain view. Bankruptcy scholarship has long conceptualized bankruptcy’s reallocation of value as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of statutory and agreed-to contractual priorities.
In “Breaking Priority,” we propose an alternative view. No hypothetical bargain is ever fully fixed because creditors continually attempt to alter the priority rules, pursuing categorical rule changes to jump ahead of competing creditors. These moves are often successful, so creditors must continually adjust to other creditors’ successful jumps. Because priority is always up for grabs, bankruptcy should be reconceptualized as an ongoing rent-seeking contest, fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps.
We highlight a number of recent and historical priority jumps. We explain how priority jumping interacts with finance theory and how it should lead us to view bankruptcy as a dynamic process. Breaking priority, reestablishing it, and adapting to new priorities is part of the normal science of Chapter 11 reorganization, where bankruptcy lawyers and judges expend a large part of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.
The paper is available here.
By Rick Antonoff, Mark Pesso, Timothy Bennett and Leah Edelboim, Clifford Chance US LLP
Recent decisions on claims trading in bankruptcy cases further develop the Second Circuit’s seminal ruling in Dish Network Corp. v. DBSD North America, Inc. that if the primary motive for a secondary market purchase of bankruptcy claims is control of the Chapter 11 process, cause may exist to “designate,” or not count, the votes cast by the purchasers in connection with a Chapter 11 plan. Read together, these decisions demonstrate the willingness of courts to scrutinize secondary market claim transactions when determining disputes over classification, treatment and, ultimately, the value claims purchasers realize on account of purchased claims.
In our Client Memorandum we discuss four decisions issued in the last year as additional examples of courts examining claims transfers under a microscope. A Third Circuit Court of Appeals decision affirmed that the purchaser of trade claims is subject to the defenses that a debtor would have against the original creditor. In another case, the bankruptcy court permitted the debtor to treat a claim differently solely because the claim was assigned to a secondary market purchaser. A Ninth Circuit appellate panel ruled that insider status does not travel with a claim that is assigned. And finally, a court sustained a debtor’s objection to an assigned claim because the assignee was unable to produce sufficient evidence of its right to assert the claim.
These cases show that courts increasingly look into relationships between the parties and their respective motives when deciding how purchased claims are treated. The full Client Memorandum is available for download here.
By Victoria Ivashina, Ben Iverson, and David C. Smith
The role that active investors play in Chapter 11 reorganization is hotly debated in bankruptcy circles. In our paper, “The Ownership and Trading of Debt Claims in Chapter 11 Restructurings,” we collect comprehensive data on individual claims for 136 large firms that filed for Chapter 11 protection to empirically test how active investors might influence the bankruptcy process. Our data allows us to observe the identities of over 77,000 claimants and precisely measure both ownership concentration as well as claims trading for these cases.
We find evidence that firms with more concentrated capital structures are more likely to enter bankruptcy with pre-negotiated or pre-packaged bankruptcy plans, suggesting that negotiations are easier when creditors are not dispersed. In addition, even if they do not have a pre-packaged plan, firms with more concentrated ownership tend to exit bankruptcy more quickly and are more likely to emerge from Ch. 11 intact rather than being sold or liquidated piecemeal.
In the second half of the paper, we turn to the question of how claims trading in bankruptcy affects the resolution of the case. We find that trading during bankruptcy tends to concentrate ownership even further, and that the bulk of claims purchasing is done by hedge funds and other active investors. Interestingly, as these active investors enter the capital structure the overall recovery rate for the case tends to decrease, suggesting that perhaps active investors shrink the size of the overall “pie” in their efforts to obtain a larger piece of it.
The full-length article can be found here.
Author: Stephen D. Adams
The House Judiciary Subcommittee on Regulatory Reform, Commercial, and Antitrust Law has held two sets of hearings in recent months on the bankruptcy safe harbors for repos and derivatives from the automatic stay, from preference and fraudulent conveyance law, and from the limitations on ipso facto clauses.
This past Wednesday, March 26, Judge Christopher Sontchi, Seth Grosshandler, Jane Vris, Thomas Jackson, and Michelle Harner testified. Last December, Jeffrey Lacker, Donald Bernstein, and Mark Roe testified.
Judge Sontchi argued that the 546(e)’s exception for all settlement transactions is too broad and also urged Congress to narrow the safe harbors for repos. Seth Grosshandler, of Cleary Gottlieb, reported on the work of the ABI safe harbors advisory committee (which includes both Judge Sontchi and Prof. Roe) and warned that the safe harbors are complex and potentially costly to alter. Jane Vris, representing the National Bankruptcy Conference (NBC), and Thomas Jackson, professor at the University of Rochester, testified on bankruptcy of SIFIs as an alternative to Dodd Frank resolution of bail-out. Michelle Harner, professor at University of Maryland School of Law, testified in her role as the Reporter to the ABI Commission on Bankruptcy Reform about the Commission.
Mark Roe, professor at Harvard Law School, testified that the safe harbors facilitate excessive short-term funding of financial institutions and impede effective resolution of large financial failures, like that of Lehman in 2008. Donald Bernstein, of Davis Polk, a member of the ABI bankruptcy commission, testified about the bankruptcy adjustments needed to adapt bankruptcy law to the FDIC’s Single Point of Entry resolution mechanisms. Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, testified about the importance of bankruptcy reform to reduce the problem of too-big-to-fail and reduce reliance on short-term debt.
For more on the bankruptcy safe harbors for derivatives and repurchase agreements, please see the post by Steven L. Schwarcz and Ori Sharon summarizing their recent paper, The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, and the post by Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, and John Thompson, entitled Lehman Bankruptcy Court Issues Safe Harbor Decision, summarizing a recent Lehman case decision on the safe harbors, both published Tuesday.
Authors: Steven L. Schwarcz and Ori Sharon
Bankruptcy law gives creditors in derivatives transactions a “safe harbor” in the form of special rights and immunities. In The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, available on SSRN here, we argue that this safe harbor grew incrementally from industry lobbying, without a rigorous vetting of its consequences. This type of legislative accretion is path dependent, in that its outcome is shaped by its historical path.
Path-dependent legislation is not necessarily bad; but if it’s not fully vetted, its significance and utility should not be taken for granted. For example, advocates of the safe harbor contend that the collapse of a highly connected derivatives counterparty might systemically disrupt the derivatives market, impacting the broader financial system. But there’s little evidence to support this.
Scholars also seriously question the safe harbor, estimating that the net exposure of the major derivatives dealers to their counterparties is small. They also argue that the safe harbor may not be focused on the right parties because it operates independently of the size of the counterparty and applies to non-financial firms. Thus a bank that makes a secured loan cannot enforce its collateral against a bankrupt borrower, but an ordinary company can enforce its collateral against a bankrupt derivatives counterparty. The safe harbor is also overly broad, tempting parties to try to document ordinary financial transactions as derivatives transactions.
Because the derivatives safe harbor has important consequences for systemic risk, there should be a more fully informed discussion of its merits.
[Editor’s note: Please stay tuned for a special post later this week on hearings on bankruptcy reform, financial institution insolvency, and derivatives in front of the U.S. House of Representatives Subcommittee on Regulatory Reform, Commercial, and Antitrust Law.]
Authors: Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, John Thompson
On December 19, 2013, Judge James M. Peck of the United States Bankruptcy Court for the Southern District of New York issued his latest decision in the Lehman Brothers cases addressing the scope of the safe harbor provisions of the Bankruptcy Code. Michigan State Housing Development Authority v. Lehman Brothers Derivatives Products Inc. and Lehman Brothers Holdings Inc. (In re Lehman Brothers Holdings Inc.). Judge Peck’s decision confirms that the contractual provisions specifying the method of calculating the settlement amount under a swap agreement are protected by the Bankruptcy Code’s safe harbors. The decision follows the reasoning of the amicus brief filed by the International Swaps and Derivatives Association (“ISDA”), which was prepared by Cadwalader. For a full discussion of the case and argument, please continue reading here.
Authors: Marshall S. Huebner and Hilary A.E. Dengel, Davis Polk
Being deemed an “insider” has important ramifications for creditors in bankruptcy and can materially impact a creditor’s risk and recovery profile in any case.
In Capmark Financial Group Inc. v. Goldman Sachs Credit Partners L.P. (Capmark), the U.S. District Court for the Southern District of New York made several positive rulings on key insider status issues favorable to market participants who regularly find themselves, sometimes through affiliated entities, playing multiple roles with respect to a borrower counterparty. Embracing the arguments advanced by the Goldman Sachs lending entities, the court rejected Capmark’s attempts to cast the lenders as “insiders” of Capmark based on an indirect equity interest in Capmark held by funds managed by certain of their affiliates – holding that Capmark failed to allege facts that would show the “extraordinary circumstances” required for veil piercing and stating that participation in an arm’s length transaction as an ordinary commercial lender will not give rise to non-statutory insider status.
The Capmark decision provides comfort and greater certainty to market participants that, absent falling into one of the expressly enumerated categories of insiders under the Bankruptcy Code, insider status should not attach to creditors who neither control a company nor deal with it at less than arm’s length. The case is further discussed here in Capmark: Clarifying Insider Status for Market Participants (ABI Journal, January 2014).
Author: the Hon. Christopher S. Sontchi
There are a variety of methodologies to determine the value of assets that are routinely presented to bankruptcy courts: (i) asset-based valuation, (ii) discounted cash flow or “DCF” valuation, and (iii) relative valuation approaches, which include the “comparable company analysis” and the “comparable transaction analysis.”
This article explains in layman’s terms each of the methodologies and how they are used to reach a conclusion as to value. An asset based valuation generally calculates the liquidation value of individual assets and aggregates them to arrive at a firm value. DCF valuation calculates the value of any asset from the present value of expected future cash flows from it, which, in turn, rests on the proposition that a dollar today is worth more than a dollar tomorrow. Relative valuation involves the pricing of comparable assets, standardized using a common variable such as earnings, cash flows, book value, or revenues. The conclusion rests on the selection of the valuation metric, e.g., EBITDA, and the similarity of the companies or transactions used. The conclusions from each of the methodologies are generally blended to arrive at a conclusion of value.
The article closes by noting that bankruptcy judges have become familiar and comfortable with the DCF, comparable companies and comparable transactions methodologies, which are often referred to as the “standard” methodologies. Departures from the standard methodologies or how they are calculated must be explained to the judge.
This article was published in the American Bankruptcy Institute Law Review (20 Am. Bankr. Inst. L. Rev. 1 (2012)) and is available online here.
Authors: Douglas G. Baird and Anthony J. Casey
In RadLAX Gateway Hotel, LLC v Amalgamated Bank, the Supreme Court’s statutory interpretation focuses on an emerging theme of its bankruptcy jurisprudence: the proper domain of the bankruptcy judge. While one might expect the Court to approach that question of domain as it has for administrative agencies, that is not the approach taken. This article explores the Court’s approach to bankruptcy’s domain. In doing so, we connect three principal strands of the Court’s bankruptcy jurisprudence. The first strand, embodied in Butner v United States, centers on the idea that the bankruptcy forum must vindicate nonbankruptcy rights. The second, most recently addressed in Stern v Marshall, focuses on the limits of bankruptcy judges in deciding and issuing final judgment on the issues before them. Bankruptcy judges must limit themselves to deciding issues central to the administration of the bankruptcy process. RadLAX is the continuation of a third strand that makes it plain that the Court reads ambiguous provisions of the Bankruptcy Code to narrow the range of decisions over which the bankruptcy judge may exercise her discretion — at least when the exercise of that discretion might impact nonbankruptcy rights. The resulting bankruptcy jurisprudence is in stark contrast with the Court’s approach in administrative law. This paper attempts to make sense of this state of affairs and connect it with the realities of bankruptcy practice today.
The article is available here on SSRN.
Authors: Thomas Jackson & David Skeel
A striking feature of the recent economic crisis was the long period of subpar economic growth that continued even after the crisis had officially ended. Although discussion about how to spur economic recovery has focused on the efficacy of Keynesian stimulus spending, this is only one of many factors that might plausibly encourage growth. For a book entitled “Financial Restructuring to Sustain Recovery,” published by the Brookings Institution, we were asked to discuss the role that bankruptcy policy plays, or might play, in economic recovery.
After summarizing how bankruptcy posits a collective solution to a common pool problem of individual creditors and thereby improves the efficient use of assets, we consider two obstacles to its effectiveness. The first is that bankruptcy proceedings often seem to begin too late. The increased influence of debtors’ principal lenders probably counteracts this problem in part, but we suspect not fully. We consider a wide range of strategies that lawmakers might use to encourage timely filing, some of which are fairly simple, while others are more speculative.
The second major issue is the relationship between bankruptcy and jobs. The question whether bankruptcy should be used to protect jobs is a recurring theme that came to the fore most recently when the government used bankruptcy to bail out Chrysler, justifying its intervention as preserving jobs. We caution that distorting the standard bankruptcy rules—focused on efficient use of assets—to save jobs in the short run may have more problematic effects overall.
The full-length article can be found here.