By Niklas Hüther (Indiana University) and Kristoph Kleiner (Indiana University)
”The bankruptcy system is supposed to work for everyone, but in many cases it works only for the powerful.” – House Judiciary Committee Chairman Jerrold Nadler, July 28th, 2021
Researchers have long recognized that judicial outcomes are subject to the biases of the ruling judge. To alleviate concerns of fairness, courts in both the U.S. and abroad claim to assign judges to individual court cases randomly. From a policy perspective, randomization promotes public confidence in the judicial process by limiting forum shopping and the individual influence of any individual judge. From an academic perspective, recent empirical research in economics and finance exploits the random assignment of judges to causally identify of a wide range of legal outcomes.
This paper revisits the claim of randomized judicial assignment in the context of U.S. Bankruptcy Court. Our research is motivated by legal scholarship arguing that debtors in recent cases are influencing judicial assignments (Levitin, 2021), as well as renewed interest in these issues from policy makers and the public (Merle and Bernstein, 2019; Randles 2020). Despite these arguments, there are reasons to believe assignment is random. For instance, after contacting all U.S. Bankruptcy Courts, Iverson et al. (2017) found that only one court (the Eastern District of Wisconsin) reports assigning cases to judges non-randomly. In addition, a range of research including Bernstein et al. (2019) provides convincing evidence that debtor characteristics fail to predict judicial assignments. Missing from this literature is any large-scale empirical evidence of non-random assignment.
Analyzing U.S. corporate bankruptcy filings between 2010 and 2020, we provide new evidence that assignment is not random, but predicted by the lending decisions of hedge funds. By focusing on investments made before the assignment of a bankruptcy judge, our technique is not suspect to standard critiques that predictability is merely an outcome of ex-post data mining; instead, in order for investors to systemically invest in firms that are later assigned a preferred judge, it must be possible to infer future judicial assignments. In addition, we focus on hedge funds, as they routinely influence a wide range of bankruptcy outcomes including emergence and debt restructurings. The prevalence of these investors allows us to explore a new channel of activism in the distress debt market: activist influence in judicial assignment process prior to filing.
In our setting, judges can decide whether to convert a Chapter 11 bankruptcy to a Chapter 7 liquidation; while secured creditors may have a preference for liquidation, unsecured creditors recover more under reorganization. Exploiting this distinction, we confirm unsecured hedge fund creditors (relative to secured hedge funds) are significantly less likely to be assigned a judge with a tendency to convert Chapter 11 cases. We also extend our analysis to an alternate bankruptcy outcome measure: the unsecured creditor recovery rate according to the confirmed plan. We find unsecured hedge funds are far more likely to be assigned a judge with a high past unsecured recovery rate.
We next test whether these estimates differ across the filings in our sample. First, we find that unsecured hedge fund claimants are assigned a preferable judge more commonly when the hedge fund invested shortly before the bankruptcy filing, suggesting hedge funds choose to invest explicitly to influence the filing. Second, we show the effects are greatest when the hedge fund is on the board of directors of the debtor at the time of filing, providing further support for the role of communication between debtor and creditor.
Finally, we conduct three robustness tests. First, we find no evidence that a judge’s future conversion rate (after controlling for the past conversion rate) is predicted by hedge fund investment, suggesting hedge funds are explicitly influencing judicial assignment based on information regarding past information. Second, focusing on the subset of districts that explicitly state random assignment within their district, we continue to find hedge fund investments predict assignment. Third, we include district-office-year fixed effects in our analysis and continue to find a relationship between hedge fund investments and assignment.
Moving forward, we believe there are two potential policies that can alleviate these issues. The first, and simplest, is for policy makers to develop a truly randomized process. Alternatively, policy makers can instead increase the number of bankruptcy judges, leading to lower predictability even if assignment is not fully randomized. Policy makers intent on a fairer judicial system should consider both proposals.
The full article is available here.
This piece previously appeared on the Oxford Business Law Blog.
By Melissa B. Jacoby (Graham Kenan Professor of Law – University of North Carolina School of Law)
After a district court halted OxyContin maker and hawker Purdue Pharma’s exit from bankruptcy by finding its restructuring plan unlawful in late 2021, the yellow brick road of this high-profile case forked in two. One path is traditional: more appellate process. The United States Court of Appeals for the Second Circuit agreed to review Purdue’s restructuring plan on a fast track and oral argument is expected to be scheduled for late April 2022. The second path reflects a popular development in the federal judiciary: the presiding bankruptcy judge appointed another sitting judge as a mediator to oversee negotiations between representatives of the Sackler family and states whose appeal had prevailed in the district court. According to the judicial mediator’s most recent report, the Sackler family has offered more money to resolve the dispute; many, though not all, of the objecting states are on board to settle. Expectations that a deal can be brokered run high.
Purdue Pharma is not the only big restructuring in which a judicial mediator has been tasked with managing a high-stakes matter. As another recent example, six judges from different federal courts served as mediators in the Puerto Rico bankruptcy for almost five years: from June 23, 2017 through January 22, 2022.
The use of sitting judges for this behind-the-scenes work is the topic of my forthcoming article. Why are judges mediating other judges’ cases, particularly when Congress encouraged use of private neutrals for alternative dispute resolution? Are traditional judicial accountability measures effective when judicial mediators work with parties and lawyers in a process that lacks a citable record? Finding that the standard accountability measures are an awkward fit for judicial mediation, the article calls on the Judicial Conference of the United States, the policy-making body for the federal judiciary, to take steps to maximize the benefits and minimize the risks of these practices. Whatever your own experiences have been with bankruptcy-related mediations, I hope you find this project useful.
The full article is available here.
By Francesca Prenestini (Bocconi University, Milan)
Most legal systems follow one of two rules for regulating the capacity of an issuer to renegotiate the terms of the bond loan to avoid insolvency or to accommodate changing capital needs. The first rule requires the individual consent of every bondholder while the second one permits the proposed agreement to be approved upon a majority decision which also binds dissenting bondholders.
This article analyzes the desirability of adopting a regulatory approach that allows a binding vote of bondholders on amendments of the core terms of the loan and other restructuring measures, including the conversion of bonds into shares. In doing so, this article examines the drawbacks of the prohibitive approach, which requires consent from all bondholders, with particular regard to the judicial cases and business practices of two major legal systems (the U.S. and Italy).
In the U.S., the Marblegate and Caesars cases have reignited the debate on out-of-bankruptcy restructurings of bond issues. In 2015, the U.S. District Court for the Southern District of New York reaffirmed that coercive exit consent transactions which force bondholders into questionable restructurings are prohibited by § 316(b) of the Trust Indenture Act of 1939 (“TIA”). Then, in January 2017, the U.S. Court of Appeal for the Second Circuit adopted a narrower interpretation, holding that § 316(b) only prohibits formal non-consensual modifications of an indenture’s core payment terms.
The district court’s interpretation, though broad, is more coherent with the text, the legislative history, and the purpose of the TIA. Section 316(b) provides that the individual right of each bondholder to receive payment of the principal of and interest on their indenture security on the due dates cannot (with a few minor exceptions) be impaired without the bondholder’s consent. This section was enacted to protect bondholders from insider abuses by giving individual bondholders the power to veto proposed amendments in an out-of-court restructuring. However, this individual veto power often precludes even fair renegotiation agreements between the issuer and the bondholders.
Under Italian law, the meeting of bondholders may approve “amendments of the terms of the loan” by majority vote. Nevertheless, in the light of quite restrictive interpretations of such a rule, those modifications may not change the structural characteristics of the bond loan.
This article suggests that governments should adopt rules that allow a majority bondholders’ vote to accept out-of-bankruptcy restructurings of bond issues. Currently two different solutions may be implemented in the U.S. and Italy: in the U.S., until § 316(b) can be reformed, the Securities and Exchange Commission could exercise its power to grant exemptions to authorize transactions and agreements otherwise banned; and in Italy, in the absence of a statutory prohibition, the contract governing the loan could include a provision allowing the meeting of bondholders to vote upon amendments of the core terms of the loan and other restructuring measures, such as the conversion of bonds into shares.
This article first examines the two different approaches to bond loans restructuring in various legal systems and in the context of sovereign debt, and considers why allowing a binding vote of the bondholders in workouts is so important given the rationales for and against this rule. Then it focuses on the U.S. legal system, and discusses the statutory provision that bans the majority rule, how the jurisprudence and business practices have evolved, and recent proposals for reform. The article also considers the Italian system, its rules and business practices, and how to overcome its limits. In the end, this article suggests an alternative rule and proposes interim solutions to the problem while awaiting statutory reform.
The full article is available here.
For previous Roundtable posts on § 316(b) of the TIA and Marblegate, see William W. Bratton, The New Bond Workouts; Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond; Benjamin Liu, Exit Consents in Debt Restructurings; Second Circuit Rules on § 316(b) in Marblegate; Mark Roe, The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table; National Bankruptcy Conference Proposed Amendments to Bankruptcy Code to Facilitate Restructuring of Bond and Credit Agreement Debt; David A. Brittenham, Matthew E. Kaplan, M. Natasha Labovitz, Peter J. Loughran, Jeffrey E. Ross, and My Chi To, 28 Law Firms Publish White Paper Addressing Trust Indenture Act Complications In Debt Restructurings; Carlos Berdejó, Revisiting the Voting Prohibition in Bond Workouts (providing evidence related to argument made in Mark Roe, The Voting Prohibition in Bond Workouts, 97 Yale L.J. 232 (1987)).
By Andreas Kostøl (Arizona State University – W.P. Carey School of Business; Norges Bank), Morten Grindaker (Norwegian Business School; Norges Bank), and Kasper Roszbach (Norges Bank; University of Groningen)
Policymakers have long been concerned about the potential negative effects of bankruptcy for CEOs and business dynamics. Fear of reputational scarring caused by bankruptcy could lead managers to take less risk than desired by owners, which could manifest in lower performance and lower rates of entrepreneurship and job growth.
CEOs influence a wide range of decisions, such as organizational practices, debt financing and whether to file for corporate bankruptcy or not. Empirical studies of Chapter 11 bankruptcy show that CEOs of large bankrupt firms suffer significant financial losses. The prospect of individually-borne income loss due to a corporate bankruptcy carries in it a risk that CEOs take decisions that are not aligned with the interest of the owners.
It remains an open empirical question, however, whether the observed personal costs should be attributed to the selection of CEOs with lower managerial skills, firm-specific human capital, or stigma in the executive labor market.
Our analysis attempts to answer this question by disentangling the stigma and skill effects by examining the causal effects of corporate bankruptcy on the personal income and career of CEOs in small and medium-sized companies in Norway. To this end, we exploit that bankruptcy petitions in Norway are randomly assigned to judges who have different degrees of strictness in their approval of bankruptcy filings. This institutional feature generates variation in firms’ likelihood of being declared bankrupt that is unrelated to firm or CEO characteristics. We use administrative panel data that identifies CEO’s sources of wealth and income and corporate positions to examine the effects of bankruptcy on their careers.
Two broad conclusions emerge from our empirical analysis.
First, we find that corporate bankruptcy has a long-lasting impact on CEOs’ careers. CEOs whose firms are declared bankrupt are 25 percentage points more likely to exit the executive workforce. Displaced CEOs find new employment quickly but do so by moving to lower-ranked positions in new firms. Bankruptcy also has an economically significant impact on CEO remuneration; we document an annual fall in capital income equal to about five percent of annual gross income. While the net present value of the average decline in capital income over the remainder of a CEO’s working-age career is equal to 60 percent of pre-bankruptcy annual income, we find no enduring effect on CEOs’ labor income after five years.
Second, our analysis shows that the displacement effects are much larger when default rates in the firms’ industry are low. For example, a CEOs is five times less likely to remain in the executive workforce if her/his firm experiences a bankruptcy while the bankruptcy frequency in the same industry is low. By contrast, variation in CEO wages is not driven by industry conditions. Post-bankruptcy, we find a greater mobility of CEOs between industries and an increased tendency to move to more productive firms with a higher-paid workforce, suggesting that managerial skills are portable.
Taken together, our findings suggest that negative career effects of bankruptcy can be attributed to stigma. When we eliminate the risk of low-skilled CEOs sorting into bankrupt firms, we find that the executive labor market interprets bankruptcy as a signal of lower managerial talent. This stigma effect is greater during better economic times. More details can be found in the full paper that is available here.
By Ron E. Meisler, Carl T. Tullson, Jennifer Madden, Justin Larsen (Skadden)
A number of recent bankruptcy court rulings have addressed the enforceability of “make-whole” premiums, payments that may be implicated in some loan agreements when debt is prepaid, or in certain cases, otherwise accelerated prior to its stated maturity. Make-whole litigation may turn on subtle distinctions of contractual language and is a zero-sum game where the outcome can be very costly to the borrower and substantially reduce recoveries to other stakeholders. Consequently, when debtors and creditors disagree on whether a make-whole has been triggered, they frequently assert complex and nuanced legal arguments.
In this article, we examine two recent make-whole cases from the Delaware bankruptcy courts: In re Mallinckrodt and In re Hertz. Mallinckrodt addressed whether a debtor’s plan of reorganization could deny payment of a make-whole, reinstate the underlying debt, and treat those claims as unimpaired. In comparison, Hertz considered whether creditors had claims for make-wholes under the specific language of the governing debt documents in the context of a plan that provided for payment of the principal and accrued interest in full, in cash, and therefore deemed those debt claims as unimpaired.
These cases reinforce the importance of carefully drafting make-whole provisions and the important distinction between chapter 11 plan of reorganization treatment, the effect of which could directly impact whether or not such creditors would be entitled to make-whole payments. Moreover, these cases emphasize that the law regarding make-wholes is not settled, and creditors and debtors alike should continue to monitor the evolving case law.
The full article is available here.
By Ronit J. Berkovich (Weil Gotshal & Manges) and Eric Einhorn (Weil Gotshal & Manges)
In a recent decision, In re Highland Cap. Mgmt., L.P.,1 the Bankruptcy Court of the Northern District of Texas held that a debtor’s rejection of an executory contract with an arbitration clause precludes the court from compelling the debtor to arbitrate—notwithstanding the strong federal policy supporting enforcement of arbitration clauses, even in bankruptcy. Although rejection of a contract constitutes a breach and may give rise to a claim for monetary damages, the Court found that specific performance of an arbitration clause was not an appropriate remedy post-rejection. Highland provides an example of how bankruptcy courts may disregard contractual provisions—including an agreement to specifically perform—where they may irreconcilably conflict with the policy of the Bankruptcy Code.
The full article is available here.
By Amelia S. Ricketts (Harvard Law School) and Jin Lee (Harvard Law School)
On February 8, 2022, the Senate Subcommittee on Federal Courts, Oversight, Agency Action, and Federal Rights held a hearing on the process through which corporations allegedly side-step accountability through divisive mergers undertaken immediately prior to bankruptcy, commonly known as the “Texas Two-Step.”
Companies have used the Two-Step when they have incurred significant liabilities in mass tort cases. The company first changes its state of incorporation to Texas or Delaware. It then carries out a divisive merger, splitting into GoodCo and BadCo. GoodCo retains all of the company assets and the non-tort liabilities, while BadCo retains the mass tort liabilities. BadCo then files for bankruptcy, while GoodCo continues business in the ordinary course. BadCo requests that the automatic stay be extended to GoodCo, preventing tort victims from seeking relief from GoodCo.
Typically, as part of the divisive merger, GoodCo and BadCo execute a funding agreement whereby GoodCo agrees to fund any victims’ trust established in bankruptcy, but usually specifying an amount far below the potential liability. One witness argued that these agreements should assuage concerns about divisive merger bankruptcies, while others argued that they did not offer tort victims real recourse.
Certain witnesses objected to using the Texas Two-Step to obtain the benefits of bankruptcy without the burdens and urged legislative reform to prevent divisive merger bankruptcies. Others argued that the current bankruptcy protections, such as bad faith dismissal and fraudulent transfer law, were sufficient to guard against abuse. However, courts are generally reluctant to dismiss a case for bad faith. Moreover, fraudulent transfer law’s usefulness is also uncertain, because the Texas state law treats the divisive merger transaction as though no transfer has occurred. The witnesses also discussed Johnson & Johnson’s use of the Two-Step as an example and test case for existing protections against abuse.
The full post is available here.
For previous Roundtable posts on the Texas Two-Step, see Samir D. Parikh, Mass Exploitation.
By Samir D. Parikh (Lewis & Clark Law School)
Financially distressed companies often seek refuge in federal bankruptcy court to auction valuable assets and pay creditor claims. Mass tort defendants – including Purdue Pharma, Johnson & Johnson, Boy Scouts of America, and USA Gymnastics – introduce new complexities to customary chapter 11 dynamics. Many mass tort defendants engage in criminality that inflicts widescale harm. These debtors fuel public scorn and earn a scarlet letter that can ultimately destroy the value of an otherwise profitable business. Scarlet-lettered companies could file for bankruptcy and quickly sell their assets to fund victims’ settlement trusts. This Article argues, however, that this traditional resolution option would eviscerate victim recoveries. Harsh public scrutiny has diminished the value of the resources necessary to satisfy claims, creating a discount that must be borne by victims.
My public benefit proposal charts a new course. Instead of accepting fire sale prices and an underfunded settlement trust, the scarlet-lettered company emerges from bankruptcy as a corporation for the public benefit. This modified reorganization offers victims the greatest recovery. The continued operation preserves value during a transition period, after which the going concern can be sold efficiently. Further, assets that have been tainted by corporate criminality are cleansed behind a philanthropy shield and sold to capture the value rebound. The victims’ collective is the owner of the new company and can participate in a shareholder windfall if the reorganized company experiences strong post-bankruptcy performance.
At the forefront of a new trend in aggregate litigation, this Article proposes a public benefit alternative to traditional resolution mechanisms. This approach delivers utility that will support application in a variety of contexts, assuming certain governance safeguards are maintained. In our new age of greater personal and corporate accountability, more scarlet-lettered companies will emerge and ultimately land in bankruptcy. The need to address the disposition of tainted assets will be paramount in compensating mass tort victims trying to reassemble fractured pieces. This Article explains a new phenomenon and reconceptualizes resolution dynamics in a way that will have policy implications that transcend aggregate litigation.
The full article will be available at 117 Nw. U. L. Rev. ___ (forthcoming 2022) and can be accessed here.
Please join the Harvard Association for Law and Business (HALB) and the Harvard Bankruptcy Roundtable for our flagship bankruptcy and restructuring panel featuring leaders from across the world of bankruptcy law and finance. Panelists will discuss a current controversy in bankruptcy, venue and forum shopping, from the perspectives of debtor and creditor side lawyers, investment bankers, and judges. In bankruptcy, where a debtor files for bankruptcy can make the difference between satisfactory and unsatisfactory outcomes – between who wins and who loses – and our panelists are experts in this high stakes process with different perspectives on the state of the law. Additionally, panelists will discuss venue reform proposals in Congress.
Confirmed in-person panelists include: Chief Judge Martin Glenn, U.S. Bankruptcy Court for the Southern District of New York; Meredith Lahaie, Partner at Akin Gump; Andy Dietderich, Partner and co-head of the Global Finance & Restructuring Group at Sullivan & Cromwell; and William “Tuck” Hardie, Managing Director at Houlihan Lokey. The panel will be moderated by Mark Roe, the David Berg Professor of Law at Harvard Law School.
The event is on March 4, 2022, at 12:30pm–1:30pm in Milstein West A. Grab and go lunch will be available at the conclusion of the event.
No previous knowledge of bankruptcy or restructuring is required. This event is open to non-law students affiliated with Harvard University. The calendar invite is available here.
Unfortunately, we are not able to accommodate non-Harvard affiliates at this time due to COVID restrictions.
By Sarah M. Bartlett (Harvard Law School)
On July 9, 2021, Southern District of New York Judge J. Paul Oetken held that §503(c) of the Bankruptcy Code prohibits board-appointed officers from receiving payments under a key employee retention plan (KERP) “absent a particularly strong showing that they do not perform a significant role in management,” as such officers are “insiders” within the definition of §101(31)(B)(ii). In re LSC Communications, Inc., 631 B.R. 818 (S.D.N.Y. 2021). This was the case even though the Bankruptcy Court found that the employees in question were officers “in title only.” Id. at 820. Judge Oetken’s ruling affects six employees who received KERP payments under the reorganization plan of LSC Communications, Inc. (“LSC”), which filed for Chapter 11 relief in April 2020.
In its initial order, the Bankruptcy Court approved payments under the KERP for all 190 covered employees. U.S. Trustee William K. Harrington appealed the decision to the District Court, claiming that, as LSC was incorporated in Delaware, the court should apply Delaware state law, which provides that any person appointed by a corporation’s board of directors is an officer. In response, LSC countered that the employees could not be considered insiders because they lacked any significant decision-making authority.
Judge Oetken wrote that case law regarding who constitutes an “officer” is “less than clear,” noting that the Bankruptcy Code does not define the term or provide any insight regarding its meaning. Id. at 824. Although Judge Oetken rejected the Trustee’s argument that state law exclusively applies when determining whether an employee is an officer under the Bankruptcy Code, he concluded that the Bankruptcy Court erred by looking beyond the fact that the six employees were appointed by LSC’s board. Even if a court chooses to undertake a more expansive analysis, he wrote, the fact that the six employees were appointed by the board and would be deemed officers under Delaware corporate law should “weigh heavily in concluding that the employees are officers for Bankruptcy Code purposes.” Id. at 826. In supporting his position, Judge Oetken claimed that giving more weight to objective criterion like appointment by the board provides greater clarity to the parties than the kind of “functional, non-exhaustive test” used by the Bankruptcy Court, although he noted that this kind of test may still be appropriate in some cases. Id. at 825.
This case, and its somewhat unusual holding, seems to present a scenario that has become exceedingly rare. In September, the Government Accountability Office (GAO) published a report finding that debtors regularly avoid restrictions in the Bankruptcy Code by paying bonuses before or after filing for bankruptcy or by designating bonuses during bankruptcy as “incentive” payments. The report stated that fewer than 1% of debtors requested court approval to pay employee bonuses during 2020 and, when debtors did seek court approval, the courts approved “nearly all” of those requests. Maria Chutchian wrote in a recent Reuters article that creditors rarely challenge such bonus payments in court, noting debtors will often arrange private deals with creditors before filing for bankruptcy. In the same article, she discusses the Mallinckrodt restructuring, in which the pharmaceutical company’s creditors chose to challenge bonus payments to executives facing accusations of misconduct related to the opioid epidemic. The judge allowed the payments, stating that “mere allegations” of misconduct did not suffice to render them inappropriate.
Finally, Jared Elias concluded in an article published in 2019 that, although fewer companies have used court-approved bonus plans in the years since the Bankruptcy Code’s bonus provisions were reformed in 2005, the overall level of executive compensation has remained the same. This lends support to the GAO’s analysis and the anecdotes collected by Reuters that KERPs are rarely used because parties have ample opportunity to achieve the same end while avoiding the scrutiny of §503(c). He argues that bankruptcy and district court judges are poorly equipped to police payments made before or after a debtor files for bankruptcy, and that the U.S. Trustee’s office and creditors struggle to do so due to information asymmetries and limited resources.
Given the above, it appears that Judge Oetken’s decision this past summer may ultimately prove to be an anomaly. In most cases, these bonus payments simply will not become a part of the bankruptcy plan. Debtors can avoid scrutiny by making payments before or after filing for bankruptcy. If they decide they must make the payments during bankruptcy, they can reduce the scrutiny they will incur by recharacterizing them as incentive payments, thereby avoiding the heightened restrictions that apply to KERPs. And, even if they decide to include the payments in their restructuring plan, it seems unlikely that creditors will challenge the payments—particularly if counsel has chosen to arrange a deal behind the scenes to avoid a dispute in court.