Venue Reform Can Save Companies
By Lynn LoPucki, Security Pacific Bank Distinguished Professor of Law at UCLA Law School
One side in litigation should not pick the court. That is exactly what happens, however, in big bankruptcies. A debtor, perhaps working together with its largest lender, can choose virtually any court in the country. The thousands of other stakeholders have no say.
The current system’s defenders argue that venue transfers will protect the stakeholders in appropriate cases. But in big case bankruptcy, venue transfer is illusory. Over the past ten years, 209 of the 317 large, public company Chapter 11s filed in the United States (66%) were filed in Wilmington, Delaware or New York City. One hundred eighty-six of the 209 (89%) were headquartered in some other district or division, but the Delaware and New York courts retained 206 of the 209 (99%).
Because cases have flowed to Delaware and New York since the 1990s, those courts’ judges now have high levels of big-case experience. In a recently completed study, Joseph Doherty and I found that significantly more companies survive under judges with greater big-case experience.
That doesn’t justify or necessitate letting corporate managers and DIP lenders pick their courts. The venue rules should require a big bankrupt to file with a big-case panel designated for its headquarters region. Within each of three or four regions, a chief judge could assign cases to maximize the development and utilization of big-case experience. That could eliminate forum shopping, level the playing field for stakeholders, reduce the pressure on judges to attract cases, and save more companies and jobs.
The ISDA 2014 Resolution Stays Protocol and the Bankruptcy Code Safe Harbors
By David Geen and Samantha Riley of the International Swaps and Derivatives Association (ISDA)
The International Swaps and Derivatives Association (“ISDA”) recently published the 2014 Resolution Stay Protocol (the “Protocol”). Developed by a working group comprised of both dealer and buy-side market participants in consultation with regulators from France, Germany, Switzerland, Japan, the United Kingdom and the United States, the Protocol has been hailed by the Financial Stability Board as a “crucial element[] of the policy framework to end too-big-to-fail.” In addition to addressing the failure of systemically important financial institutions (“SIFIs”) under special resolution regimes, such as the Orderly Liquidation Authority provisions of the Dodd-Frank Act or the EU Bank Recovery and Resolution Directive, Section 2 of the Protocol also addresses the failure of SIFIs under the U.S. Bankruptcy Code (the “Code”).
Section 2 of the Protocol was developed to support SIFI resolution strategies under the Code where operating companies, such as banks and broker dealers, are kept out of insolvency proceedings altogether, while affiliates, such as a parent holding company, are restructured through Chapter 11 proceedings. Section 2 introduces a short, temporary stay on the exercise of default rights that arise because of the parent’s or other affiliate’s entry into bankruptcy proceedings to enable the SIFI to take actions to preserve the operating companies as going concerns. If the actions taken satisfy the conditions established by the Protocol, the termination rights that arose as a result of the SIFI entering bankruptcy proceedings would be permanently overridden.
Naturally, questions have arisen as to the interplay between Section 2 of the Protocol and the safe harbors for swap agreements under the Code. The Code stays, and safe harbors, default rights that arise because a counterparty to an ISDA Master Agreement subject to the Protocol enters proceedings under the Code; it does not stay (and therefore does not need to safe harbor) contracts between non-debtor affiliates and their counterparties. The Protocol only addresses the affiliate contracts, and thus does not alter the scope or application of the safe harbors.
To help interested parties better understand the Protocol, ISDA has developed a detailed FAQ. The full text of the Protocol can be found on ISDA’s website.
U.S. District Court Holds that Puerto Rico’s Recovery Act is Unconstitutional
By Mark Ellenberg, Howard Hawkins, Lary Stromfeld, Ivan Loncar, and Thomas Curtin of Cadwalader Wickersham & Taft LLP
On February 6, 2015, in Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico, the U.S. District Court for the District of Puerto Rico held that the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”) is expressly preempted by section 903 of the Bankruptcy Code. Section 903 of the Bankruptcy Code expressly prohibits all states, including Puerto Rico, from enacting laws that prescribe a “method of composition” that discharges debts. The Recovery Act, which was loosely based on chapter 9 of the Bankruptcy Code, would have permitted Puerto Rico’s power authority (PREPA), highway authority (HTA) and water authority (PRASA) to adjust their debts without the consent of all creditors. The court concluded that this scheme ran afoul of section 903, even though municipal entities in Puerto Rico are expressly excluded from the coverage of Chapter 9. The decision is among the first to explicitly hold that section 903 expressly preempts the states, including Puerto Rico, from enacting any debt adjustment scheme that results in the discharge of indebtedness, even if the affected entities have no remedy under the Bankruptcy Code. The court also denied the Commonwealth’s motion to dismiss the plaintiffs’ claims under the Contracts Clause and certain of the plaintiffs’ claims under the Takings Clause.
To read further, click here.
Puerto Rico Public Corporation Debt Enforcement and Recovery Act
Puerto Rico is facing the most critical fiscal situation in its history. Its public corporations are especially compromised, overwhelmed by growing deficits and unsustainable debt loads but barred from reorganizing under federal law. Last June, Puerto Rico enacted the Puerto Rico Public Corporation Debt Enforcement and Recovery Act, which allows eligible public corporations to restructure their debt burdens.
The Recovery Act is likely preempted by federal bankruptcy law. Although the Recovery Act was justified as a valid exercise of the Commonwealth’s police power, the statute is likely unconstitutional under the Supremacy Clause. Where state law conflicts with federal law — as does the Recovery Act with section 903 of the Bankruptcy Code — the state law is preempted. On February 6, 2015 Judge Francisco Besosa of the U.S. District Court for the District of Puerto Rico held this was the case in Franklin California Tax-Free Trust v. Commonwealth of Puerto Rico and Blue Mountain Capital Management v. Governor Alejandro Garcia-Padilla.
Yet despite the Recovery Act’s probable constitutional infirmity, the threat of potential public corporation default nonetheless exerted sufficient pressure to motivate temporary consensual relief. In choosing this approach, Puerto Rico risks weakening outside investor interest in future securities offerings. But perhaps such high-stakes federalism will prompt Congress to reconsider the basis for and desirability of Puerto Rico’s idiosyncratic treatment under Chapter 9 of the Bankruptcy Code, and elsewhere in federal law.
This article was published in the Harvard Law Review, February 2015. To read the full article, click here.
This post comes from Robert Niles (J.D./M.B.A. ’16), a member of the Bankruptcy Roundtable team
The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy
By Charles J. Tabb, University of Illinois College of Law
The received wisdom in bankruptcy jurisprudence is that the Fifth Amendment Takings Clause independently limits the exercise of the bankruptcy power under the Bankruptcy Clause. Accordingly, secured creditors in bankruptcy are assumed to enjoy a constitutional right to receive the full value of their collateral in the bankruptcy case.
The thesis of this article is that the received wisdom is wrong. Professor Tabb argues that the Takings Clause of the Fifth Amendment does not and should not constrain the powers of Congress to modify the substantive rights of secured creditors under the Bankruptcy Clause. Instead, the only meaningful limits on the modification of substantive rights of stakeholders pursuant to the bankruptcy power are those that inhere in the Bankruptcy Clause itself.
The Bankruptcy Clause has only two limitations, both of which are extremely easy to satisfy regarding the treatment of secured creditors: that the law be “uniform,” and “on the subject of bankruptcies.”
The article first explains why it matters whether we continue to subscribe to the received wisdom that the Takings Clause limits what can be done to secured creditors in bankruptcy. Then it examines in considerable detail the historical evolution of bankruptcy jurisprudence in this area. Finally, the article assesses how we might best strike a prudential and meaningful constitutional balance.
To read the full article, click here.
ISDA Resolution Stay Protocol: A Brief Overview
On November 12, 2014, the International Swaps and Derivatives Association (“ISDA”) officially released the ISDA 2014 Resolution Stay Protocol (the “Protocol”), a mechanism that contractually imposes a stay on certain default rights in ISDA contracts between adhering parties during the resolution of a significantly important financial institution (SIFI) counterparty or one of its affiliates.
The first section of the Protocol—addressing default rights under Special Resolution Regimes (“SRRs”) (e.g., the U.S.’s OLA and FDIA)—is relatively uncontroversial. It merely ensures that adhering cross-border counterparties will be bound by the preexisting stay provisions of a foreign SRR, even if the jurisdictional limitations of the SRR would normally exempt such cross-border counterparties. This section went into affect for the 18 adhering banks on January 1, 2015.
The second section of the Protocol—addressing default rights under the U.S. Bankruptcy Code—has been met with significantly more contention. This section confines, to a limited extent, the use of currently existing “safe harbors” in the Code, by contractually limiting certain cross-default rights in ISDA contracts in the case of a counterparty’s affiliate’s bankruptcy, so that the affiliate is not also forced into bankruptcy, where close-out rights are safe-harbored. Significantly, this section will not go into effect until further regulations are promulgated by the Federal Reserve and other U.S. regulators. The concept behind the Protocol’s second section is that a failure of one part of a SIFI should not necessarily lead to defaults and close-outs of derivatives and repos sitting in affiliates of the SIFI, if the affiliate is still performing on its obligations.
The HLS Bankruptcy Roundtable has focused on the Code’s safe harbors previously. Click here for an analysis of the effect of the safe harbors on systemic risk; click here for an argument for narrowing the safe harbors for repos.
Congress is also currently considering the issue of the safe harbors in the case of a SIFI failure. Click here and here for previous coverage of currently pending legislation, the Financial Institution Bankruptcy Act, which would impose a short stay on financial contracts in the case of a SIFI resolution under the Bankruptcy Code.
For a full discussion of the Protocol, please see Mayer Brown’s Legal Update, here.
(This post was drafted by Stephanie Massman, J.D. ’15.)
Fixing the Trust Indenture Act to Allow Restructuring Votes
By Mark J. Roe, Harvard Law School
The Trust Indenture Act of 1939 bars binding bondholder votes on core payment terms. The inability of deal proponents to get a binding vote can lead the debtor to file for an otherwise unnecessary bankruptcy. To get a deal done when there are economically-important holdouts, deal proponents often seek exit consents to induce enough holdout bondholders to reluctantly tender into a deal they don’t otherwise like, by stripping the bond indenture of those covenants on which bondholders can vote.
Exit consent transactions have generally been upheld, despite that in analogous corporate settings such distortions induce doctrinal and deal structure issues. Recent decisions indicate that exit consents that oust the bondholders from an effective individual choice ran afoul of the Trust Indenture Act, which may well have been the intent of the 1930’s drafters of the law.
Regardless, the anti-voting provision is anachronistic. It was passed when bankruptcy law did not respect bondholder votes without a judge’s substantive approval of the deal, but the Code was updated in 1978 to allow binding votes. Bondholders should also be free to agree in advance to a binding vote in an out-of-court workout. More restructurings will succeed and avoid bankruptcy. And proponents will have less reason to resort to arm-twisting with exit consents. Similar individualized consent difficulties and holdout issues have hobbled sovereign debt restructurings, with sovereign debt issues moving in recent years to include majority vote provisions.
For my analysis of the incentives and structure of bond restructurings in light of the TIA, see 97 Yale L.J. 232 (1987).
SDNY Issues Novel Opinion Holding that Out-of-Court Restructurings May Violate Noteholder Rights Under the Trust Indenture Act
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.
To read more, click here.
Bankruptcy Survival
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.
Momentive Ruling May Pave the Road for Below-Market “Takeback Paper” Cramdowns of Secured Creditors
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.