The Case in Brief Against Chapter 14
Author: Bruce Grohsgal, Pachulski Stang Ziehl & Jones, LLP
Resolution of a distressed financial company under Dodd-Frank Title II is a last – but crucial – resort. Dodd-Frank, Title I, requires each large financial enterprise to file a “living will” that provides for its orderly resolution under the Bankruptcy Code. Dodd-Frank Title II may only be used to liquidate a failing financial company that would “pose a significant risk to the financial stability of the United States” if resolved in a bankruptcy proceeding or under other federal or state law. The FDIC must conduct a Title II resolution “in a manner that mitigates such risk and minimizes moral hazard.” Dodd-Frank also expressly prohibits both a taxpayer-funded bailout and the Federal Reserve’s lending to a failing or failed financial firm.
Dodd-Frank has drawn fire, nonetheless, as encouraging, rather than preventing, bailouts. Detractors urge repealing Title II of Dodd-Frank and amending the Bankruptcy Code to include a new Chapter 14 in its place.
The proposed Chapter 14’s central flaw is that it does nothing to reconcile Dodd-Frank’s purposes of mitigating systemic risk and minimizing moral hazard with the Bankruptcy Code’s starkly contrasting aims of reorganizing troubled companies, preserving going concerns and maximizing payments to creditors.
This article briefly summarizes Dodd-Frank’s orderly resolution regime and then addresses some of the core proposals for a new Chapter 14. It concludes that the proposed Chapter 14 will not mitigate systemic risk, minimize moral hazard, or improve on Dodd-Frank’s prohibitions against bailouts, which are the primary purposes of Title II of Dodd-Frank.
The article is available here.
The Chapter 14 Proposal in the Senate
Author: Stephen D. Adams*
[This week the Roundtable looks at the Chapter 14 proposal in the Senate. This post provides an overview of Chapter 14 as background to Bruce Grohsgal’s thoughtful piece from the ABI Journal available here.]
The Taxpayer Protection and Responsible Resolution Act of 2014 (S. 1861), commonly known as “Chapter 14”, aims to “end ‘too big to fail’ by repealing Dodd-Frank’s Title II” and “replacing it with a bankruptcy process” capable of safely resolving a Systemically Important Financial Institution.
The Chapter 14 proposal envisions a number of changes to the bankruptcy process, grouped into a new bankruptcy chapter (hence “Chapter 14”, a previously unused chapter) that would be available to bank holding companies. Chapter 14 would be run by a special group of financially experienced district judges, could allow for the FDIC to be appointed as trustee, and would have no period of plan exclusivity. In order to effect a quick sale similar to the FDIC’s single point of entry strategy for Title II, the Senate bill would add a two-day stay to bankruptcy’s swap safe harbors to give the trustee a chance to transfer the entire swap portfolio to a new company that is solvent. Repos, however, are treated like secured debt, but with the ability to immediately sell off high quality collateral (though not non-agency Mortgage-Backed Securities).
The Senate Bill draws on work from the Hoover Institution’s Resolution Project that proposed the original Chapter 14 in 2009 and 2010 and updated it recently.
Documents related to the original Chapter 14 proposal work, including proponents’ descriptions of the case for a new Chapter 14, can be found here. The text of S. 1861 can be found here. Professor Thomas Jackson’s Congressional testimony about Chapter 14 in 2014 can be found here.
*Editor, Harvard Law School Bankruptcy Roundtable, and Research Director, Harvard Law School Bankruptcy and Corporate Restructuring Project.
Reports of Equity’s Death Have Been Greatly Exaggerated
By Adam J. Levitin, Georgetown University Law Center
Mark Berman is very
kind to take notice of my article in his recent analysis of Law v. Siegel, posted on the HLS Bankruptcy Roundtable, here. We agree on a great deal about the case and scope of equity practice. A question persists about the scope of Law v. Siegel, though, and what it is proscribing when it reiterates the view that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.” The question, then, is which non-Code practices are properly characterized as “equity”. My own view is that very little of modern bankruptcy practice is in fact “equity.”
Law v. Siegel, for example, should not affect such important non-Code practices as judicial interpretation of Bankruptcy Code statutory terms or judicially-created doctrines like substantial consolidation, which are sometimes mistakenly listed among the bankruptcy court’s “equitable powers”. As I wrote earlier, though, because such practices are interstitial and formed as broad principles, they are, in my view, better understood as part of a federal common law of bankruptcy, and distinguished from equitable powers, which are based on case-by-case specifics, as in Law v. Siegel. As interstitial powers, these lie outside any widening or narrowing of bankruptcy court’s equitable powers.
Moreover, the uncertainties about when actual equitable practices contradict statutes will continue. In cases of clear contradiction, the interpretive result will be easy. But cases where it is unclear whether a conflict truly exists will continue to invite negotiation between and among the parties because of the cost and uncertainty of litigation. Despite the Supreme Court’s best efforts, consideration of the equities will likely remain a part of our bankruptcy system.
For a fuller treatment of this subject, please continue here.
Revisiting the Recidivism-Chapter 22 Phenomenon in the U.S. Bankruptcy System
Author: Edward I. Altman, NYU Stern School of Business
This study finds that about 15% of all debtors, who emerge as continuing entities from reorganization under Chapter 11 bankruptcy, or are acquired as part of the bankruptcy process, ultimately file for bankruptcy protection again. This recidivism rate spikes to 18.25% when considering only those firms which emerge as a continuing, independent entity. This highlights what appears to be a significant recidivism problem of our Chapter 11 system.
This article argues that the so-called “Chapter 22” issue should not be dismissed by the bankruptcy community as acceptable just because no interested party objected to the plan of reorganization during the confirmation hearing. Indeed, by applying the Z-Score model to large samples of Chapter 11 and Chapters 22, 33, and 44 firms, highly different and significant expected survival profiles are shown at the time of emergence. The bond-rating-equivalent of the multi-filing sample was CCC versus a BB-profile for the single-filing Chapter 11 sample. I believe that credible distress prediction techniques can be important indicators of the future success of firms emerging from bankruptcy and could even be used by the bankruptcy court in assessing the feasibility of the plan of reorganization – a responsibility that is embedded in the Bankruptcy Code.
The full article is available here.
‘Wither’ the Equity Powers of the Bankruptcy Court
Author: Mark N. Berman, Nixon Peabody LLP
The United Sta
tes Supreme Court’s Law v. Siegel decision has been explained away as an understandable limitation of a bankruptcy court’s use of Bankruptcy Code Section 105(a)’s expansive authority based on conventional techniques of statutory construction. Bankruptcy courts will not be able to use Section 105(a) to authorize an order that is otherwise prohibited by another section of the Bankruptcy Code. However, it is also possible to read the decision as yet another stop on the road to limiting the ability of the bankruptcy courts to ‘do equity.’
Revisiting Professor Levitin’s 2006 law review article entitled Toward a Federal Common Law of Bankruptcy: Judicial Lawmaking in a Statutory Regime, 80 Am. Bankr. L.J. 1-87 (2006), I posit that the equity jurisdiction of the bankruptcy courts has already been statutorily restricted and the United States Supreme Court has made it clear that everyone should be prepared for further limitation of what has historically been its power. The Supreme Court’s warning is repeated in this latest decision.
The full alert is available here.
[Editor: The full text of Professor Adam Levitin’s noted article, Toward a Federal Common Law of Bankruptcy: Judicial Lawmaking in a Statutory Regime, can be found here.]
The Evolution of European Insolvency Law Part 2: The EU Commission’s Proposal for the Amendment of the European Insolvency Regulation
Author: Dr. Björn Laukemann, Maître en droit (Aix-en-Provence), Senior Research Fellow at the Max Plack Institute Luxembourg for International, European and Regulatory Procedural Law
Following the external evaluation (Part 1), the EU Commission released a proposal for the amendment of the European Insolvency Regulation in December 2012, aimed at enhancing the efficiency of cross border insolvency proceedings and thus ensuring a proper “functioning of the internal market and its resilience in economic crises”. The following main changes were proposed:
- The Regulation’s scope of application now includes hybrid proceedings (“debtor in possession”), pre-insolvency proceedings and debt discharge proceedings for natural persons. The Commission will scrutinize whether specific national proceedings fall within the revised scope.
- Retaining the jurisdictional criterion of the debtor’s centre of main interests, the proposal clarifies the criteria and improves the procedural framework for determining the competent court (examination ex officio, information of foreign creditors and creditors’ right to judicial review).
- The proposal empowers the court to refuse to open secondary proceedings (i.e. parallel territorial proceedings opened in the Member State of the debtor’s establishment) if they are unnecessary to protect the interests of local creditors, and thus to reduce detrimental effects on rescue efforts (abolishment of the winding-up-requirement; improved cooperation and communication between main and secondary proceedings, also on a court-to-court basis).
- Member States are required to establish publicly accessible and interconnected electronic registers in which the relevant court decisions are published.
- The implementation of standard forms will facilitate the lodging of claims for foreign creditors.
- A framework for the coordination of insolvency proceedings within groups of companies is set up (obligation of courts and liquidators to cooperate and communicate with each other; extending certain rights of administrators to proceedings of other group members, e.g. the right to be heard, to participate, to request a stay of proceedings and to propose a rescue plan).
Part 3 will address the reactions of the European Parliament and the Council and comment on ongoing and future developments.
Get in Line: Chapter 11 Restructuring in Crowded Bankruptcy Courts
By Benjamin Iverson, Kellogg School of Management at Northwestern University
On average, total bankruptcy filings rise by 32% during economic recessions, leaving bankruptcy judges with far less time per case exactly when financial distress is worst. The inflexible nature of the bankruptcy system coupled with the varying demands placed upon it, leads to the concern that time constraints might limit the effectiveness of bankruptcy when economic conditions deteriorate.
In my paper, “Get in Line: Chapter 11 Restructuring in Crowded Bankruptcy Courts,” I test whether Chapter 11 restructuring outcomes are affected by time constraints in busy bankruptcy courts. Using the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005 as a shock that decreased caseloads dramatically, I show that as bankruptcy judges become busier they tend to allow more firms to reorganize and liquidate fewer firms. I interpret this as evidence that busy bankruptcy judges defer to the debtor in possession more often, scrutinizing each case less and thereby allowing reorganization more often. In addition, I find that firms that reorganize in busy courts tend to spend longer in bankruptcy, while firms that are dismissed from busy courts are more likely to re-file for bankruptcy within three years of their original filing.
Perhaps most striking, I also show that busy courts impose costs on local banks, which report higher charge-offs on business lending when caseload increases. If time constraints create higher costs of financial distress, it appears that these costs are typically passed on to the creditors of the bankrupt firms in the form of higher losses on distressed loans.
The full-length article can be found here.
Another Court of Appeals Broadly Reads Settlement Payment Safe Harbor
By Michael L. Cook, Schulte Roth & Zabel LLP
The Courts of Appeals, with few exceptions, have broadly read the safe harbor defense contained in Bankruptcy Code §546(e) over the past 24 years. It insulates a “settlement payment” or “margin payment” on a “securities contract,” “commodity contract” or “forward contract” from a trustee’s fraudulent transfer or preference claims unless the debtor makes the payment with “actual intent to hinder, delay or defraud creditors.” Despite policy arguments by lower courts, trustees, creditors and commentators, the appellate courts have claimed to rely on the Code’s “plain language” to deny recovery. In this Article, we discuss a recent Seventh Circuit decision that (a) reversed a district court’s “policy” decision purporting to divine Congress’s intent as to the proper application of the safe harbor provision; (b) rejected decisions by the Fifth and Ninth Circuits that refused to apply the safe harbor in the context of a Ponzi scheme; and (c) followed recent decisions of the Second and Fourth Circuits.
We discuss the Seventh Circuit’s close reading and application of the statutory language, “clearly and predictably using well established principles of statutory construction.” Citing Supreme Court precedent, the court refused to rely on legislative history that was “neither passed by a majority of either House nor signed into law.” Instead, the court explained why the safe harbor in the case before it yielded a sensible result, avoiding instability and uncertainty in the securities business.
We also review recent conflicting decisions in the lower courts that have resulted from imaginative attempts by lawyers to avoid application of the safe harbor defense. Finally, we discuss another case pending in the Second Circuit that pushes the safe harbor defense to its outer limits. That case asks (a) whether an intermediary is required in a safe harbor case, and (b) whether the defendant must show an adverse effect on financial markets.
Schulte Roth & Zabel Client Alert, April 3, 2014: http://www.srz.com/Seventh_Circuit_Reads_Bankruptcy_Safe_Harbor_Broadly_to_Insulate_Preferential_Settlement_Payment_to_Commodity_Broker/
Bankruptcy Law as a Liquidity Provider
Authors: Kenneth Ayotte & David Skeel
Since the outset of the recent financial crisis, liquidity problems have been cited as the cause behind the bankruptcies and near bankruptcies of numerous firms, ranging from Bear Stearns and Lehman Brothers in 2008 to Kodak more recently. As Kodak’s lead bankruptcy lawyer explained to the court on the first day of the case: “We’re here for liquidity.” In this Article, we offer the first theoretical analysis of bankruptcy’s crucial role in creating liquidity for firms in financial distress.
The dominant normative theory of bankruptcy (the “Creditors Bargain theory”) argues that bankruptcy should be limited to solving coordination problems caused by multiple creditors. Using simple numerical illustrations, we show that two well-known problems that cause illiquidity–debt overhang and adverse selection– are more severe in the presence of multiple, uncoordinated creditors. Hence, bankruptcy is justified in addressing them.
We discuss the Bankruptcy Code’s existing liquidity-providing rules, such as the ability to issue new senior claims, and the ability to sell assets free and clear of liens and other claims. In addition to identifying this function in a variety of provisions that have not previously been recognized as related, our theory also explains how the recent trend toward creditor control in Chapter 11 cases can be explained as an attempt to create illiquidity for strategic advantage. Although bankruptcy’s liquidity providing rules are essential, especially in the current environment, they also carry costs, such as the risk of “continuation bias.” To address these costs, we propose qualitative principles for striking the balance between debtor liquidity and respect for nonbankruptcy rights.
University of Chicago Law Review, Vol. 80, Fall 2013. A draft is available on SSRN.
Activist Investors, Distressed Companies, and Value Uncertainty
Authors: Michelle M. Harner, Jamie Marincic Griffin, and Jennifer Ivey-Crickenberger
Hedge funds and other private investment funds often play a key role in chapter 11 cases. They may hold the debtor’s prepetition secured debt or provide postpetition financing to the debtor. They also may buy and trade the debtor’s secured and unsecured debt both before and after a chapter 11 filing. These activities can provide much-needed liquidity to a debtor and foster a robust secondary market for creditors looking to exit the credit. A fund’s participation in a case, however, sometimes generates litigation and, arguably, both delays the resolution and increases the cost of the case. Consequently, many commentators and practitioners debate the utility of funds in restructurings.
In our most recent article on funds in chapter 11, we conduct an original empirical study of funds as purchasers of chapter 11 debtors. Specifically, the study analyzes cases where a fund (individually or as part of a group) acquires control of a debtor through the chapter 11 process by purchasing either substantially all of the debtor’s assets or a majority interest in the reorganized stock. In the stock acquisition context, we were concerned only with the investment of new capital.
Overall, the data suggest that funds have the potential to provide value in chapter 11. But neither the participation of funds nor the chapter 11 process itself is a panacea, and more empirical and traditional case studies are needed to understand fully the impact of funds on corporate restructurings. We hope our study encourages further research.
The full-length article can be found here.