By J. B. Heaton (J.B. Heaton, P.C.)
The issue of share repurchases has captured the attention of United States senators on both sides of the aisle, with Senate Minority Leader Chuck Schumer, D-NY, Senator Bernie Sanders, I-VT., and Senator Marco Rubio, R-FL, each proposing legislation limiting share repurchases and dividends. One need not agree with all parts of their plans to acknowledge that excessive dividends and share repurchases can have severe negative social consequences.
In a new paper forthcoming in the Journal of Business, Entrepreneurship and the Law, I explore five negative consequences of dividends and share repurchases. First, they dramatically increase the riskiness of corporate debt, diverting resources into credit monitoring and credit speculation. Voluntary creditors must charge a high price for credit ex ante – subsidized by tax payers through interest expense deductions – to protect them from the ex post effects of the existing legal regime, and many resources are spent on monitoring and trading on the fluctuating risks of default and only partial recovery on corporate debt. Second, the existing legal regime requires a bankruptcy system to process large and complex corporate failures. Third, it leaves firms less resilient to financial crises. Fourth, it unfairly shifts costs to involuntary and unsophisticated creditors in violation of the implicit social bargain of limited liability. Finally, it distorts the supply of securities toward riskier debt that is publicly subsidized through the deductibility of interest, reducing the supply of safer assets.
One possible solution that deserves further study is restricting dividends and share repurchases to corporations that have low debt and adequate insurance against harm to involuntary creditors and pay reasonable wages and benefits. Such a rule would still allow corporations with high debt, little insurance, and low wages and benefits to operate, but they could pay shareholders only after meeting all their other obligations.
This proposal is consistent with what corporate law is supposed to provide to investors and society alike. A long-held view in the academy is that shareholders are “residual claimants” in the sense that they are paid in full only after the corporation pays its creditors. The reality, of course, is far different. Corporations give away significant assets to their shareholders in the form of dividends and share repurchases long before they have satisfied creditors, both voluntary contract creditors and involuntary tort creditors. Existing law is quite permissive in allowing indebted corporations to distribute this cash to shareholders. As a result, shareholders are hardly “last paid” capital providers of corporate-law folklore but rather “first-in, first-out, and then some” capital providers. They receive their capital back and much more while the corporation has often very large liabilities outstanding. As my paper explores, neither corporate law nor voidable transfer law are strong enough to prevent the destructive social impact of dividends and share repurchases.
J.B. Heaton is a data scientist, financial economist and legal scholar. His paper, “The Social Costs of Dividends and Share Repurchases,” is available here.
By Richard Levin (Jenner & Block LLP) and Roland Pettersson (LEC Abogados).
This Working Paper analysis the hypothetical transfer and conveyance of Petróleos de Venezuela, S.A.’s assets to a new state-owned entity by the Venezuelan Government, and the possible creditor responses to such action, on account of the Venezuela’s NOC current financial-distress situation. The study is conducted from the perspective of Venezuelan law, which might provide certain legal remedies under Civil, Commercial and Administrative law—although with somehow little practical success expectations, given other factors and externalities—as well as from the perspective of U.S. law, which is of particular relevance, given (i) significant asset exposure in the U.S., where PDVSA—through CITGO—maintains an important operation, (ii) the contractual terms in the bulk of Venezuela and PDVSA’s financial indebtedness relies on U.S. law and provides for submission to the jurisdiction of NY courts, and (iii) many creditors are actually U.S. persons. Thus, this Working Paper examines the above situation, given the multiple issues and complexities on the case, starting from the very nature of PDVSA as an state-owned entity under Venezuelan law, but with particular emphasis on the creditors’ side of the equation and the theory of fraudulent transfer, which is analyzed both from the standpoint of Venezuelan law, as well as from U.S. insolvency framework and international law in general.
The full working paper is available here.
By Mark Walker (Guggenheim Securities)
Lee Buchheit and Mitu Gulati have proposed an innovative and aggressive strategy to facilitate the restructuring of Venezuela’s external debt based on consensual agreement between Venezuela and a supermajority of its broad creditor universe. Borrowing from the United Nations Security Council’s decision (supported by action of the United States) to shield Iraq’s assets from seizure by its creditors in order to promote a restructuring of Iraq’s debts, they propose that the Security Council or (more likely) the President of the United States by Executive Order shield Venezuela’s assets (particularly revenues from the sale of oil into the United States) from legal process. The rationale for their proposal rests on the premises that (1) virtually all of Venezuela’s foreign exchange is generated by sales of oil into the United States, (2) the revenues from exports of oil to the United States are vulnerable to attachment by creditors and therefore a small group of aggressive creditors could strangle the entire economy of the country, (3) existing restructuring techniques are inadequate to the task and (4) the policy of the United States is to promote the restructuring of sovereign debt based on an agreement between the debtor state and a supermajority of its creditors in the context of a process in which all creditors are bound by the vote of a supermajority.
This article argues that (1) a new Venezuelan government (which all agree is a prerequisite to a restructuring) will have substantial means to shield the country’s oil revenues from seizure by creditors, (2) a new government will also be able to expand its foreign exchange earnings to include sale of oil outside the United States, (3) the proposals do not create a mechanism to allow all of Venezuela’s creditors to have a voice in the terms of a restructuring — by supermajority or otherwise — and would treat U.S. and non U.S. creditors differently and (4) the unintended consequences of the proposals advanced by Buchheit and Gulati would negatively affect the ability of emerging market sovereigns, and Venezuela in particular, to fund themselves in the debt markets and would be disruptive of the sovereign debt market generally. Referring to the paper that the author and Richard Cooper wrote one year ago, the author argues that there are tested, market-based mechanisms to achieve the goal of a consensual restructuring arrived at by a supermajority vote of creditors, in particular a restructuring of PDVSA’s debts under a newly enacted Venezuela law that is implemented with the support of a Chapter 15 proceeding under the United States Bankruptcy Code.
The full article is available here.
By Ryan M. Rossner (Harvard Law School, J.D. 2019)
On February 25, the OECD published another report in its Capital Market Series, Corporate Bond Markets in a Time of Unconventional Monetary Policy, which noted both a significant increase of outstanding nonfinancial corporate debt and a simultaneous decrease in bond quality post-financial crisis. Authored by Mats Isaksson, Serdar Çelik, and Gul Demirtaş, the report drew upon a dataset of almost 85,000 unique corporate bond issues by nonfinancial companies from 114 countries between 2000 and 2018.
The report provides a detailed account of capital markets development post-financial crisis with comparisons among different jurisdictions. The authors emphasize that levels of nonfinancial corporate bond issuances have reached record highs. Global outstanding debt in the form of corporate bonds issued by nonfinancial companies reached almost $13 trillion USD at the end of 2018, twice the amount in real terms than was outstanding in 2008. The report links the expansion of corporate bond issuances to regulatory initiatives aimed at encouraging corporate bond issuances, expansionary monetary policy, and (particularly in the EU) quantitative easing. The report also forecasted a record repayment period ahead with $2.9 trillion coming due for advanced economy issuers and $1.3 trillion for emerging economy issuers within 3 years.
The US remains the largest corporate bond market and US issuers raised the most funds over the period. However, the authors found that the number of US nonfinancial issuers increased only modestly in the post-crisis era, suggesting increased issuer concentration in US primary corporate bond markets. Over the same period, Japan, the EU, Korea, and China all increased both their use of corporate bond issuances as a means of borrowing and their number of issuers. Most strikingly, the number of Chinese companies issuing bonds increased steeply from 68 issuers in 2007 to a peak of 1,451 in 2016.
Amidst the expansion, the authors found a marked decrease in bond quality. To support these conclusions, the authors pointed to a marked expansion of non-investment grade bonds, and the increase of BBB-rated bonds (the rating just above non-investment grade) as a percentage of investment grade debt (to 54% in 2018).
The report also noted a decrease in covenant protection for non-investment grade corporate bonds. The authors devised a “Covenant Protection Index” of US issuances, by looking at the presence or absence of 27 different types of covenants in bond indentures. While the index is a rough measure of covenant protection, it demonstrated a downward trend for non-investment grade bonds. The authors attribute the decrease in covenant protections to increased issuer bargaining power in a low interest rate environment, as investors have been willing to forgo certain protections in favor of higher yields.
The authors note that the combination of increased bond issuances, a “prolonged period of low issuer quality,” and “lower levels of covenant protection” for noninvestment grade bonds suggest that in an economic downturn the amount of expected future corporate bond defaults “may be considerably larger than that experienced in the financial crisis.” This report comes shortly after Federal Reserve Chairman Jay Powell, during the January FOMC meeting press conference, described the current state of corporate debt as a “macroeconomic risk,” which could “amplify” a negative downturn.
For a previous Roundtable post on distressed debt, see Edward Altman & Robert Benhenni, “The Anatomy of Distressed Debt Markets.”
By Jonathan C. Gordon (Jones Day).
Consider an insolvency proceeding outside the United States. To obtain ancillary relief in the U.S., an authorized representative from that foreign proceeding can file a petition with a U.S. court under chapter 15 of the Bankruptcy Code. In chapter 15, the foreign representative acts as a liaison between the U.S. proceeding and the foreign proceeding. For example, the representative must update the U.S. court of substantial developments in the foreign proceeding.
But what happens when that foreign representative (appointed by a foreign court) commits misconduct in the U.S. proceeding; what can the U.S. court do? As I explain in my paper, courts have struggled with a solution. For one, the Bankruptcy Code does not address this situation (nor does the related UNCITRAL Model Law). And common law is equally unavailing; courts have tried and suggested potential solutions, but those approaches (and others) fall short.
In my paper, I propose a novel solution that is simple yet effective: the U.S. court should request the foreign court to replace the foreign representative. I also analyze legal issues related to the solution’s implementation, such as judicial authority, burden of proof, timing, and interim relief.
The full paper, recently published in the ABI Law Review, can be accessed here.
By Saule T. Omarova (Cornell University)
“Too big to fail” – or “TBTF” – is a popular metaphor for a core dysfunction of today’s financial system: the recurrent pattern of government bailouts of large, systemically important financial institutions. The financial crisis of 2008 made TBTF a household term, a powerful symbol of the pernicious society-wide pattern of “privatizing gains and socializing losses.” It continues to frame much of the public policy debate on financial regulation even today, ten years after the crisis. Yet, the analytical content of this term remains remarkably unclear.
In a forthcoming article, I take a fresh look at the nature of the TBTF problem in finance and offer a coherent framework for understanding the cluster of closely related, but conceptually distinct, regulatory and policy challenges this label actually denotes. I begin by identifying the fundamental paradox at the heart of the TBTF concept: TBTF is an entity-centric, micro-level metaphor for a complex of interrelated systemic, macro-level problems. I argue that, while largely unacknowledged, this inherent tension between the micro and the macro, the entity and the system, critically shapes the design and implementation of the key post-2008 regulatory reforms in the financial sector.
To trace these dynamics, I deconstruct the TBTF metaphor into its two basic components: (1) the “F” factor focused on the “failure” of individual financial firms; and (2) the “B” factor focused on their “bigness” (i.e., relative size and structural significance). Isolating and examining these conceptually distinct components helps to explain why the potential for failure (and bailout) of individual firms – or the “F” factor – continues to be the principal focus of the ongoing TBTF policy debate, while the more explicitly structural, relational issues associated with financial firms’ “bigness” – or the “B” factor – remain largely in the background of that debate.
Analyzing post-crisis legislative and regulatory efforts to solve the TBTF problem through this simplifying lens reveals critical gaps in that process, which consistently favors the inherently micro-level “F” factor solutions over the more explicitly macro-level “B” factor ones. It also suggests potential ways of rebalancing and expanding the TBTF policy toolkit to encompass a wider range of measures targeting the relevant systemic dynamics in a more direct and assertive manner. Admittedly, implementing such deliberately structural measures would require a qualitative shift in the way we think and talk about the financial system and its dysfunctions – not an easy precondition to meet in practice. Yet, as I argue in the article, this deep attitudinal shift is the necessary first step toward finally achieving the lofty – and persistently elusive – goal of eliminating the TBTF phenomenon in finance.
The complete article is available for download here.
By Sarah Paterson (London School of Economics & Political Science)
In a recent article, I argue that we have repeatedly failed to identify clearly our concerns for fairness in different types of debt restructuring situations, and that this has confused corporate bankruptcy policy debate. To defend the article’s thesis, I build a theoretical frame by unpacking the principles and the procedural demands of fairness from diverse fields of scholarship such as moral and political philosophy, biological sciences, psychology, organisation theory, group theory and economics. I apply this theoretical frame to three very different types of debt restructuring: a restructuring of a small or medium sized enterprise; a restructuring of a large corporate; and a restructuring of a financial institution in English law. In each case, a fairly typical fact pattern is outlined to ground the analysis, and the quality and extent of the fairness concerns examined.
The analysis in the article concentrates exclusively on fairness. It does not consider the trade-off between fairness and other objectives (such as cost reduction), or utilitarian objections (such as concern that a situation which differentiates between classes of stakeholder in its approach to the fairness of the case would make stakeholders worse off overall), or arguments that what we might consider to be questions of fairness should properly be reinterpreted as economic questions. In short, its objective is not to argue that fairness should prevail over all other considerations, but rather to explore, as an initial question, the quality of fairness in each of the situations with which it is concerned.
S. Paterson, ‘Debt Restructuring and Notions of Fairness’ (2017) 80(4) Modern Law Review 600 available here.
By James M. Wilton (Ropes & Gray, LLP)
The majority federal law test for recharacterization of insider debt in bankruptcy establishes a multi-factor test drawn from federal tax cases. The test is problematic and has been rejected by Fifth and Ninth Circuit Courts of Appeals in favor of a state law rule of decision. The U.S. Treasury, in fact, has moved away from use of multi-factor tests even in tax cases because they are unworkable and produce “inconsistent and unpredictable results.”
In an article published this month in The Business Lawyer, I predict that the U.S. Supreme Court will resolve the circuit split over debt recharacterization in favor of a state law rule of decision. The article is intended for transactional lawyers interested in structuring transactions to minimize debt recharacterization risk and for bankruptcy litigators interested in understanding the arguments both for and against application of a federal or a state law rule of decision. For the circuits that have endorsed a state law rule of decision for debt recharacterization, the article examines the appropriate test for determining choice of law and surveys the substantive state law of debt recharacterization in thirteen jurisdictions, including New York and Delaware.
The article concludes that debt recharacterization under state law allows equity sponsors and other corporate insiders to provide credit support to distressed businesses, with greater assurance that loans will be enforceable both under state law and in bankruptcy court.
The full article is available here.1
- ©2019. Published in The Business Lawyer, Vol. 74, Winter 2018-2019, by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association or the copyright holder.
By Jared A. Ellias (University of California, Hastings) & Robert Stark (Brown Rudnick LLP)
On the eve of the financial crisis, a series of Delaware court decisions added up to a radical change in law: Creditors would no longer have the kind of common law protections from opportunism that helped protect their bargain for the better part of two centuries. In this Article, we argue that Delaware’s shift materially altered the way large firms approach financial distress, which is now characterized by a level of chaos and rent-seeking unchecked by norms that formerly restrained managerial opportunism. We refer to the new status quo as “bankruptcy hardball.” It is now routine for distressed firms to engage in tactics that harm some creditors for the benefit of other stakeholders, often in violation of contractual promises and basic principles of corporate finance. The fundamental problem is that Delaware’s change in law was predicated on the faulty assumption that creditors are fully capable of protecting their bargain during periods of distress with contracts and bankruptcy law. We show through a series of case studies how the creditor’s bargain is, contrary to that undergirding assumption, often an easy target for opportunistic repudiation and, in turn, dashed expectations once distress sets in. We further argue that the Delaware courts paved the way for scorched earth distressed governance, but also that judges can help fix the problem.
The full article is available here.
By Robert K. Rasmussen (University of Southern California Gould School of Law)
It is common to observe that investors receive both cash flow rights and control rights against a borrower. The crucial differences between these two “rights” are rarely focused on. Cash flow rights are legal entitlements. Outside of bankruptcy, failure to pay entitles a lender to resort to a legal remedy against the borrower. Inside of bankruptcy, the Bankruptcy Code structures the way in which these legal entitlements will be adjusted. Control rights are different. They do not confer direct power over the business, nor do they provide lenders with a judicial remedy that allows them to assert control. Rather, they work indirectly. The Bankruptcy Code, in turn, pays scant attention to a lender’s control rights.
This disparate treatment stems from the lending contract. That agreement provides enforceable rights to cash and as we have seen in recent years – there is little limit to the creativity in dividing up cash flow rights. The same contract, however, does not place control in the hands of a lender, even on a contingent basis because legal doctrines threaten creditors who put their hands on the levers of power. Outside of bankruptcy, the lingering shadow of lender liability doctrine leads lawyers to counsel clients to avoid contracting for control upon a borrower’s default. Inside of bankruptcy, lenders that exercise what a court finds to be excessive control face the threat of having their claims equitably subordinated. In addition to these threats, it is far from clear that a bankruptcy court would enforce a contract that gave direct control to the debtor’s lenders should the debtor default. These restrictions on contracting, however, are questionable. Opening up the contract space for direct contracting on control could increase contracting surplus.
The full article is available here.