Optimal Capital Structure and Bankruptcy Choice: Dynamic Bargaining vs. Liquidation

posted in: Valuation | 0

By Samuel Antill and Steven R. Grenadier (Stanford Graduate School of Business)

In this work, we develop and solve a continuous-time dynamic bargaining model of Chapter 11 reorganization. We include many features of the Chapter 11 process, such as the automatic stay, suspension of dividends, the exclusivity period, post-exclusivity proposals by creditors, and the potential for forced conversion to Chapter 7. The reorganized firm may issue new debt and continue operating. Moreover, both debtors and creditors face uncertainty over future asset values as they debate reorganization plans. We solve for the equilibrium and the corresponding expected payoffs to creditors and equityholders.

Using this equilibrium, we proceed to model a firm’s optimal capital structure decision in a framework in which the firm may later choose to enter either Chapter 11 reorganization or Chapter 7 liquidation. Creditors anticipate equityholders’ future reorganization incentives and price them into credit spreads when the debt is issued (ex ante). The implied capital structure results in both higher credit spreads and dramatically lower leverage than existing models suggest. Giving creditors more bargaining power in bankruptcy typically leads to higher leverage and ex ante firm value, consistent with empirical evidence. If reorganization is less efficient than liquidation, the added option of reorganization can actually make equityholders worse off ex ante, even if the firm is eventually liquidated.

The full article is available here.

WSJ Examiners – Claims Trading

posted in: Claims Trading | 0

Does claims trading impede chapter 11 reorganizations? And, if so, would disclosure of additional information about traded claims remove the impediments it creates?

Kenneth A. Rosen answers “yes” to both questions. He argues that ownership of an in-the-money claim incentivizes liquidation and thus encourages bad-faith rejections. Disclosure, he contends, would enable courts to assess more accurately whether a party’s rejection of a plan was made in good faith.

Elliot Ganz disagrees on both scores. He maintains that claims traders try to maximize a debtor’s going-concern value rather than immediately lock in paper gains. In so doing, they provide liquidity and expertise that improves the reorganization process. Disclosure, however, would publicize their strategies and thus chill their participation.

Who has the better argument? The Wall Street Journal’s expert panel of Examiners agrees with Mr. Ganz.

Marc Leder, Brett Miller, Anders J. Maxwell, Sharon Levine, Jack Butler, and Mark Roe all agree that claims trading is generally beneficial and that current disclosure requirements are adequate. Mr. Butler also details the history of claims trading to show that Congress was aware of the practice when it adopted the Bankruptcy Reform Act of 1978.

Finally, Mark Roe addresses a common criticism of claims trading–namely, that it hinders resolution via a negotiated plan because claims traders, fearful of insider trading liability and other risks, will not participate in plan formation. He argues that 363 sales ameliorate this problem because such sales may proceed absent negotiation among the various classes of creditors.

(This post was authored by Ben A. Sherwood, J.D. ’17.)

Buyer Beware: Courts Put Claims Trades Under a Microscope

posted in: Claims Trading | 0

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.

The Ownership and Trading of Debt Claims in Chapter 11 Restructurings

posted in: Claims Trading | 0

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.

A Recent Decision in the Fisker Case Brings New Life to the Credit Bidding Debate

posted in: Claims Trading | 0

Author: Nelly Almeida, Weil Gotshal & Manges LLP

On January 10, 2014, the United States Bankruptcy Court for the District of Delaware in In re Fisker Automotive Holdings, Inc., et al., capped a secured lender’s right to credit bid its $168 million claim at $25 million (the amount it paid to purchase the claim). While the court noted that its decision was non-precedential, it may still have serious implications for the future of credit bidding.

Credit bidding has long been considered a fundamental protection afforded to secured creditors by section 363(k) of the Bankruptcy Code. Under section 363(k), at a sale of its assets, a secured creditor may “credit bid” the amount of its secured claim in lieu of cash unless the court “for cause” orders otherwise. The Fisker decision highlights the uncertainty surrounding what constitutes sufficient “cause” for a court to limit or abrogate a lender’s right to credit bid. In almost all cases where courts have found “cause,” the focus has been on whether there is a clearly defined existing dispute to a claim or lien. In Fisker, however, the court emphasized other “fairness” factors, such as the expedited nature of the proposed sale and the interest of promoting a fair auction, even though the opinion suggests that questions existed as to whether the potential credit bidder’s claims were secured. Thus, Fisker leaves us to wonder whether these “additional factors” would have been enough standing alone; indeed, what would have been enough?

A full length blog post discussing the decision and its implications can be found here.

EDITOR’S UPDATE: On February 20th, the US District for Delaware denied the secured creditor’s emergency motion for direct appeal to the Third Circuit.  Nelly Almeida’s description of the decision and the resulting auction can be found here.