Corporate Governance, Bankruptcy Waivers and Consolidation in Bankruptcy

By Daniel J. Bussel (UCLA School of Law)

Bankruptcy law—once the vanguard of enterprise liability —has increasingly tended to kowtow to formalities of corporate law standing in the way of effective reorganization.

In two areas in particular, corporate law is seen by some courts and commentators as imposing rigid and substantive limitations on bankruptcy rights.

First, although bankruptcy courts have long held that access to bankruptcy relief may not be waived in a contract, recent decisions have enforced state corporate law’s choice to defer to contractual governance arrangements baked into corporate charters that hinder or preclude an entity from filing for bankruptcy relief.

Second, influential appellate decisions have pushed bankruptcy courts to respect the legal boundaries between affiliated entities within a corporate group for substantive insolvency law purposes, even as those boundaries are routinely ignored for operational, financial, tax and regulatory purposes.

Professors Baird and Casey, expanding upon earlier work by Professor LoPucki, have noted and embraced this judicial trend toward respecting corporate law formalities.  They have coined the term “withdrawal rights” to describe the phenomenon of prebankruptcy contractual arrangements enforceable under state corporate law that operate to allow a particular creditor to opt-out of the bankruptcy process by segregating key operating assets in entities that are effectively precluded from obtaining bankruptcy relief without the creditor’s express consent.

In CORPORATE GOVERNANCE, BANKRUPTCY WAIVERS AND CONSOLIDATION IN BANKRUPTCY, I argue that these techniques, however clever, run smack into traditional and still vibrant bankruptcy doctrines that find contractual waivers of access to bankruptcy relief void as against public policy, and that permit consolidation of entities whose formal separateness is inconsistent with the actual and effective operation of the corporate enterprise under reorganization.

Thus “Golden Share” arrangements in which a creditor is issued a special class of equity (the Golden Share) and the debtor’s charter is amended to preclude bankruptcy filing absent the Golden Shareholder’s consent, fail as unenforceable contractual waivers of bankruptcy rights.

Moreover, constituents with claims against affiliated companies in bankruptcy proceedings that effectively operate as a unified enterprise should not be surprised when they are treated as a claimant against that unified enterprise, except to the extent that the bankruptcy equities themselves demand otherwise, and so long as the value of their rights in property are adequately protected, even if the formalities of entity separateness are otherwise respected.  The restrictive approach to substantive consolidation adopted by some appellate courts, notably the Third Circuit in Owens-Corning, that encourages reliance on formal entity separation, should be rejected.

Bankruptcy courts are destined to struggle with the problem of withdrawal rights forever. Powerful creditors have never fully accepted the concept that they can be compelled to participate in a collective proceeding in the event of the common debtor’s insolvency and have sought ways to opt out of those proceedings when it is to their advantage to do so. They show no signs of flagging in efforts to structure bankruptcy-remote relations through statutory exceptions and preferences, the creation of property rights in their favor, and contractual strictures. If they have the political strength to carve out express exemptions in the Bankruptcy Code, courts may have little flexibility to prevent the opt-out.

But absent a federal statutory exemption, to the extent that state law corporate formalities manipulated to the advantage of certain constituencies through special contractual arrangements become impediments to effective bankruptcy reorganizations, those formalities are quite properly overridden by bankruptcy law.  Bankruptcy law limits the efficacy of the “Golden Share” and other contractual arrangements incorporated into company charters, and the entity partition techniques observed by LoPucki, Baird and Casey (among others).  Those limits should be factored into market expectations surrounding asset securitization and other structuring techniques designed to avoid the ordinary operation of bankruptcy law upon a particular creditor’s claim. If they are properly factored in, it is difficult to believe that securitization of core assets of non-financial operating companies will remain a cost-effective alternative to more traditional financing arrangements. The market should place little value on a bankruptcy withdrawal right that is likely to prove illusory when it matters most.

The full article is available here.

Creditor Governance

By William R. McCumber (College of Business, Louisiana Tech University) and Tomas Jandik (Sam M. Walton College of Business, University of Arkansas)

A traditional view of creditors is that they are largely passive investors unless a borrower violates the terms of a loan agreement or misses a payment. However, like institutional shareholders, creditors hold concentrated positions in firm securities (loan shares), are sophisticated investors, and have access to senior management and non-public information. Since debt financing is much more common than equity financing, and because the great majority of credit agreements are honored, it is important to better understand how creditors advise and monitor portfolio (borrower) firms. We find that creditors play a significant role in corporate governance under normal circumstances, i.e. when firms are not in technical violation or default. Borrower firms are less likely than non-borrowers firms to file for bankruptcy in the intermediate future, and borrowers shift financial and investment decisions away from value-reducing policies and toward value-creating investments. Importantly, these changes are profitable for borrower firms since both cash flows and returns on assets improve at least three years after loan origination, which in turn decreases creditor portfolio risk. We also find that when creditors retain a larger proportion of the loan on their books, changes in borrower firm financials are more pronounced, providing evidence that creditors exert a greater governing force when more exposed to borrower risk.

The full article is available here.