Holdout Panic
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates, Insider Status | 0

By Stephen J. Lubben (Seton Hall Law School)

Stephen J. Lubben

It has been recognized that corporations themselves are designed to promote collective action, and thus “a primary function of corporate law is to coordinate and constrain individual behavior – even profit-motivated behavior.”  Given that corporate debt instruments largely serve a governance function amongst creditors, it is not surprising that they, like corporations themselves, tend to quash individual action in favor of the group.  But the divergence between individual and group interests comes to the fore in times of stress.

An individual creditor can be either an oppressed minority investor or a holdout.  Majority holders can be either the group seeking an efficient and beneficial restructuring, or effectively an insider group that collaborates with more formal insiders to extract value from minority creditors.  Which reality is genuine is highly dependent on the particular facts of the case at hand, and may be quite difficult for an outsider to discern.

Restructuring law attempts to balance this uncertainty by providing a series of checks and balances.  In general, restructuring law begins with a preference for the collective, but encircles the collective with a series of rules that protect individual creditors from abuse.  

Some of the balance comes from the agreements that create the creditor relationship or duties related to those agreements; however, other aspects of balance are external and come from outside structures like the Bankruptcy Code or the Trust Indenture Act.  In general, the basic challenge here is to find the point at which the illegitimate power of holdouts is reduced without trampling on the legitimate rights of minority creditors.  It is very easy to avoid holdouts if the majority always wins.

My paper explores the ways in which modern restructuring practice has moved toward that “majority always wins” extreme.  This change was not part of some grand plan, but rather the result of a series of incremental decisions, each reacting to perceived abuses by holdouts.  But in indulging our fears of holdouts, we have lost the essential balance of the system.

Take the example of the RSA – or restructuring support agreement – that, in a variety of ways, can represent a generalized assault on the requirement in section 1123(a)(4) that a chapter 11 plan must “provide the same treatment for each claim or interest of a particular class.”  RSAs achieve this end by providing for backstop fees paid to a select group that will never have to backstop anything or DIP loans that the debtor does not really need.

In one recent case, pre-bankruptcy the debtor contracted with a sub-group of its secured noteholders to have those noteholders make an interest payment on the notes.   That is, some of the secured noteholders paid the interest payment due to all the secured noteholders.

In exchange, these distinctive noteholders received new “super-priority secured notes” secured by a lien that surpassed the old secured notes’ liens, while also carrying a hefty 10% coupon.  When the debtor filed for chapter 11 later that same year, to implement its own RSA-driven plan, the new super-priority notes were paid in full, with interest and “make whole call” fees.  In short, the select lenders made a small, six-month loan for a very high return at low risk.  This opportunity was not available to everyone in the original class of noteholders.

In short, I conclude that the modern American restructuring system has evolved to favor the interests of the majority to the point where a debtor and a majority of its lenders can inflict serious harm on minority creditors.  At some point, this reality is bound to have consequences for both the debt markets and the utility of chapter 11.

The full article is available here.

Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain
by | posted in: Cramdown and Priority | 0

Post by Frederick Tung, Professor at Boston University School of Law

In “Breaking Bankruptcy Priority:  How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, Mark Roe and I question the stability of bankruptcy’s priority structure and suggest a new conceptualization of bankruptcy reorganization that challenges the long-standing creditors’ bargain view. Bankruptcy scholarship has long conceptualized bankruptcy’s reallocation of value as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of statutory and agreed-to contractual priorities.

In “Breaking Priority,” we propose an alternative view. No hypothetical bargain is ever fully fixed because creditors continually attempt to alter the priority rules, pursuing categorical rule changes to jump ahead of competing creditors. These moves are often successful, so creditors must continually adjust to other creditors’ successful jumps. Because priority is always up for grabs, bankruptcy should be reconceptualized as an ongoing rent-seeking contest, fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps.

We highlight a number of recent and historical priority jumps. We explain how priority jumping interacts with finance theory and how it should lead us to view bankruptcy as a dynamic process. Breaking priority, reestablishing it, and adapting to new priorities is part of the normal science of Chapter 11 reorganization, where bankruptcy lawyers and judges expend a large part of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.

The paper is available here.