Disagreement and Capital Structure Complexity

By Kenneth Ayotte (University of California, Berkeley School of Law)

Complex capital structures are prevalent in many recent high-profile Chapter 11 bankruptcy cases.  One recent example is Toys ‘R’ Us, whose debt structure included dozens of subsidiary entities, with separate debt facilities against entities owning the intellectual property, the real estate, and international operations, among other asset groups.  Why do capital structures become fragmented and complex in this way, and what are the implications for bankruptcy law?

In my working paper, I suggest one reason why a firm’s owners may have the incentive to engineer fragmented capital structures, using the idea that investors may disagree about the values of the various assets that make up the firm.  Fragmenting the capital structure horizontally—that is, pledging different assets and asset groups to different creditor classes—allows the firm to sell asset-based claims that are targeted to the investors who value those assets most highly. This targeting is good for the firm’s owners, because it minimizes the firm’s overall cost of capital.

This complexity can become costly, however, when firms encounter financial distress.  The same disagreement-driven fragmentation that allows the company to borrow more cheaply up front can lead to costly valuation disputes in and around bankruptcy, since creditors place a higher valuation on their own collateral than do the other creditors.  This can lead to valuation disputes that are socially costly in terms of professional fees, delays, and lost opportunities.  An example of this is the Energy Future Holdings case.  Following it’s 2007 leveraged buyout, the capital structure was divided into two silos, with one silo of entities (called the “E” side) holding regulated power assets, and a separate silo of entities holding the non-regulated power assets (the “T” side), with separate creditor groups on each side.  The initial plan to avoid bankruptcy by converting E- and T-side debt into parent-level equity failed after more than a year of negotiations, as the two sides could not come to agreement about the relative value of the two sides.  The resulting bankruptcy took over four years to reach plan confirmation and generated over $500 million in professional fees, to the detriment of creditor recoveries.

The theory has several implications.  One is that disagreement about valuation can lead to inefficient liquidation of viable firms, as creditors may prefer to walk away with the collateral they value highly, rather than fight for that value in a reorganization where the other creditors (from their perspective) are clinging to inflated valuations of their own collateral.  These kinds of forces may have been at play in the Toys ‘R’ Us case.  The B-4 term lenders, including the hedge fund Solus Alternative Asset Management, believed they were better off monetizing their intellectual property collateral in a liquidation of Toys ‘R’ Us than backing a deal to keep existing stores open.  The recent cancellation of the auction of this collateral suggests that these lenders may have held optimistic beliefs than the marketplace about the value of these assets.

From an academic standpoint, the theory provides a new answer to a long-standing question in the literature: why do we need a corporate reorganization mechanism in the first place? Traditional answers to this question revolve around the need to solve illiquidity problems.  In the presence of disagreement, I suggest an alternative benefit.  A traditional Chapter 11 reorganization allows parties to walk away with securities backed by the assets they financed before bankruptcy, about which the creditors are likely to be more optimistic.  Thus, the creditors can continue “agreeing to disagree” about the values of their respective pieces, thus promoting settlement and avoiding socially costly valuation disputes.  This is not possible when the firm is sold as a going concern for cash, since cash has a commonly known value.

Finally, my model emphasizes that when capital structures are fragmented, bankruptcy costs can be driven by haggling and litigation over the value of the parties’ entitlements, even when the parties agree about what to do with the bankrupt firm.  This suggests that the time may be ripe for rethinking and improving the resolution of valuation disputes in bankruptcy.  In a related paper, published in University of Pennsylvania Law Review, Edward Morrison and I review valuation opinions in bankruptcy cases.

The full article is available here.

Transplanting Chapter 11 of the US Bankruptcy Code into Singapore’s Restructuring and Insolvency Laws: Opportunities and Challenges

By Gerard McCormack (University of Leeds) and Wai Yee Wan (Singapore Management University – School of Law)

In 2017, Singapore introduced wide-ranging reforms to its insolvency and restructuring laws with a view to enhancing its attractiveness as an international centre for debt restructuring. A key theme of the reforms is the transplantation (with modification) of certain provisions from Chapter 11 of the US Bankruptcy Code including the automatic moratorium, cross-creditor cram-down, rescue financing and pre-packs. These provisions are engrafted into the existing scheme of arrangement framework, which in turn has its roots in the United Kingdom (UK).

In our paper, relying on the US experience and the reactions to similar reform proposals in the European Union (including the UK), we critically evaluate the effectiveness of the legal transplantation and discuss the possible unintended consequences of such transplantation.

We raise three issues. First, the new cross-class cram-down provisions could lead to valuation disputes and satellite litigation, such as whether the directors and scheme managers have properly discharged their duties. Second, the 2017 reforms shift power from the creditors to the management of the debtor company. This may prove to be disadvantageous to creditors in Singapore (and many other Asian countries) where the majority of the companies, including publicly listed companies, have concentrated shareholdings, and managers owe their existence to those who are in control. Finally, there remains the question whether the Singapore schemes will be recognised overseas, which will be important if the scheme proposes to modify debt obligations that are governed by non-Singapore law.

The full article is available here. The article is recently published in Journal of Corporate Law Studies.

 

Valuation Disputes in Corporate Bankruptcy

Kenneth Ayotte (U.C. Berkeley School of Law); Edward R. Morrison (Columbia Law School)

In bankruptcy, valuation drives disputes. Prior bankruptcy scholarship points to disagreements about valuation and judicial valuation error as key drivers of Chapter 11 outcomes. Avoiding valuation disputes and errors is also the underlying driver of most proposed reforms to Chapter 11.

This paper studies all reported bankruptcy court opinions filed between 1990 and mid-2017 that provide detail about a valuation dispute and methodologies employed. We have two goals. The first is to understand how parties and their expert witnesses justify opposing views, and how judges decide between them. The second is to provide practical guidance to judges.

We find sharper disagreement among experts regarding inputs to the discounted cash flow method (DCF) than regarding inputs to multiples-based methods. In nearly half of cases involving DCF, experts fight over the discount rate; in nearly three quarters, they fight over cash flow projections. By contrast, disagreement over inputs to multiples-based methods, such as the choice of comparable companies, occurs in less than a fifth of the cases. This pattern helps explain why many judges view DCF as far more complex and error-prone than multiples-based methods.

There are also surprisingly pervasive (and often self-serving) errors in expert testimony. This is particularly true when valuation experts apply DCF. The choice of discount rates is frequently unsupported by, and often at odds with, finance theory and evidence. We also find experts strategically weighting methods with values most favorable to their clients.

We propose simple strategies based in finance theory that judges can employ to reduce the scope for valuation disagreements in Chapter 11. For example, we argue that courts should reject the use of company-specific risk premia in discount rates and be highly skeptical whenever experts weight some valuation methods more than others in calculating “average” estimated values.

The full article is available here.