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.

The New Bond Workouts

By William W. Bratton (University of Pennsylvania Law School)

Bond workouts are a dysfunctional method of debt restructuring, ridden with opportunistic and coercive behavior by bondholders and bond issuers. Yet since 2008 bond workouts have quietly started to work. A cognizable portion of the restructuring market has shifted from bankruptcy courts to out-of-court workouts by way of exchange offers made only to large institutional investors. The new workouts feature a battery of strong-arm tactics by bond issuers, and aggrieved bondholders have complained in court. A fracas followed in courts of the Second Circuit, where a new, broad reading of the primary law governing workouts, section 316(b) of the Trust Indenture Act of 1939 (“TIA”), was mooted in the Southern District of New York, only to be rejected by a Second Circuit panel.

In “The New Bond Workouts,” Adam Levitin and I exploit the bond market’s reaction to the recent volatility in the law to reassess the desirability of section 316(b). Section 316(b), which prohibits majority-vote amendments of bond payment terms and forces bond issuers seeking to restructure to resort to untoward exchange offers, has attracted intense criticism, with calls for its amendment or repeal. Yet section 316(b)’s staunch defenders argue that mom-and-pop bondholders need protection against sharp-elbowed issuer tactics.

Many of the empirical assumptions made in the debate no longer hold true. Markets have learned to live with section 316(b)’s limitations. Workouts generally succeed, so there is no serious transaction cost problem stemming from the TIA; when a company goes straight into bankruptcy, there tend to be independent motivations. But workout by majority amendment will not systematically disadvantage bondholders.  Indeed, the recent turn to secured creditor control of bankruptcy proceedings makes workouts all the more attractive to them, as their claims tend to be unsecured. Accordingly, we cautiously argue for the repeal of section 316(b). Section 316(b) no longer does much work, even as it prevents bondholders and bond issuers from realizing their preferences regarding modes of restructuring and voting rules. The contractual particulars are best left to the market. Still, markets are imperfect, and a free-contracting regime may result in abuses. Accordingly, repeal of section 316(b) should be accompanied by the resuscitation of the long forgotten intercreditor good faith duties, which present a more fact-sensitive way to police overreaching in bond workouts than section 316(b).

The full paper is available here.


For previous Roundtable posts on Marblegate, section 316(b), and bond workouts, see “Second Circuit Rules on § 316(b) in Marblegate“; Liu, “Exit Consents in Debt Restructurings“; Roe, “The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table.”

Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond

Lawyers from Davis Polk, Drinker Biddle, and Wilmer Hale recently held a panel discussion entitled “Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond.” Jude Gorman of Reorg Research moderated.

The panelists considered the future of out-of-court restructurings and refinancings in light of the Second Circuit’s recent Marblegate decision, the latest development in the litigation between Marblegate Asset Management and Education Management Corp. The panelists discussed several issues surrounding section 316(b) of the Trust Indenture Act (“TIA”), including its underlying policy rationale, how the statute might serve capital markets most effectively, the practical application of 316(b) after the Second Circuit’s decision, and the likelihood of near-term changes to the legal context for out-of-court restructurings. Of particular note, James Millar, of Drinker Biddle, discussed how guarantees of bonds may be treated independently from the underlying bond under the TIA and, hence, subject to 316(b). George Shuster, of WilmerHale, noted that the decision could lead unhappy bondholders to pursue involuntary chapter 11 cases or fraudulent transfer actions. Byron Rooney, of Davis Polk, discussed how the lower court decision in Marblegate had disrupted opinion practice. Finally, Mark Roe emphasized that the SEC has broad authority to issue exemptions, presumably prospectively and generally, as well as on a case-by-case basis; although the SEC has used this authority only occasionally, in theory, bond market players unhappy with the impact of 316(b) could seek conditional exemptions.

Reorg Research’s summary of the session is available here.

(This post comes from Paavani Garg, J.D. ’18.)

 

Three Ages of Bankruptcy

posted in: Workouts and Pre-Packs | 0

By Mark J. Roe (Harvard Law School)

During the past century, three decisionmaking systems have arisen to accomplish a bankruptcy restructuring — judicial administration, a deal among the firm’s dominant players, and a sale of the firm’s operations in their entirety. Each is embedded in the Bankruptcy Code today, with all having been in play for more than a century and with each having had its heyday — its dominant age. The shifts, rises, and falls among decisionmaking systems have previously been explained by successful evolution in bankruptcy thinking, by the happenstance of the interests and views of lawyers that designed bankruptcy changes, and by the interests of those who influenced decisionmakers. Here I argue that these broad changes also stem from baseline market capacities, which shifted greatly over the past century; I build the case for shifts underlying market conditions being a major explanation for the shifts in decisionmaking modes. Keeping these three alternative decisionmaking types clearly in mind not only leads to better understanding of what bankruptcy can and cannot do, but also facilitates stronger policy decisions today here and in the world’s differing bankruptcy systems, as some tasks are best left to the market, others are best handled by the courts, and still others can be left to the inside parties to resolve.

The full article is available here.

Second Circuit Rules on § 316(b) in Marblegate

posted in: Workouts and Pre-Packs | 0

Last week, the Second Circuit decided Marblegate Asset Management, LLC v. Education Management Corp., holding that § 316(b) of the Trust Indenture Act (“TIA”) protects only bondholders’ formal, legal right to repayment, not their practical ability to recover. The Second Circuit’s 2–1 decision thus resolves uncertainty surrounding out-of-court bond workouts and returns to the pre-Marblegate practice.

The majority viewed the statute’s text as ambiguous and consulted the legislative history; it emphasized legislative history supporting the idea that § 316(b) protects only against the formality of a bondholder vote altering payment terms and discarded legislative history to the contrary as shards. The dissent concluded that the transaction “annihilated” a bondholder’s right to payment and, hence, ran afoul of statute’s plain language — which requires that a bondholder’s right to payment cannot be affected or impaired without the affected bondholder’s consent.

Law firms reacted rapidly to the decision. Wachtell Lipton, which represented the winning appellant, and Weil Gotshal both extoll the opinion. Paul, Weiss and Morgan Lewis see in the decision a clear rule that bars only express changes to core terms. Several firms, such as Shearman & Sterling and White & Case, emphasized that the decision will facilitate out-of-bankruptcy restructurings.

Squire Patton Boggs highlights limitations, arguing that the law remains “neither clear nor predictable” on when an out-of-court restructuring goes so far as to impair bondholders’ right to repayment. They caution against assuming that any action short of a direct alteration of core repayment terms is now permissible.

In his American Bankruptcy Institute column, Bill Rochelle notes that the decision’s focus on legislative history, including views contemporaneous with the statute’s passage, was unusual and, by implication, indicates that the dissent’s textual decision-making mode fits better with current Code interpretation. Seyfarth Shaw notes the decision’s limited practical effect because of the widespread use of binding votes in pre-packaged Code restructurings, which avoid § 316(b)’s restrictions.


The Roundtable has posted previously on Marblegate and § 316(b). In one post, Mark Roe argued that bondholders should not be barred by statute from choosing in their indenture whether to be allowed to reposition their bonds via a fair vote. Other posts include a summary of the National Bankruptcy Conference’s proposed amendments to the Bankruptcy Code to facilitate bond restructuring; a 28-law firm legal opinion white paper on transactional complications arising from the Marblegate district court decision; and an international perspective on the TIA’s prohibition on collective action clauses.

Revisiting the Voting Prohibition in Bond Workouts

posted in: Workouts and Pre-Packs | 0

Author: Carlos Berdejó, Loyola Law School, Los Angeles

Economic theory suggests that corporate law should enable parties to contract freely in order to promote their best interests, leading to socially optimal arrangements.  This is particularly true for corporate bonds, which are governed by detailed indentures and held by large, sophisticated investors.  However, the Trust Indenture Act, which for 75 years has regulated the terms of U.S. public corporate debt, contains numerous mandatory rules, including a prohibition on collective action clauses (CACs).  A CAC allows a qualifying majority of bondholders to modify the interest rate, maturity and principal of an outstanding bond issue in a manner that binds all bondholders, including those who may prefer to hold-out to extract a larger payment.  This longstanding prohibition limits the ability of firms to restructure their debt via private workouts and can exacerbate the costs of financial distress by unnecessarily forcing issuers into bankruptcy.  Most countries other than the U.S. do not prohibit CACs and afford parties flexibility in choosing the qualifying majority that may amend the core terms of a bond issue.

My article, Revisiting the Voting Prohibition in Bond Workouts, examines contracting choices in Brazil, Chile and Germany, countries that have recently enacted reforms affecting their bond markets, including changes in restrictions on CACs.  I find that not only do market participants embrace increased flexibility with respect to CACs, but that interest rates decrease as a result, lowering the cost of capital for issuers.

* * *

[Related Work Note: The work in Revisiting the Voting Prohibition in Bond Workouts provides evidence relating to the argument made in Mark Roe, The Voting Prohibition in Bond Workouts, 97 Yale L.J. 232 (1987), that the prohibition unwisely impeded out-of-bankruptcy recapitalizations and channeled some parties’ incentives towards coercive restructurings that would not have been needed if straight-forward votes were allowed.  That article can be found here.  More generally, academic bankruptcy theory has focused on the extent to which contract terms should be respected by law, inside and outside of bankruptcy.  See Alan Schwartz, Bankruptcy Workouts and Debt Contracts, 36 J. of L. & Econ. 595 (1993), available here.  –Stephen Adams, Editor]

“Trade Away!”—Bankruptcy Court for the Southern District of New York Decides That Original Issue Discount From Fair Value Exchanges Is Allowable in Bankruptcy

posted in: Claims Trading | 0

Authors: Richard L. Wynne and Lance Miller, Jones Day

Debt exchanges have long been utilized by distressed companies to address liquidity concerns and to take advantage of beneficial market conditions.  A company with burdensome debt obligations might seek to exchange existing notes for new notes with the same outstanding principal but with borrower-favorable terms (a “Face Value Exchange”).   Alternatively, the company could attempt to exchange existing notes for new notes with a lower face amount (a “Fair Value Exchange”).  Under either scenario, a debt exchange will create “original issue discount” (“OID”) equal to the difference between the face amount of the new notes and the value generated by the exchange for the company (i.e., the fair market value of the old notes).  For tax and accounting purposes, OID is treated as interest that is amortized over the life of the note, with the face amount scheduled to be paid on maturity.

When a company files for bankruptcy, however, unaccrued OID should arguably be disallowed under section 502(b)(2) of the Bankruptcy Code as “unmatured interest.”  However, to encourage out-of-court restructurings, both the Second and Fifth Circuit Courts of Appeal have ruled that unaccrued OID from Face Value Exchanges should not be disallowed.  In In re Residential Capital , LLC, 501 B.R. 549 (Bankr. S.D.N.Y. 2013), the court expanded that rationale to apply to Fair Value Exchanges.  If interpreted broadly and adopted by other courts, the decision will bring certainty to the markets that OID resulting from a debt-for-debt exchange will be allowed in bankruptcy, regardless of how the exchange is structured.

A more detailed discussion of the ruling is available here.