By Daniel J. Merrett (Jones Day) and Mark G. Douglas (Jones Day)
The ability of a bankruptcy trustee or chapter 11 debtor-in-possession (“DIP”) to avoid fraudulent transfers is an important tool promoting the bankruptcy policies of equality of distribution among creditors and maximizing the property included in the estate. One limitation on this avoidance power is the statutory “look-back” period during which an allegedly fraudulent transfer can be avoided—two years for fraudulent transfer avoidance actions under section 548 of the Bankruptcy Code and, as generally understood, three to six years if the trustee or DIP seeks to avoid a fraudulent transfer under section 544(b) and state law by stepping into the shoes of a “triggering” creditor plaintiff.
The longer look-back periods governing avoidance actions under various state laws significantly expand the universe of transactions that may be subject to fraudulent transfer avoidance. Indeed, under a ruling recently handed down by the U.S. Bankruptcy Court for the Western District of North Carolina, the look-back period in avoidance actions under section 544(b) may be much longer—10 years—in bankruptcy cases where the Internal Revenue Service (“IRS”) or another governmental entity is the triggering creditor. In Mitchell v. Zagaroli (In re Zagaroli), 2020 WL 6495156 (Bankr. W.D.N.C. Nov. 3, 2020), the court, adopting the majority approach, held that a chapter 7 trustee could effectively circumvent North Carolina’s four-year statute of limitations for fraudulent transfer actions by stepping into the shoes of the IRS, which is bound not by North Carolina law but by the 10-year statute of limitations for collecting taxes specified in the Internal Revenue Code.
Zagaroli does not break new ground on the power of a bankruptcy trustee or DIP to bring avoidance actions under section 544(b) of the Bankruptcy Code. Nevertheless, the court’s endorsement of the majority approach on the availability of a longer look-back period in cases in which the IRS is a creditor is notable. Widespread adoption of this approach could significantly augment estate avoidance action recoveries.
The full article is available here.
By Ronit J. Berkovich (Weil)
In a recent decision, In re Energy Future Holdings Corp., 2021 U.S. App. LEXIS 7400 (3d Cir. 2021) (“EFH II”), the Third Circuit held that a stalking horse may assert an administrative expense claim under section 503(b)(1)(A) of the Bankruptcy Code for certain transactional expenses, even when it is not entitled to a termination fee.
In EFH II, the debtors terminated a merger agreement with a stalking horse and the stalking horse applied for payment of a termination fee. After the application was denied, the stalking horse filed an administrative expense application for costs incurred in attempting to complete the merger. In response, various bondholders jointly filed a motion to dismiss and a motion for summary judgment. After the Delaware Bankruptcy Court granted the bondholders’ motions, the Third Circuit ruled that the administrative claim should not have been denied without further factual inquiry because the stalking horse plausibly alleged that it benefited the estate by providing information, accepting risks, and paving the way for a later successful deal.
In so holding, the Third Circuit applied a broad standard for pleading a plausible administrative claim under section 503(b)(1)(A). Going forward, it may be harder to obtain denial of an administrative expense application in the Third Circuit without a discovery process and evidentiary hearing. While this decision establishes an alternative means for stalking horses to recover certain transactional expenses, its actual impact remains to be seen, as parties can draft provisions in transactional documents to address the scope of recoverable administrative claims.
The full article is available here.
By Allison Buccola (Independent) and Vince Buccola (Assistant Professor, The Wharton School)
Puerto Rico’s Title III proceedings under PROMESA mark the return of debt repudiation as a feature of the government debt restructuring landscape. Backed by an official committee, the Federal Oversight and Management Board has argued that some $6 billion of bonds the Commonwealth issued are void and worthless. According to the Board, the bonds were sold illegally, in contravention of a constitutional debt limit, so that (also according to the Board) they cannot bind the Commonwealth. A similar argument was lodged in Detroit’s bankruptcy. For the better part of a century before that, however, repudiation was mostly unheard of in the United States.
The invocation of ultra vires to escape bond obligations is nothing new, though. In the second half of the nineteenth century, municipal debtors frequently welched on their debts. In the 1850s and 1860s, cities, towns, and counties across the Midwest and West issued bonds to finance the construction of railroads and other infrastructure. Many ultimately defaulted. Rather than simply announce that they couldn’t or wouldn’t pay, however, they often contended that they needn’t pay: for one or another reason, the relevant bonds had been issued ultra vires and so were no obligation of the municipality at all. Litigation in the federal courts was common. Several hundred repudiation disputes made their way to the Supreme Court in the forty years starting 1859.
With an eye to the modern cases, we set out to understand how the Court reckoned with repudiation. We read every one of the 196 cases in which the Justices opined on bond validity (i.e. the enforceability of a bond in the hands of innocent purchasers). In a recently published article, we correct received wisdom about the cases and remark on the logical structure of the Court’s reasoning.
To the extent the municipal bond cases are remembered, modern scholars usually think of them as exemplary instances of a political model of judging. The caricature has the Court siding with bondholders even when the law called on them to rule for the repudiating municipalities. The Justices—or a majority of them—are imagined as staunch political allies of the capitalist class, set against the institutions of state government and their regard for agricultural interests. We find that this picture is inconsistent with reality. In fact, the Court ruled for the repudiating municipality in a third of all the validity cases. As importantly, the Court’s decisions reflected a readily articulable formal logic, a logic the Justices seem, to our eyes, to have applied soundly.
The Court’s analytical approach traded on a distinction between legal and factual bases for repudiation. A municipality might repudiate either on a theory that no legal authority permitted the contested bond to be issued under the circumstances the bondholder alleged or, alternatively, on a theory that the circumstances alleged did not in fact pertain. Where the theory of repudiation turned on a legal predicate, the Court simply proceeded to the merits, comparing the bond to the powers granted to the issuer by state law at the time of issuance. Repudiating municipalities often prevailed.
Where the theory of repudiation turned on a factual predicate, by contrast, bondholders fared much better. The defining theme in such cases was a procedural mechanism that precluded assessment of the merits, namely the adaptation of estoppel doctrine to the municipal context. It was, and still is, customary for bonds to recite circumstances relevant to issuance. Estoppel allowed buyers in the secondary market to credit whatever facts—but only facts—the issuer declared true at the time of issuance. In a number of debt-limit cases reminiscent of Puerto Rico, this logic propelled bondholders to a judgment. Estoppel did not resolve all fact-based repudiation arguments. It did not foreclose a trial if, for example, the contested bond failed to recite a predicate fact. Nevertheless estoppel was an important feature of the bond cases, one which, given the profound asymmetry of information that prevailed with respect to matters of fact, probably helped to sustain the bond market as a source of capital for municipal development.
The article can be found here.
By Edward J. Janger (Professor, Brooklyn Law School) and Stephan Madaus (Professor, Martin-Luther-University Halle-Wittenberg)
The Nortel bankruptcy case is simultaneously the biggest success and biggest failure in the recent history of cross-border restructuring practice. On the plus side, the coordinated sale of an insolvent telecom firm’s key assets created a pool of value worth $7 billion—much larger than could have been accomplished through piecemeal local liquidation of spectrum licenses and intellectual property rights. On the minus side, the fights over value allocation swallowed up a gargantuan part of that value—an estimated $2.6 billion.
This article suggests a simple, perhaps naïve, solution to this problem. The fights centered on alleged entitlements to priority—upward deviations from equal treatment and pro rata distribution. These fights were complicated by Nortel’s structure as a global corporate group. The claims were based on, among other things: (1) liens; (2) corporate structure; (3) territorial jurisdiction; and (4) local statutory priorities. Interactions among these claims to priority made it virtually impossible to unscramble the egg. In our view, a straightforward solution to this problem is to remember that a creditor asserting priority has the burden of establishing the realizable value of its claim to priority in excess of its pro rata distribution.
The article proceeds in three steps.
First, it describes the current architecture for dealing with the insolvency of corporate groups and the problem posed by cases like Nortel and Lehman.
Second, it details the various types of claims to priority that can exist within a corporate group and explores the nature of priority. It then develops the concept of “homeless value” and the “rump estate.” Claims to priority may be hierarchical or they may be plural. They may be traceable to assets, countries, or entities, or they may inhere in the group. Regardless, when a firm continues to operate in bankruptcy (or is sold as a going concern), the relative position of the claimants must be fixed at the outset. Thereafter, subject to respecting the priority of the newly fixed claims, governance should be situated with the variable claimants to this unsituated value—the “rump estate.” These claimants are the ones who will benefit from any increase in value and pay for any decrease.
Third, the article suggests an approach to value allocation that would vastly simplify cases like Nortel, but which also provides a mechanism to allocate value in rescue cases where the firm continues to operate. The simple point is that priority claimants should have the burden of establishing the realizable value of their priority. This requirement establishes an entitlement floor for, and limits the veto rights of, these priority claimants. As such, it provides a legal default for allocating value in going concern sale cases, and a cram-down standard for restructurings.
The full article is available here.
By Jared A. Ellias (Bion M. Gregory Chair in Business Law and Professor of Law, UC Hastings College of Law) and George Triantis (Professor of Law and Business, Stanford Law School)
It is widely recognized that bankruptcy law can stymie regulatory enforcement and present challenges for governments when regulated businesses file for Chapter 11. It is less-widely understood that bankruptcy law can present governments with opportunities to advance policy goals if they are willing to adopt tactics traditionally associated with activist investors, a strategy we call “government bankruptcy activism.” The bankruptcy filings by Chrysler and General Motors in 2009 are a famous example: the government of the United States used the bankruptcy process to help both auto manufacturers resolve their financial distress while promoting the policy objectives of protecting union workers and addressing climate change. A decade later, the government of California applied its bargaining power and used an innovative state law in the Pacific Gas & Electric Company’s Chapter 11 case to protect climate policies and the victims of wildfires. These examples illustrate that, by tapping into the bankruptcy system, governments gain access to the exceptional powers that a debtor enjoys under bankruptcy law, which can complement the traditional tools of appropriations and regulation to facilitate and accelerate policy outcomes. This strategy is especially useful in times of urgency and policy paralysis, when government bankruptcy activism can provide a pathway past veto players in the political system. However, making policy through the bankruptcy system presents potential downsides as well, as it may also allow governments to evade democratic accountability and obscure the financial losses that stakeholders are forced to absorb to help fund those policy outcomes.
The full article is available here.
By Noam Sher (Assistant Professor of Law, Ono Academic College, Israel)
In a recent article, I present a new theory for analyzing bankruptcy-reorganization proceedings, as well as a reorganization mechanism for public companies that may best meet legislative objectives: maximizing firm value and dividing it according to the claimants’ legal priorities. Called Gordian knot theory, the article suggests that there is a strong structural and material connection between reorganization stages, whereby bargaining and litigation between the claimants over the reorganization pie lead to progressive destruction of the firm’s value and infringement on their legal rights. To demonstrate this theory, this Article focuses on reorganization’s allocation and reallocation stages—where the claimants’ original and new rights are determined, respectively—and how the connection between them prevents the bankruptcy proceedings’ legislative objectives from being met. Alternative approaches suggested for attaining these objectives, including Roe’s, Bebchuk’s, Baird’s, Aghion, Hart and Moore’s, and Adler and Ayres’ models, have focused on the firm valuation problem and suggested solving it by market mechanisms. The Gordian knot theory suggests, however, that it is impossible to attain the legislative objectives strictly by determining the firm’s value efficiently while leaving allocation problems to bargaining and litigation.
This article further presents a new mechanism for public companies, the reorganization without bankruptcy mechanism. This mechanism overcomes the aforementioned allocation problems by structuring reorganization in a single shot that includes the allocation and reallocation of rights, while eliminating the need for bargaining and court proceedings. The mechanism is based around the existing requirement for a firm’s auditors to issue a going-concern warning when there is substantial doubt as to whether the firm can remain solvent over the next twelve months. Under the proposed mechanism, the warning initiates twelve months of voluntary rehabilitation. Then, if the warning is still in place, the junior classes will be able to buy out all of the senior classes at a price of the latter’s claims, similar to Bebchuk’s options model. A successful buy erases the original debt. If the claimants do not purchase the firm, it is considered insolvent.
This Article presents the mechanism and discusses its advantages: inter alia, in the pre-bankruptcy period, the firm is solvent, it has not breached its contracts, and it is not involved in complex allocation disputes. These advantages bring the reorganization process in line with the legislative objectives, and permit firms to achieve rehabilitation by allowing for funding based on market mechanisms and management’s sole discretion, providing management with incentives for adequate disclosure, and initiating rehabilitation based on objective criteria — all free of bargaining and litigation biases.
The full article can be found here.
By Jordan Neyland (Assistant Professor of Law, Antonin Scalia Law School at George Mason University) and Kathryn St. John (Legal Associate, Supreme Court of Victoria)
One of the most important decisions that firms and courts face in bankruptcy is how to dispose of company assets. The differences between the available options are not trivial. A popular mechanism is contained in §363 of the bankruptcy code, which enables the sale of a firm’s assets with court approval. This allows for a quick sale of a firm without the need for developing and approving a plan of reorganization under Chapter 11, which can save both time and money, as the firm’s assets may otherwise sit idle or depreciate.
Despite the benefits of a quicker resolution, 363 sales are contentious because certain classes of claimants, particularly shareholders and unsecured creditors, may lose a valuable opportunity to “wait and see” if the value of the assets will increase. Given that unsecured creditors and shareholders are last in line to get paid, they may gain if the asset value increases, whereas secured creditors prefer a quick sale to cash out before any value is potentially lost. But how much shareholder and unsecured creditor wealth is lost as the lottery-like opportunity, or “option” to wait, disappears? Without an active market for these rights, this value is unseen, yet very real.
In a recent article, we investigate the value of this option and how it affects the wealth of the parties to the bankruptcy. We use well-established financial models (i.e., Black-Scholes-Merton) to put a dollar value on how much shareholders lose with the approval of a 363 sale. We take numerical values from the seminal case In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), which provides an ideal case study because most of the firm value was from equity holdings in a publicly traded company.
The results are dramatic. Under certain conditions, shareholders stand to lose value worth more than one quarter of total firm assets from a 363 sale. That is, by forgoing the “wait and see” option, shareholder value decreases from around one quarter of the firm’s assets to close to zero. In the Lionel case, where the value of the firm’s assets was about $170 million, this decline in value equates to wiping out nearly $45 million in shareholder wealth. Higher priority claimants capture that value.
Even under more conservative estimates, we show that shareholder and lower-priority creditor wealth is dramatically affected by the loss of the “wait and see” option. Large amounts of wealth may be transferred from shareholders to creditors by bringing forward assets sales by just a few months.
We identify factors that are likely to influence the magnitude of the “hidden” shareholder and lower-priority creditor wealth loss. These include the volatility and value of the asset to be sold, in addition to the difference between the time required to arrange an asset sale and the time it may take to finalize a plan of reorganization. We note that the current common law rules governing 363 sales do not require consideration of this set of factors, which are potentially more value-relevant than factors, such as asset depreciation, that courts currently use to determine whether a business justification for a sale exists.
We suggest that courts consider the factors identified in our analysis and the “hidden” wealth effects when deciding whether to approve a 363 sale. This consideration should improve courts’ understanding of parties’ stakes and incentives, leading to better informed decision-making.
The full article is available here.
By Anthony J. Casey (Professor, The University of Chicago Law School) and Joshua Macey (Assistant Professor, The University of Chicago Law School)
The United States Bankruptcy Code gives debtors wide discretion to reorganize in the venue of their choice. These lenient venue selection rules long have allowed bankruptcy courts in the District of Delaware and the Southern District of New York to dominate the market for large Chapter 11 cases, though recently the Southern District of Texas has also begun to attract a large number of cases.
This state of affairs has produced a vigorous debate. Critics of liberal venue rules charge that bankruptcy districts are engaged in a “race to the bottom” as judges compete for blockbuster cases. Others counter that competition for cases improves efficiency and predictability as judges develop expertise in overseeing large Chapter 11 cases.
This Article cautions that developments in foreign jurisdictions may limit the effectiveness of these venue reform proposals. In recent years, foreign jurisdictions have emerged as convenient forums for distressed debtors. For instance, in many cases, the English scheme of arrangement now represents a viable alternative to the American bankruptcy system, and over the past decade, a number of companies have chosen to use an English scheme of arrangement to restructure their debt instead of chapter 11, with the first United States-headquartered business doing so in 2019. Other jurisdictions have also sought to entice foreign debtors, with insolvency specialists speculating that Singapore, in particular, could become a restructuring hub.
Because American bankruptcy courts freely recognize foreign insolvency proceedings, firms that are directed to file in less favored districts may instead choose to reorganize in a foreign jurisdiction. In this environment, attempts to limit venue selection within the United States will have the opposite of their intended effect, replacing domestic venue shopping with even worse global forum shopping. By ignoring the availability of global forums, current venue reform proposals could, perversely, drive opportunistic debtors and creditors to restructure in foreign jurisdictions.
To address this, we argue that, rather than limit domestic venue choice, lawmakers should: (1) support the development of ex ante commitment to mechanisms for choosing venue and forum; and (2) whenever possible, resolve inconsistencies in substantive law across venues and forums. These are general principles of reform, and the implementation will depend on context. For example, commitment mechanisms look different for venue than they do for forum. But, if designed properly, these measures can reduce the costs of venue and forum shopping without giving up the benefits that come from allowing some choice of venue and forum.
It is worth noting that the merits of our proposal are independent of one’s view on the current state of venue shopping. If venue shopping is a real problem, the principles we introduce address that problem. If venue shopping is not a problem, the principles do no harm and even expand the choice set for debtors. Similarly, while the principles address the problem of global forum shopping, the benefits with regard to venue shopping exist with or without global forums. The same cannot be said of the status quo or the reforms currently being considered.
The article can be found here.
By Edward J. Janger (Professor, Brooklyn Law School) and Adam J. Levitin (Professor, Georgetown University Law Center)
In Distorted Choice in Corporate Bankruptcy, David Skeel offers a nuanced description of restructuring support agreements (RSAs) and how they can help a debtor to achieve the necessary consensus around a proposed Chapter 11 plan of reorganization. We take issue, however, with Skeel’s permissive view toward RSAs that permits provisions that would short circuit the “process” protections contained in Chapter 11. Such provisions include pre-disclosure lock-ups, milestones, and coercive deathtraps.
Chapter 11 contemplates bargaining in the shadow of certain basic statutory “distributional” entitlements: equal treatment, best interests, full cash payment of administrative expenses, and a guaranteed minimum-cramdown distribution. As such, RSAs can either reinforce the link between entitlement and distribution, or they can sever it.
In our view, Skeel insufficiently appreciates the purpose of process—how procedural protections such as classification, disclosure, and solicitation surrounding the vote forge the crucial link between bankruptcy bargaining and core principles of corporate governance and pre-bankruptcy entitlement. We offer, instead, an approach which sorts between process-enhancing RSAs and those that facilitate end-runs.
The article can be found here.
By Amir Licht (Professor, Interdisciplinary Center Herzliya, Israel)
In several common law jurisdictions, creditors of corporate debtors enjoy legal protections through vicinity-of-insolvency fiduciary duties, beyond what their contracts with those companies afford them. These duties form a notoriously murky area, where legal space warps. The contours of this area are fuzzy. Courts openly acknowledge that it is difficult to identify clear guideposts for its threshold—as to when exactly these duties are enlivened. In a forthcoming article, I purport to make two main contributions. First, the article expands the theoretical basis for a special legal regime in virtually insolvent firms by pointing out escalation of commitment as a potent and relevant factor that has been largely overlooked by insolvency scholars. Second, this article addresses the substantive content of the duty to protect creditors where such duties are recognized.
The standard account that is usually invoked to explain and justify special fiduciary duties to consider creditors’ interest points to the danger of opportunistic high-risk behavior by managers on behalf of shareholders. I argue that this account may be sound but is nonetheless lacking. In addition to such risk-shifting opportunism, lawmakers should also be mindful of managers’ tendency to unjustifiably continue failing projects, known as escalation of commitment. Escalation of commitment refers to a phenomenon, in which people tend to remain married to their original choices and to commit resources to them even when it is no longer rational to do so. Escalation of commitment is ubiquitous. It has been observed in organizations large and small, in business corporations and in the public sector. Escalation of commitment is not only an irrational and emotional personal behavior. More often than not, it takes place in a broader social context of one’s ingroup—in particular, the board of directors, the organization, and one’s community and culture.
Escalation of commitment poses an equal, if not greater, challenge than risk shifting does to optimal regulation of companies in looming or virtual insolvency. Being largely detached from rational calculations, escalation of commitment presents a more compelling justification for legal regulation, and a more interventionist one at that. In this view, managers—especially owner-managers—of virtually insolvent firms may not enjoy the usual level of deference that the law affords to their business judgment in regular times, as their discretion at that point is prone to be clouded by a misplaced motivation to stay the course, weather the storm, and similarly-spirited no-quitting notions.
Factors that could facilitate de-escalation include better information on costs and benefits of the project, regular evaluation and monitoring of projects, clear criteria for success and minimum target performance levels, and clear feedback about underperforming projects. Such measures will have limited efficacy, however, if the information they generate is interpreted and acted on by decision-makers who have initiated the failing project and even by different persons who are nonetheless related to those decision-makers. Change in management is thus essential.
While Delaware law rejects the idea of a pre-insolvency creditor-focused fiduciary duty, several jurisdictions do recognize duties to protect creditors, either as a duty to consider creditors’ interests or as the rule against wrongful (or insolvent, or reckless) trading. I argue that these duties should be enlivened at the very edge of the zone of insolvency, close to the latter. At that point, the mission of directors should transform from entrepreneurial to custodial. That is, they should implement strategies that aim to preserve the firm—in working condition, to the extent possible, with a view to resuming regular business—but avoid seeking new projects with a view to maximizing profits. This could mean that the shield of the business judgment rule may not be available to the same extent as in regular circumstances. The Covid-19 pandemic that swept the globe in 2020 provides a fresh context for this approach and underscores the need to implement such a regime sensibly, with high deference to business decisions even if outside the scope of the business judgment rule. The article concludes with a comparative analysis of creditor-oriented duties in several common law jurisdictions and examines how they could implement a custodial approach.