Recent Delaware Bankruptcy Rulings Address Whether a Plan of Reorganization Can Deny a ‘Make-Whole’ Payment Without Impairing Lenders’ Claims

By Ron E. Meisler, Carl T. Tullson, Jennifer Madden, Justin Larsen (Skadden)

A number of recent bankruptcy court rulings have addressed the enforceability of “make-whole” premiums, payments that may be implicated in some loan agreements when debt is prepaid, or in certain cases, otherwise accelerated prior to its stated maturity. Make-whole litigation may turn on subtle distinctions of contractual language and is a zero-sum game where the outcome can be very costly to the borrower and substantially reduce recoveries to other stakeholders. Consequently, when debtors and creditors disagree on whether a make-whole has been triggered, they frequently assert complex and nuanced legal arguments.

In this article, we examine two recent make-whole cases from the Delaware bankruptcy courts: In re Mallinckrodt and In re Hertz. Mallinckrodt addressed whether a debtor’s plan of reorganization could deny payment of a make-whole, reinstate the underlying debt, and treat those claims as unimpaired. In comparison, Hertz considered whether creditors had claims for make-wholes under the specific language of the governing debt documents in the context of a plan that provided for payment of the principal and accrued interest in full, in cash, and therefore deemed those debt claims as unimpaired.

These cases reinforce the importance of carefully drafting make-whole provisions and the important distinction between chapter 11 plan of reorganization treatment, the effect of which could directly impact whether or not such creditors would be entitled to make-whole payments. Moreover, these cases emphasize that the law regarding make-wholes is not settled, and creditors and debtors alike should continue to monitor the evolving case law.

The full article is available here.

Arbitrate? You Can’t Make Me! Rejection Trumps Arbitration, Says Texas Bankruptcy Court

posted in: Bankruptcy, Chapter 11 | 0

By Ronit J. Berkovich (Weil Gotshal & Manges) and Eric Einhorn (Weil Gotshal & Manges)

Eric Einhorn
Ronit J. Berkovich

In a recent decision, In re Highland Cap. Mgmt., L.P.,1 the Bankruptcy Court of the Northern District of Texas held that a debtor’s rejection of an executory contract with an arbitration clause precludes the court from compelling the debtor to arbitrate—notwithstanding the strong federal policy supporting enforcement of arbitration clauses, even in bankruptcy.  Although rejection of a contract constitutes a breach and may give rise to a claim for monetary damages, the Court found that specific performance of an arbitration clause was not an appropriate remedy post-rejection.  Highland provides an example of how bankruptcy courts may disregard contractual provisions—including an agreement to specifically perform—where they may irreconcilably conflict with the policy of the Bankruptcy Code.

The full article is available here.

Senate Judiciary Committee Subcommittee Hearing on the “Texas Two-Step”: A Recap

By Amelia S. Ricketts (Harvard Law School) and Jin Lee (Harvard Law School)

Amelia Ricketts
Jin Lee

On February 8, 2022, the Senate Subcommittee on Federal Courts, Oversight, Agency Action, and Federal Rights held a hearing on the process through which corporations allegedly side-step accountability through divisive mergers undertaken immediately prior to bankruptcy, commonly known as the “Texas Two-Step.”

Companies have used the Two-Step when they have incurred significant liabilities in mass tort cases. The company first changes its state of incorporation to Texas or Delaware. It then carries out a divisive merger, splitting into GoodCo and BadCo. GoodCo retains all of the company assets and the non-tort liabilities, while BadCo retains the mass tort liabilities. BadCo then files for bankruptcy, while GoodCo continues business in the ordinary course. BadCo requests that the automatic stay be extended to GoodCo, preventing tort victims from seeking relief from GoodCo.

Typically, as part of the divisive merger, GoodCo and BadCo execute a funding agreement whereby GoodCo agrees to fund any victims’ trust established in bankruptcy, but usually specifying an amount far below the potential liability. One witness argued that these agreements should assuage concerns about divisive merger bankruptcies, while others argued that they did not offer tort victims real recourse.

Certain witnesses objected to using the Texas Two-Step to obtain the benefits of bankruptcy without the burdens and urged legislative reform to prevent divisive merger bankruptcies. Others argued that the current bankruptcy protections, such as bad faith dismissal and fraudulent transfer law, were sufficient to guard against abuse. However, courts are generally reluctant to dismiss a case for bad faith. Moreover, fraudulent transfer law’s usefulness is also uncertain, because the Texas state law treats the divisive merger transaction as though no transfer has occurred. The witnesses also discussed Johnson & Johnson’s use of the Two-Step as an example and test case for existing protections against abuse.

The full post is available here.

For previous Roundtable posts on the Texas Two-Step, see Samir D. Parikh, Mass Exploitation.

Scarlet-Lettered Bankruptcy: A Public Benefit Proposal for Mass Tort Villains

By Samir D. Parikh (Lewis & Clark Law School)

Samir D. Parikh

Financially distressed companies often seek refuge in federal bankruptcy court to auction valuable assets and pay creditor claims. Mass tort defendants – including Purdue Pharma, Johnson & Johnson, Boy Scouts of America, and USA Gymnastics – introduce new complexities to customary chapter 11 dynamics. Many mass tort defendants engage in criminality that inflicts widescale harm. These debtors fuel public scorn and earn a scarlet letter that can ultimately destroy the value of an otherwise profitable business. Scarlet-lettered companies could file for bankruptcy and quickly sell their assets to fund victims’ settlement trusts. This Article argues, however, that this traditional resolution option would eviscerate victim recoveries. Harsh public scrutiny has diminished the value of the resources necessary to satisfy claims, creating a discount that must be borne by victims.

My public benefit proposal charts a new course. Instead of accepting fire sale prices and an underfunded settlement trust, the scarlet-lettered company emerges from bankruptcy as a corporation for the public benefit. This modified reorganization offers victims the greatest recovery. The continued operation preserves value during a transition period, after which the going concern can be sold efficiently. Further, assets that have been tainted by corporate criminality are cleansed behind a philanthropy shield and sold to capture the value rebound. The victims’ collective is the owner of the new company and can participate in a shareholder windfall if the reorganized company experiences strong post-bankruptcy performance.

At the forefront of a new trend in aggregate litigation, this Article proposes a public benefit alternative to traditional resolution mechanisms. This approach delivers utility that will support application in a variety of contexts, assuming certain governance safeguards are maintained. In our new age of greater personal and corporate accountability, more scarlet-lettered companies will emerge and ultimately land in bankruptcy. The need to address the disposition of tainted assets will be paramount in compensating mass tort victims trying to reassemble fractured pieces. This Article explains a new phenomenon and reconceptualizes resolution dynamics in a way that will have policy implications that transcend aggregate litigation.

The full article will be available at 117 Nw. U. L. Rev. ___ (forthcoming 2022) and can be accessed here.

Ongoing Concern: Bankruptcy and Restructuring Perspectives on Venue Disputes March 4 @ 12:30 pm – 1:30 pm

posted in: Bankruptcy | 0

Please join the Harvard Association for Law and Business (HALB) and the Harvard Bankruptcy Roundtable for our flagship bankruptcy and restructuring panel featuring leaders from across the world of bankruptcy law and finance. Panelists will discuss a current controversy in bankruptcy, venue and forum shopping, from the perspectives of debtor and creditor side lawyers, investment bankers, and judges. In bankruptcy, where a debtor files for bankruptcy can make the difference between satisfactory and unsatisfactory outcomes – between who wins and who loses – and our panelists are experts in this high stakes process with different perspectives on the state of the law. Additionally, panelists will discuss venue reform proposals in Congress.

Confirmed in-person panelists include: Chief Judge Martin Glenn, U.S. Bankruptcy Court for the Southern District of New York; Meredith Lahaie, Partner at Akin Gump; Andy Dietderich, Partner and co-head of the Global Finance & Restructuring Group at Sullivan & Cromwell; and William “Tuck” Hardie, Managing Director at Houlihan Lokey. The panel will be moderated by Mark Roe, the David Berg Professor of Law at Harvard Law School.

The event is on March 4, 2022, at 12:30pm–1:30pm in Milstein West A. Grab and go lunch will be available at the conclusion of the event.

No previous knowledge of bankruptcy or restructuring is required. This event is open to non-law students affiliated with Harvard University. The calendar invite is available here.

Unfortunately, we are not able to accommodate non-Harvard affiliates at this time due to COVID restrictions. 

S.D.N.Y. Judge Holds Bankruptcy Code Prohibits Board-Appointed Officers from Receiving Payments Under a KERP

By Sarah M. Bartlett (Harvard Law School)

Sarah M. Bartlett

On July 9, 2021, Southern District of New York Judge J. Paul Oetken held that §503(c) of the Bankruptcy Code prohibits board-appointed officers from receiving payments under a key employee retention plan (KERP) “absent a particularly strong showing that they do not perform a significant role in management,” as such officers are “insiders” within the definition of §101(31)(B)(ii). In re LSC Communications, Inc., 631 B.R. 818 (S.D.N.Y. 2021). This was the case even though the Bankruptcy Court found that the employees in question were officers “in title only.” Id. at 820. Judge Oetken’s ruling affects six employees who received KERP payments under the reorganization plan of LSC Communications, Inc. (“LSC”), which filed for Chapter 11 relief in April 2020.

In its initial order, the Bankruptcy Court approved payments under the KERP for all 190 covered employees. U.S. Trustee William K. Harrington appealed the decision to the District Court, claiming that, as LSC was incorporated in Delaware, the court should apply Delaware state law, which provides that any person appointed by a corporation’s board of directors is an officer. In response, LSC countered that the employees could not be considered insiders because they lacked any significant decision-making authority.

Judge Oetken wrote that case law regarding who constitutes an “officer” is “less than clear,” noting that the Bankruptcy Code does not define the term or provide any insight regarding its meaning. Id. at 824. Although Judge Oetken rejected the Trustee’s argument that state law exclusively applies when determining whether an employee is an officer under the Bankruptcy Code, he concluded that the Bankruptcy Court erred by looking beyond the fact that the six employees were appointed by LSC’s board.  Even if a court chooses to undertake a more expansive analysis, he wrote, the fact that the six employees were appointed by the board and would be deemed officers under Delaware corporate law should “weigh heavily in concluding that the employees are officers for Bankruptcy Code purposes.” Id. at 826. In supporting his position, Judge Oetken claimed that giving more weight to objective criterion like appointment by the board provides greater clarity to the parties than the kind of “functional, non-exhaustive test” used by the Bankruptcy Court, although he noted that this kind of test may still be appropriate in some cases. Id. at 825.

This case, and its somewhat unusual holding, seems to present a scenario that has become exceedingly rare. In September, the Government Accountability Office (GAO) published a report finding that debtors regularly avoid restrictions in the Bankruptcy Code by paying bonuses before or after filing for bankruptcy or by designating bonuses during bankruptcy as “incentive” payments. The report stated that fewer than 1% of debtors requested court approval to pay employee bonuses during 2020 and, when debtors did seek court approval, the courts approved “nearly all” of those requests. Maria Chutchian wrote in a recent Reuters article that creditors rarely challenge such bonus payments in court, noting debtors will often arrange private deals with creditors before filing for bankruptcy. In the same article, she discusses the Mallinckrodt restructuring, in which the pharmaceutical company’s creditors chose to challenge bonus payments to executives facing accusations of misconduct related to the opioid epidemic. The judge allowed the payments, stating that “mere allegations” of misconduct did not suffice to render them inappropriate.

Finally, Jared Elias concluded in an article published in 2019 that, although fewer companies have used court-approved bonus plans in the years since the Bankruptcy Code’s bonus provisions were reformed in 2005, the overall level of executive compensation has remained the same. This lends support to the GAO’s analysis and the anecdotes collected by Reuters that KERPs are rarely used because parties have ample opportunity to achieve the same end while avoiding the scrutiny of §503(c). He argues that bankruptcy and district court judges are poorly equipped to police payments made before or after a debtor files for bankruptcy, and that the U.S. Trustee’s office and creditors struggle to do so due to information asymmetries and limited resources.

Given the above, it appears that Judge Oetken’s decision this past summer may ultimately prove to be an anomaly. In most cases, these bonus payments simply will not become a part of the bankruptcy plan. Debtors can avoid scrutiny by making payments before or after filing for bankruptcy. If they decide they must make the payments during bankruptcy, they can reduce the scrutiny they will incur by recharacterizing them as  incentive payments, thereby avoiding the heightened restrictions that apply to KERPs. And, even if they decide to include the payments in their restructuring plan, it seems unlikely that creditors will challenge the payments—particularly if counsel has chosen to arrange a deal behind the scenes to avoid a dispute in court.

J. Crew, Nine West, and the Complexities of Financial Distress

By Kenneth Ayotte (University of California – Berkeley School of Law) and Christina Scullly (University of California – Berkeley School of Law)

Kenneth Ayotte
Christina Scully

The Nobel laureate Herbert Simon describes a complex system as one “made up of a large number of parts that interact in a nonsimple way.” The modern large Chapter 11 fits this definition quite well. Debt contracts with overlapping provisions lie within capital structures with multiple classes of claims, layered across numerous legal entities. Distressed restructuring transactions give rise to complex litigation over entitlements to the firm’s value. Bankruptcy case governance strategies are driven by intercreditor and restructuring support agreements that are constantly evolving.

Traditional law and economics theory of bankruptcy has little to say about this complexity, except to assume that rational, forward-looking “sophisticated parties” have anticipated it and managed it optimally. Taken to its logical conclusions, this perspective leaves no useful role for bankruptcy law. After all, if some feature of the Bankruptcy Code were useful, sophisticated parties would find a way to put it in their contracts. Mandatory features, even bedrock ones like the automatic stay, become no more than harmful interferences with contractual freedom.

Simplified models that assume omnisciently rational actors are useful tools in corporate finance: they isolate the forces that drive capital structure decisions and generate testable empirical predictions. But as normative models of bankruptcy law design, they are fundamentally flawed. We provide two case studies, one involving a complex contract (J. Crew), and another involving a complex capital structure (Nine West). Taken together, they suggest that it is time for law and economics scholars to take the uncomfortable but necessary step to acknowledge bounded rationality. Bankruptcy law must function not just for the optimal contracts a theorist derives, but also for the “good enough” contracts parties actually write, and the unpredictable interactions these imperfect contracts can generate.

Our first case study recounts the narrative behind the J. Crew restructuring, the most well-known of many “liability management transactions” that have become part of the distressed borrower’s playbook. The J. Crew case illustrates how a complex loan agreement with numerous interacting terms gives rise to loopholes that sophisticated parties can exploit. We describe the two-step transaction by which J. Crew combined multiple provisions in a term loan agreement to transfer the lenders’ collateral to an unrestricted subsidiary to refinance other debt. Though one particular “trap door” provision received the most public attention, our study reveals that other contractual weaknesses, such as the administrative agent’s low-powered incentives as a lender representative, also enabled the collateral transfer.

The growing importance of liability management strategies suggests that the true effect of greater sophistication is not optimal debt contracts, but instead, a magnification of their inevitable flaws. To understand these trends, we first need a model of contracting where such weaknesses can exist. Acknowledging bounded rationality in contracting is a necessary first step toward an agenda that understands the imperfect ways complex contracts evolve. This agenda can help scholars gain an understanding what drives contractual change, why loopholes form and close, and the costs and benefits of contractual complexity.

A second case study, Nine West, illustrates a “butterfly effect” of complex capital structures: small changes can have large and unanticipated effects when a bankruptcy occurs. Sycamore Capital Partners acquired Nine West and related fashion brands in a leveraged buyout in 2014. It reorganized its corporate structure in the process, leaving most of the debt with Nine West and spinning out other brands to itself, free of debt. An eleventh-hour decision to add more debt to the deal, and to make this debt senior through subsidiary guarantees, gave rise to a dizzyingly complex array of entitlement disputes between parent and subsidiary creditors about the uncertain ownership of assets and responsibility for debts across the entities in the Nine West corporate group. These disputes contributed to the exorbitant professional fees incurred in the bankruptcy case that consumed over 20% of the company’s enterprise value. 

Insights from the study of complex systems can more realistically inform our models of bankruptcy law design. For example, an important feature of complex systems design is robustness: the system must be able to function effectively under suboptimal conditions. Features like the automatic stay and judicial oversight play a valuable role in preventing imperfections and gaps from propagating. Because interactions across contracts are most likely to lead to unanticipated effects, a perspective based in bounded rationality is also consistent with bankruptcy’s special role as a tool for addressing multiple creditor problems. Overall, we believe there is significant insight to be gained from the recognition that even sophisticated parties are imperfect.

The full article is available here.

Creditor Rights, Corporate Leverage and Investments, and the Firm Type

By Aras Canipek (University of Konstanz), Axel H. Kind (University of Konstanz), and Sabine Wende (University of Cologne – Faculty of Management, Economics and Social Sciences)

Aras Canipek
Axel Kind
Sabine Wende

Stronger creditor rights reduce credit costs and thus may allow firms to increase leverage and investments, but also increase distress costs and thus may prompt firms to lower leverage and undertake risk-reducing but unprofitable investments. Using a German bankruptcy reform, we find evidence on average consistent with the latter hypothesis. We also hypothesize and find evidence that the effect of creditor rights on corporate leverage and investments depends on the firm type, as it influences the effect creditor rights have on credit costs and distress costs and thus which effect dominates. For example, our findings suggest that stronger creditor rights are costly for large firms, for which the effect of creditor rights on distress costs should outweigh the effect on credit costs, but beneficial for small firms, for which the effect on credit costs should outweigh the effect on distress costs. Our understanding not only reconciles the mixed empirical evidence of existing studies, but also has important implications for optimal bankruptcy design. In particular, our findings are contrary to a widely held opinion that bankruptcy law should be uniform and balance the effect of creditor rights on credit costs and distress costs. Rather, they point to a menu of procedures in which a debtor-friendly and creditor-friendly procedure co-exist and thus allow different types of firms to utilize the procedure that suits them best. If such a menu is not possible, our analysis suggests that countries should choose a debtor-friendly or creditor-friendly procedure, depending on the most important firm type in the country.

The full article is available here.

Congressional Committees Propose Changes to Bankruptcy Code Prohibiting Non-Consensual Releases of Third Parties and Limiting Other Important Bankruptcy Tools

By Michael J. Cohen, Michael A. Rosenthal & Matthew J. Williams (Gibson Dunn)

The recent decision in In re Purdue Pharma did not uphold the third-party releases in the bankruptcy court’s approved plan. This post discuss the third-party releases issue.

— Harvard Law School Bankruptcy Roundtable Editors

Michael J. Cohen
Michael A. Rosenthal
Matthew J. Williams

On July 28, 2021, certain Democratic members of Congress, primarily in response to the $4.325 billion contribution made by the Sackler family to fund the settlement underpinning Purdue Pharma’s chapter 11 plan, introduced the Nondebtor Release Prohibition Act of 2021 (the “NRPA”), which proposes to amend the Bankruptcy Code to (i) prohibit the use of non-consensual third party releases in chapter 11 plans, (ii) limit so-called “Section 105” injunctions to stay lawsuits against third parties to a period no greater than 90 days after the commencement of a bankruptcy case, and (iii) provide a ground for dismissing a bankruptcy case commenced by a debtor that was formed within 10 years prior to such case via a divisional merger that separated material assets from liabilities.

When viewed against the backdrop of current complex chapter 11 practice, the NRPA is a flawed remedy for issues for which alternative means of redress already exist. First, the proposed elimination of the important bankruptcy tools of non-consensual third party releases and Section 105 injunctions – each of which is extraordinary in nature and only permitted in the rarest of circumstances – is a blunt force measure that threatens to vitiate the longstanding bankruptcy policy of favoring settlements over interminable value-destructive litigation.  Second, the loss of these tools may cause inequitable disruption in currently pending cases and stymie the implementation of critical creditor-supported strategies to resolve the most difficult cases going forward.  Moreover, a per se prohibition against non-debtor releases would contravene core bankruptcy principles by elevating the interests of a minority of creditors who would otherwise be bound to the terms of a chapter 11 plan containing such a release that is supported by the requisite majorities required under the Bankruptcy Code.  Third, while the disincentive against divisional mergers would affect a far more limited set of cases, it appears that the harm raised by some divisional mergers that are followed by bankruptcy may be adequately addressed through clarifying the applicability of fraudulent transfer law to challenge these transactions.

On November 3, 2021, the House Judiciary Committee sent the NRPA to the House floor for further consideration; the Senate Judiciary Committee has yet to act on the bill.  For more detail on the NRPA and our analysis of the bill, please find the full article here.

Mandatory Aggregation of Mass Tort Litigation in Bankruptcy

By Ralph Brubaker (James H.M. Sprayregen Professor of Law, University of Illinois College of Law)

The recent decision in In re Purdue Pharma did not uphold the third-party releases in the bankruptcy court’s approved plan. This post discuss the third-party releases issue.

— Harvard Law School Bankruptcy Roundtable Editors

Ralph Brubaker

This response to Professor Lindsey Simon’s Bankruptcy Grifters article challenges the controversial practice at the epicenter of the bankruptcy grifter phenomenon that Simon critiques: so-called nonconsensual nondebtor (or third-party) “releases” and “channeling” injunctions that discharge the mass tort obligations of solvent nondebtor entities who have not themselves filed bankruptcy. These nondebtor releases are an illegitimate and unconstitutional exercise of substantive lawmaking powers by the federal courts that contravenes the separation-of-powers limitations embedded in both the Bankruptcy Clause and Erie’s constitutional holding. The federal courts have manufactured out of whole cloth the unique, extraordinary power to impose mandatory non-opt-out settlement of a nondebtor’s mass tort liability on unconsenting tort victims through the bankruptcy proceedings of a codefendant. The bankruptcy “necessity” that supposedly justifies this astounding and unique settlement power—to mandate nonconsensual non-opt-out “settlements” that are otherwise impermissible and unconstitutional—is (at best) naive credulity or (at worst) specious sophistry.

Nonconsensual nondebtor releases are not “necessary” for the bankruptcy process to facilitate efficient aggregate settlements of the mass tort liability of both bankruptcy debtors and nondebtor codefendants. The bankruptcy jurisdiction, removal, and venue provisions of the Judicial Code already contain the essential architecture for mandatory, universal consolidation of tort victims’ claims against both bankruptcy debtors and nondebtor codefendants. Bankruptcy can be an extremely powerful aggregation process that facilitates efficient (and fair) settlements of the mass tort liability of nondebtors, even (and especially) without nonconsensual nondebtor releases, particularly if the Supreme Court elucidates the full expanse of federal bankruptcy jurisdiction. Nondebtor releases are an illicit and unconstitutional means of forcing mandatory settlement of unconsenting tort victims’ claims against solvent nondebtors, and the Supreme Court should finally resolve the longstanding circuit split over the permissibility of nonconsensual nondebtor releases by categorically renouncing them.

The full article is available here and is forthcoming in the Yale Law Journal Forum.

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