By Steven T. Kargman (Kargman Associates/International Restructuring Advisors)
The article provides an overview of certain key legal and policy issues that are likely to arise in any eventual Venezuelan debt restructuring. Specifically, the article focuses on what will likely be some of the central elements of any future debt restructuring, including the possibility of debt-for-equity swaps and oil warrants, and it also reviews various considerations in connection with a possible insolvency filing by Venezuela’s state-owned oil company, PDVSA. Further, the article discusses legal and policy considerations related to economic recovery efforts that Venezuela may undertake in the future, including matters related to any efforts to revive Venezuela’s oil industry as well as any attempts to diversify Venezuela’s economy so that it is not so reliant on a single commodity, oil. Finally, the article examines the issue of asset recovery and how a future Venezuelan regime might seek to recover assets that have been misappropriated from Venezuela.
By Edward J. Janger (Brooklyn Law School) and Adam J. Levitin (Georgetown University Law Center)
Business reorganizations are corporate control transactions. When a debtor is insolvent or nearly so, control is in play along two different axes. The first axis allocates control within the existing capital structure. The filing of bankruptcy effectuates a change of control from equity to debt. On the second axis, the company itself is on the auction block, meaning that its assets, or even the entire firm, may be transferred to a new owner. Outside investors may wish to buy the company, and the choice among offers implicates serious governance concerns. This article considers the dynamics of control through the lens of restructuring support agreements (“RSAs”)—contractual agreements among creditors, and sometimes the debtor, to support restructuring plans that have certain agreed-upon characteristics. We conclude that RSAs offer a salutary bridge between the efficiencies of a quick “all asset” sale and the procedural protections of a plan of reorganization. However, they also pose a potential avenue for opportunistic abuse. Specifically, we are concerned with provisions in an RSA that hold value maximization hostage to a reordered priority scheme. Thus, we argue that courts should scrutinize RSAs carefully, and prohibit those that lock in opportunistic value reallocation.
Opportunistic behavior can arise on all sides of restructuring negotiations. Insolvency creates opportunities for creditors (and the debtor) to use transactional leverage to influence the allocation of scarce assets: secured creditors may foreclose; banks may engage in setoff; key suppliers may threaten to stop supplying; landlords can threaten to evict; unsecured creditors may get judgments and start grabbing assets; and purchasers may seek to take advantage of a depressed valuation to purchase the company on the cheap. To the extent that the debtor has value as a going concern, individual creditors may have the power to extort value by threatening to force liquidation. Alternatively, fully secured creditors may prefer a quick realization on their collateral, because they do not benefit from increasing the value of the firm.
The Bankruptcy Code seeks to limit these uses of situational leverage in a number of ways: (1) it stays unilateral creditor action (the automatic stay); (2) it allows for the unwinding of certain prepetition transfers (avoidance); (3) it sets a baseline distribution if the firm liquidates, but promises more if the firm can restructure (best interests/adequate protection); (4) it creates a structured bargaining process that ensures adequate information and reduces the ability of a creditor to holdout in the face of a reorganization plan that is supported by key creditor constituencies (supermajority acceptance); and (5) it sets an entitlement baseline if the firm reorganizes (cramdown). Bargaining in bankruptcy is informed by these procedural requirements and substantive entitlements. If a deal is not reached, liquidation follows.
Recently, in Czyzewski v. Jevic Holding Corp., the Supreme Court raised concerns about procedural innovations that might be used to create “end-runs” around the plan process and these procedural protections. In this regard, RSAs can be a useful tool for aiding compliance with the plan process. However, they are also sometimes also referred to as “lockup” agreements. Once an RSA is proposed and supported by key constituencies, the costs of opposing the contemplated plan may be prohibitive for most creditors. The proposal may operate as a fait accompli. If the RSA freight train is being used to stop creditors from developing information or identifying bases for objection, the device becomes problematic.
The difficulty is distinguishing beneficial RSAs from harmful ones. In our view, a fundamental norm of chapter 11 should govern RSAs, all-asset sales, and a range of other transactions: the common interest in value maximization may not be held hostage by a creditor seeking to improve its own priority. The essay begins by describing the practice surrounding restructuring support agreements and identifies some of the anecdotal concerns raised. We then catalogue the good and bad in RSAs. Next, we illustrate how to distinguish the good from the bad by focusing on bargaining in the shadow of entitlements. Finally, we flesh out the concept of an end-run around the plan process in the context of an RSA and identify “badges of opportunism” that should raise an inference that the practice is being abused.
On January 13, 2020, the United States Bankruptcy Court for the District of Delaware issued an opinion in In re La Paloma Generating Company, LLC., Case No. 16-12700 [Adv. Pro. No.19-50110], which examined the implied covenant of good faith and fair dealing in the context of an intercreditor agreement (ICA) governing the relationship between the First Lien Lender (First Lien Lender) and the Second Lien Lenders (Second Lien Lenders) to the Debtors. The bankruptcy court held a party cannot be in breach of the covenant of good faith and fair dealing under New York law when merely enforcing a contractual right, in this case the First Lien Lender enforcing the ICA.
Fraud and irrationality are often blamed for financial manias and panics. Investor euphoria can unleash social and technological breakthroughs, but the subsequent collapse can destroy value and radicalize the political sphere. Are these events random, idiosyncratic, or driven by some force? The ex-post answers—be they monetary, criminal, or international contagion—have a profound impact on the role of government in society, but have questionable predictive power.
The historical narrative in this article does not argue that overvaluation, changes in money market rates, and fraud play no part in financial panics. However, the instigating events that lead creditors to become sensitive to information which might impair contractual protections suggests that financial panics are reactive to changes in jurisdictional bankruptcy processes. The history of bankruptcy law is intertwined with that of crises and banking law, and—as argued using over 50 case studies spanning the Dutch Tulipomania of 1637 to the Great Recession of 2008—consistently causes and accelerates financial manias and panics.
This narrative can be illustrated by the most recent case study in this article: The Great Recession. Following the earlier Asian Financial Crisis, international investors demanded safe debt. Whereas home mortgages were sensitive to information regarding borrower bankruptcy, these mortgages could become safe debt if default risk were reduced. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) restricted access to bankruptcy in favor of insolvency debt management plans and gave home mortgage lenders priority over other creditors. BAPCPA—along with the Bankruptcy Amendments and Federal Judgeship Act of 1984’s safe harbor around negotiable derivatives, which gave counterparties priority over other creditors—purposely reduced incentives to monitor counterparties and gave markets a (false) sense of security about the mortgages underlying the repo market. The low default risk increased liquidity and allowed lenders to remove risky assets from their balance sheet and expand mortgage financing.
While it’s not possible to quantify the effect of the bankruptcy process relative to all of the other effects, the case studies in this article hope to illustrate how these mechanisms operate to develop more resilient economies. Without appropriate legal technology to solve collective action problems in the presence of asymmetric information, market failures arise in the form of systemic runs on credit extended to banks and other intermediaries. In the wake of financial panics, these technologies are developed by the government, courts, and the private market to improve access to financing, alleviate failures, and reset the cycle.
By Brook Gotberg (University of Missouri Law School; Chair, Small Business Committee of the Bankruptcy & COVID-19 Working Group)
In the wake of the national shutdown of most commercial activity in response to the COVID-19 pandemic, many small businesses are struggling with financial disruption, restrictions on reopening, and uncertainty regarding future business prospects. Small businesses make up the vast majority of private firms in the United States, and provide nearly two-thirds of all new jobs. These businesses have been the most visible economic casualties of the global pandemic, with many already closing for good, and many others reevaluating their prospects. Certain industries, particularly dining and entertainment, have been particularly hard-hit, and could face large-scale obliteration.
A group of interdisciplinary scholars, the Small Business Committee of the Bankruptcy & COVID-19 Working Group, has been meeting regularly since March to discuss policy proposals for bankruptcy that would best protect viable small businesses from unnecessary death. Although bankruptcy serves as a method to discharge debt, it also operates to stop collection efforts, which may be essential even for companies with little to no debt. We fear that many formerly profitable small businesses will unnecessarily fail in the face of the current constraints on bankruptcy protection – constraints which assume a functioning economy, not the current reality. Moreover, a mass filing of bankruptcies could overwhelm the bankruptcy system itself, particularly in light of the accelerated time frames currently designated for small businesses under the Bankruptcy Code.
We therefore recommend that the Code be temporarily adjusted to put a six-month freeze on most typical deadlines, affording debtors additional time to propose a plan of reorganization. Furthermore, we recommend that debtors be allowed an amortized schedule to repay past-due rent.
Our reasoning for this proposal is simple. While bankruptcy law in normal times can distinguish viable companies from non-viable companies and recommend reorganization or liquidation accordingly, these are not normal times. Baseline assumptions for the value of businesses depend on revenues, which are now artificially constrained. Creditors, trustees, and judges cannot make informed decisions on the viability of a given enterprise based on the recent past, and that uncertainty is unlikely to be resolved in the near future. It is therefore essential to allow bankrupt firms more time to take advantage of the automatic stay while reassessing options for reorganization.
Furthermore, the hit to revenues will likely create debt overhang for otherwise profitable businesses that could prove impossible to overcome in the short run. This is particularly true for rental obligations. For many small businesses, past-due rent is likely to be the primary obligation, but the law does not permit debtors to repay past-due rent over time, as is permitted for other forms of debt. Current bankruptcy rules require a debtor to commit to its outstanding rental agreements within 60 days of filing, and then to repay all past-due rental obligations “promptly” (see 11 U.S.C. § 365(b) and (d)(4)(A)). Our policy recommendation would permit small business debtors to repay rental obligations over the life of the plan – three to five years, under the Small Business Reorganization Act (SBRA).
Similarly, we also recommend that interest accumulated on oversecured collateral after the date of the national emergency proclamation, March 13, 2020, be disallowed in an effort to preserve the respective positions of all creditors.
Recognizing the burden placed on landlords and secured creditors by these recommendations, our proposed changes to deadlines do not interfere with swift cash collateral motions and motions to obtain alternative financing. We also recommend that, although most motions to lift the stay would not be permitted, creditors should be allowed to lift the stay in circumstances where it can be shown that the debtor is wasting or spoiling the collateral.
A simultaneous permanent closure of small businesses would be catastrophic for the American economy, as hinted at by the surge in unemployment that followed the temporary closures. Beyond the loss of jobs, closure of businesses would mean fewer services offered within the community, and closed storefronts would likely invite blight, particularly in already vulnerable communities. This could erase years of hard-won economic and social progress.
The goal of the Bankruptcy & COVID-19 Working Group is to make workable policy recommendations that will have a meaningful impact in mitigating the harm caused by COVID-19 to the American economy. The group continues to meet, gather data, and review additional policy recommendations. The goal is to minimize the long-term damage caused by the global pandemic by exploring how bankruptcy policy can do the most good.
On December 19, 2019, the Second Circuit issued its amended opinion in In re Tribune Company Fraudulent Conveyance Litigation, 2019 WL 6971499 (2d Cir. Dec. 19, 2019), which held the “safe harbor” provision in section 546(e) of the Bankruptcy Code covers Tribune Company’s payments made to public shareholders as Tribune constitutes a “financial institution” in pursuance with the Bankruptcy Code definition, and such definition includes the “customer” of a financial institution when the financial institution acts as the customer’s “agent or custodian…in connection with a securities contract”.
The Second Circuit’s opinion was controversial in light of the Supreme Court’s recent ruling in Merit Management Group, LP v. FTI Consulting, Inc., 138 S.Ct. 883 (2018) on the scope of safe harbor, with law firms perceiving it as moving away from the position of Merit by opening new room for application of safe harbor protection. Jones Day suggests that the Tribune’s reasoning “avoided the strictures of Merit”, while Nelson Mullins finds it “shifting the focus from the financial institution as a ‘mere conduit’ to an ‘agent’.” Kramer Levin comments that the decision represents a “dramatic, and perhaps unexpected, extension of the safe harbor from the position it occupied in the immediate aftermath of Merit.” Weil calls it throwing the 546(e) safe harbor a lifeline.
Firms also find the case paving a way to protect LBO payments from subsequent attacks. King & Spalding notes that the Second Circuit’s opinion provides protection for recipients involved in LBO transaction where the debtor is the “customer” of the intermediary financial institutions. Cadwalader believes that the decision may “narrow the impact” of Merit, as market participants could structure their transaction to involve a financial institution thereby bypassing the “mere conduit” carve-out. Skadden agrees on the likely trend of structured LBOs, highlights that the customer defense is “likely to continue gaining momentum” after the Second Circuit’s decision. Parties would ensure they meet the “financial institution” and “customer” criteria methodically articulated in Tribune. “An appropriately structured principal/agent relationship could continue to shelter transfers or distributions within the ambit of section 546(e) safe harbors,” says Weil, adding that the operative facts will be key to strengthen the position.
Finally, Gibson Dunn notes that Tribune is not binding on other circuits. It remains to be seen whether such holding will be extended to different circumstances by other courts. “Some courts may find (in contrast to the Second Circuit) that the Supreme Court in Merit could not possibly have intended that its narrowing of the section 546(e) safe harbor be so easily vitiated by an argument that the Court itself acknowledged in a footnote,” says Kramer Levin.
In a prior Roundtable post, Professor Bussel noted that a plain meaning interpretation of the term “financial institution” should not include the customers of commercial banks, thus precluding a sharp change from Merit.
By Benjamin Iverson (BYU Marriott School of Business), Jared A. Ellias (University of California, Hastings College of the Law), and Mark Roe (Harvard Law School)
We recently estimated the bankruptcy system’s ability to absorb an anticipated surge of financial distress among American consumers, businesses, and municipalities as a result of COVID-19.
An increase in the unemployment rate has historically been a leading indicator of the volume of bankruptcy filings that occur months later. If prior trends repeat this time, the May 2020 unemployment rate of 13.3% will lead to a substantial increase in all types of bankruptcy filings. Mitigation, governmental assistance, the unique features of the COVID-19 pandemic, and judicial triage should reduce the potential volume of bankruptcies to some extent, or make it less difficult to handle, and it is plausible that the impact of the recent unemployment spike will be smaller than history would otherwise predict. We hope this will be so. Yet, even assuming that the worst-case scenario could be averted, our analysis suggests substantial, temporary investments in the bankruptcy system may be needed.
Our model assumes that Congress would like to have enough bankruptcy judges such that the average judge would not be pressed to work more than was the case during the last bankruptcy peak in 2010, when the bankruptcy system was pressured and the public caseload figures indicate that judges worked 50 hour weeks on average.
To keep the judiciary’s workload at 2010 levels, we project that, in the worst-case scenario, the bankruptcy system could need as many as 246 temporary judges, a very large number. But even in our most optimistic model, the bankruptcy system will still need 50 additional temporary bankruptcy judgeships, as well as the continuation of all current temporary judgeships.
Our memorandum’s conclusions were endorsed by an interdisciplinary group of academics and forwarded to Congress.
By Steven L. Schwarcz (Duke University School of Law)
Large financial institutions, such as U.S. Bank or Bank of NY Mellon, typically administer the governance of bond indentures—the contract under which bonds are issued—on behalf of the investors; in that role, they are called indenture trustees or, more colloquially, bond trustees. In Bond Trustees, and the Rising Challenge of Activist Investors, the 2020 TePoel Lecture at Creighton University School of Law, I examine how bond trustees should respond to this challenge.
Bondholders are the primary beneficiaries of indenture governance, just as shareholders are the primary beneficiaries of corporate governance. As beneficiaries, bondholders and shareholders have much different expectations. Indenture governance and corporate governance have evolved differently to meet those different expectations.
For example, because bondholders are only entitled to receive principal and accrued interest on their bonds, indenture governance has evolved to protect that recovery. In contrast, because shareholders, as residual claimants of the firm, are entitled to (and thus expect to receive) the firm’s surplus value, corporate governance has evolved to increase that value.
Most people would consider corporate governance as more important than indenture governance. In part, that’s because corporations and stock markets are highly visible to the average person. Also, a corporate manager’s job—to try to increase shareholder value—involves more judgment and discretion, and thus can be more interesting (and more desirable of scholarly study), than an indenture trustee’s job of merely protecting bondholder recovery.
Still, indenture governance is critically important. Domestically and worldwide, the amounts invested in bonds dwarfs the amounts invested in stock. Recent data show, for example, that global bond issuance is almost 30 times greater than global equity issuance.
An indenture trustee’s governance duties turn on whether the trustee is acting pre-default, or post-default. Once an indenture defaults, the law requires the indenture trustee to act on behalf of the bondholders as would a prudent person in similar circumstances regarding its own affairs. Many post-default decisions—such as whether to accelerate the maturity of the bonds or to liquidate collateral—involve difficult judgment calls. These decisions are made more difficult by what I have called a “protection gap”: when things go wrong, investors often blame parties with deep pockets, especially indenture trustees, for failing to protect them. Post-default indenture governance becomes even more complicated when the bondholders themselves have conflicting interests, caused, for example, by conflicting payment priorities or conflicting sources of payment.
Notwithstanding its complexities, post-default indenture governance is informed by case law. And perhaps because of its complexities, post-default indenture governance is also informed by legal scholarship. In contrast, pre-default indenture governance is not yet well informed by either case law or legal scholarship. The rising challenge of activist investors is now making it critical to also understand what an indenture trustee’s pre-default duties should be.
Historically, an indenture trustee’s pre-default duties have been seen as ministerial and limited to the specific terms of the indenture, such as selecting bonds for redemption and preparing and delivering certificates. Since the financial crisis, some investors argue that indenture trustees of securitized bond issues, in which investors are paid from collections on underlying financial assets such as mortgage loans, should have pre-default fiduciary duties. Indeed, complaints in recent lawsuits allege that those indenture trustees should “police the deal” for the investors.
These allegations are not compelling. Indenture trustees receive relatively tiny fees and don’t even negotiate the terms of the indentures. In contrast, the institutional investors in securitized bond issues, including activist investors, are highly sophisticated. Indenture trustees could not understand complex securitized bond issues better than those investors.
Furthermore, parties other than indenture trustees are assigned monitoring duties to protect the investors. Notably, securitized bond issues require a party, usually called a servicer, to service and collect payment on the underlying financial assets. In litigation following the financial crisis, which caused widespread defaults on residential mortgage loans, some investors argued that indenture trustees in mortgage securitization transactions should have monitored or supervised the performance of the mortgage-loan servicer.
Imposing such duties on the indenture trustee would be duplicative and expensive. Rather, an indenture trustee that actually becomes aware of servicing problems should act in a common sense and practical manner. For example, it might enter into conversations with the servicer about its performance and communicate the results of those conversations to the investors. It also might seek, or request the investors to provide, formal investor directions.
Typically, indentures allow investors with at least 25-50 percent of voting rights to direct the indenture trustee to act.
By Charles Tabb and Carly Everhardt (Foley & Lardner)
In Ritzen Group Inc. v. Jackson Masonry, LLC,the Supreme Court unanimously held that a bankruptcy court’s order denying relief from the automatic stay constituted a final order, and thus that order may—and must—immediately be appealed if so desired. The holding regarding finality is important, because parties normally only have an absolute right to appeal when an order is final, not when an order is interlocutory. In Ritzen, the Court announced a clear blueprint for gauging the finality of any bankruptcy order.
The opinion comes just a few years after the Supreme Court decided Bullard v. Blue Hills Bank, in which the Court held that an order denying confirmation of a plan was not final, because the plan confirmation process could continue notwithstanding the denial. In Ritzen, the Court distinguished Bullard, explaining that the stay relief proceeding constituted its own complete procedural unit, separate and apart from any claims resolution issues. Ritzen puts to rest the view that Bullard signaled relaxed finality in the context of bankruptcy.
The article analyzes Ritzen and how it will impact strategic decisions by creditors regarding stay relief and other forms of bankruptcy litigation. The article considers open questions left by the Court, including the impact on the finality of an order which states it was entered “without prejudice,” and whether res judicata may apply in cases where creditors make multiple requests for relief.
By Jared A. Ellias (University of California Hastings College of the Law), George Triantis (Stanford Law School)
During the COVID-19 pandemic, Congress has moved quickly to get trillions of dollars of emergency relief to consumers, small businesses, and large firms. These efforts aim to rescue millions of American consumers and businesses from insolvency.
It is troubling, though, that the federal government is ignoring the law that already exists for cushioning the blows associated with financial distress: the bankruptcy system. In its strategy to provide relief and stimulus, the government is in effect offering roadside emergency assistance when the infrastructure and expertise of a hospital is easily accessible.
Because the bankruptcy system entails a detailed restructuring process, it forces companies to think hard about how they’ve been doing things and whether it makes sense to continue doing them that way. Cash infusions from programs like those in the CARES Act, on the other hand, are only designed to keep businesses’ heads above water. That’s all that some companies need, but for others that were already struggling before the crisis hit, such as J.Crew and Neiman Marcus, bankruptcy can encourage them to focus on their long-term health.
Our existing bankruptcy system isn’t only crucial for helping companies move past their immediate crisis of zero revenue and illiquidity, it will also be essential in helping entire industries adapt to a prolonged period of uncertainty created by the coronavirus pandemic.