Valuation is a critical and indispensable part of the bankruptcy process. How collateral and other estate assets (and even creditor claims) are valued will determine a wide range of issues, from a secured creditor’s right to adequate protection, postpetition interest, or relief from the automatic stay to a proposed chapter 11 plan’s satisfaction of the “best interests” test or whether a “cram-down” plan can be confirmed despite the objections of dissenting creditors. Depending on the context, bankruptcy courts rely on a wide variety of standards to value estate assets, including retail, wholesale, liquidation, forced sale, going-concern, or reorganization value. Certain assets, however, may be especially difficult to value because valuation depends on factors that may be difficult to quantify, such as the likelihood of success in litigating estate causes of action.
The U.S. Court of Appeals for the First Circuit recently addressed this issue in In re Montreal, Maine & Atlantic Railway, Ltd., 956 F.3d 1 (1st Cir. 2020) (“MMA Railway”). The First Circuit affirmed a ruling that a secured creditor failed to satisfy its burden of establishing that collateral in the form of indemnification claims settled by the estate had any value entitled to adequate protection. According to the court, with respect to a disputed claim, a showing of possible damages is not enough. Instead, the creditor must establish the likely validity of the claim and the likelihood of recovery.
MMA Railway is a cautionary tale for secured creditors. Creditors bear the ultimate burden of proof in establishing the value of their collateral under section 506(a) of the Bankruptcy Code—a determination that has important consequences in many contexts in a bankruptcy case. The First Circuit’s ruling highlights the importance of building a strong evidentiary record to support valuation. It also indicates that certain types of collateral (e.g., disputed litigation claims) are more difficult to value than others.
Federal courts regularly resolve consolidated corporate tax refund disputes in bankruptcy cases. In the current economic downturn, the ownership of a large tax refund paid to an affiliated group of corporate debtors can be significant. See, e.g., FDIC v. AmFin Corp., 757 F.3d 530, 532 (6th Cir. 2014) ($170 million refund). If a corporate debtor’s parent owns the refund, it is part of the parent’s bankruptcy estate, and the subsidiary may be an unsecured creditor for any claimed benefits. But if the debtor parent is an agent or trustee for its affiliates, the parent cannot use the refund to repay its creditors.
Corporate parents and their subsidiaries often file a consolidated tax return. That enables affiliates to offset their losses against each other so as to reduce the group’s overall tax liability. Because only the corporate parent may file a consolidated return, any refund is also paid to the parent, not to individual affiliates. Affiliated groups, therefore, usually enter into tax sharing or allocation agreements. These agreements – or their absence – have generated a spate of litigation.
The Circuit Courts of Appeals had been sharply split on how to resolve tax refund ownership issues until the U.S. Supreme Court resolved the issue this past February in Rodriguez v. FDIC (In re Western Bancorp, Inc.), 589 U.S. ___, 140 S. Ct. 713 (Feb. 25, 2020). Without deciding the merits, the Court remanded the case to the Tenth Circuit, directing it to apply state law to resolve the refund ownership dispute between the parent’s bankruptcy trustee and a subsidiary. The Supreme Court also rejected a purported federal default rule promulgated by the Ninth Circuit in 1973 that had been adopted by a few other Circuits, describing it as inappropriate federal “common lawmaking.” On May 26, 2020, following the Supreme Court’s remand, the Tenth Circuit, applied Colorado law, construed the relevant group tax sharing agreement, and held for the subsidiary bank, now in the hands of a FDIC receiver.
This article describes relevant issues litigated over the past fifty years. It also notes open issues that will continue to be litigated following the Rodriguez decision.
By Tomas Richter (Clifford Chance) and Adrian Thery (Garrigues)
Under EU Directive 2019/1023 promulgated in June 2019, the 27 Member States of the European Union must enact rules supporting preventive restructurings of businesses threatened by insolvency. The restructuring frameworks to be enacted are in a large part modelled after the U.S. Chapter 11 yet they are not carbon copies of it. Also, the 27 Member States have widely differing insolvency laws against whose background the preventive restructuring frameworks must operate, and significantly diverging institutions by which they will have to be applied. The implementation tasks will be both varied and formidable.
However, certain threshold questions are very similar across jurisdictions when it comes to particular topics relevant to corporate restructurings. In the context of agreeing to and adopting a restructuring plan, some of the key questions arise in relation to classification of investors’ claims and interests, grouping these claims and interests into classes, voting in the classes, and obtaining an official approval of the restructuring plan after investors have expressed their opinions on it via the voting mechanism.
The purpose of this first guidance note, published by INSOL Europe, is to flag some of the key issues that national legislators will want to consider in this particular context when implementing the restructuring frameworks prescribed by Title II of the Directive, and, at least at times, also to respectfully suggest which approaches, in the authors’ humble opinions, might perhaps be explored more productively than others.
By Shana A. Elberg, Seth E. Jacobson, & George R. Howard (Skadden)
Today, U.S. borrowers are more indebted than ever before. Borrowers have become increasingly aggressive in using secured leverage, and in taking advantage of “cov-lite” loan documents to engage in creative (and sometimes controversial) transactions to transfer assets beyond the reach of existing secured lenders by way of distributions to shareholders or contributions to unrestricted subsidiaries and then utilize those assets to raise additional secured financing. While the debt levels and cov-lite structures of leveraged loans may create risks for many stakeholders, lenders under asset-based loan facilities (“ABL facilities”) should be well-positioned to weather any storm. ABL facilities typically offer lenders greater protections in a liquidation scenario. In addition, ABL facilities often are a critical lynchpin of debtor-in-possession financing facilities when borrowers are looking to effectuate comprehensive restructurings through chapter 11. There are several tools available to ABL lenders to protect their credit position in the event that a borrower finds itself in a distressed situation. Lenders should position themselves to understand and use the chapter 11 process to ensure their debt claims retain, and even gain, protections in bankruptcy.
By Efraim Benmelech (Northwestern University – Kellogg School of Managemen, Nitish Kumar (University of Florida), and Raghuram Rajan (University of Chicago – Booth School of Business)
Is collateral at all valuable to creditors in corporate lending? At one level, it is clear why collateral should be important for lenders: it consists of hard assets that are not subject to asymmetric valuations in markets and that the borrower cannot alter easily. Collateral gives comfort to a lender that, even if the lender does little to monitor the borrower’s activity and the borrower’s cash flows prove inadequate to service the debt, the lender’s claim is protected by underlying value.
Yet even if assets are important to lending, why does debt need to be secured by them? After all, in a bankruptcy filing the firm’s assets will all be there to support the lender’s claim. Why protect the lender further through claims on specific collateral? In a related work (The Decline of Secured Debt), we find that firms tend to issue more secured debt when their credit quality is low or at times when average credit spreads across firms are higher or economic growth is slower. These are times when firms may find access to credit more difficult, creditors may fear greater stockholder-debtholder conflicts, and borrowers may need to collateralize debt issuances in order to regain access to funding. Moreover, with new lenders unwilling to lend without the comfort of collateral, existing lenders might rush to secure their claims so as not to be diluted. Indeed, negative pledge clauses (whereby the borrower commits to a lender that it will not issue secured debt to any other lender, failing which the debt payment will be accelerated) allow creditors to large companies to stay unsecured until they sense a greater likelihood of borrower distress, at which point they will move to secure their claims.
If collateral matters to creditors for the enforcement of debt claims, even in the case of large, mature companies but in a more contingent way, we should see it reflected in the pricing of secured claims vis-à-vis unsecured claims, especially in how that pricing moves with the state of the firm and the economy. Security should be of little value to lenders when a firm is far from distress or the economy is healthy, and it should become much more valuable (and hence secured debt should promise lower interest rates than unsecured debt) as a firm nears distress or the economy deteriorates.
The difficulty in identifying the effects of security on debt pricing derives from the circumstances under which it is offered. Since riskier firms will offer security at riskier times, a comparison of rates offered by secured debt issuances against rates offered by unsecured debt issuances across firms, or by the same firm over time, will tend to be biased toward suggesting higher rates for secured debt issuances.
In this paper, we use multiple data sets to get at the true pricing of secured debt, stripped as best as possible of the selection bias. Our identification strategy compares spreads on secured and unsecured credit of the same firm and at the same point in time.
We conclude from all these ways of obtaining the value of security that the selection bias is important, and correcting for it suggests that security is valuable to creditors – creditors typically require a lower spread when their claim is secured. Most important, however, we show that creditors value security differently for different firms and at different times.
For highly rated firms, creditors pay almost nothing for the added protection afforded by security, whereas for low-rated firms, they pay a lot. Yields on bonds issued by investment grade firms (those with an S&P rating of BBB− or better) are 20 basis points lower when secured, whereas this yield differential (unsecured versus secured) jumps to 112 basis points for a firm having a non-investment grade rating. Similarly, implied yields from bond trades in secondary market suggest that investors are willing to give up almost 161 basis points in spread for the added protection of security for non-investment grade issuers, whereas they are not willing to reduce spread at all for the added protection of security in the case of investment grade issuers.
Equally important, as a firm’s credit quality deteriorates, we see the valuation of secured claims improve relative to unsecured claims, suggesting that security becomes more valuable. We also find that secured spreads decline relative to unsecured spreads as the economy’s health – as reflected in GDP growth or the economywide Baa–Aaa spread – deteriorates.
The upshot is that collateral does not seem to matter for debt enforcement in normal times for a healthy firm, since debt linked to specific assets do not seem to enjoy better prices. Indeed, given the negligible pricing benefit, firms may want to avoid any loss in financial slack and operational flexibility at such times by not issuing secured debt. However, in tougher times, creditors do seem to value security, and firms do issue secured debt, either because creditors demand it or because of the better pricing.
By Professor Nancy Rapoport (William S. Boyd School of Law, University of Nevada, Las Vegas)
As someone who studies professional fees in large chapter 11 cases, I’ve thought a lot about how quickly those professional fees can escalate. Successful chapter 11 bankruptcies are expensive, though, in almost all cases, the end result—a successful reorganization—is a good result. But can the fees be controlled effectively?
I think that they can, although there are all sorts of reasons why, often, fees aren’t monitored very closely. There’s usually a disconnect between who’s paying those fees and who’s monitoring the work. In a non-bankruptcy context, a lawyer might bill a client on a monthly basis and get relatively fast feedback from the client regarding issues of reasonableness. The image that comes to mind is of a lawyer pushing a bill across a table and an experienced client pushing it back to request reductions for potentially unreasonable fees or expenses. But the process is different for fees paid to professionals in chapter 11 cases. Bankruptcy courts are charged with the responsibility of reviewing the fees and expenses for reasonableness, and the Office of the United States Trustee serves as another set of eyes, as would a fee examiner.
For estate-paid professionals, the bankruptcy court must first approve the fee applications, which then get paid either from a carveout of a secured creditor’s collateral or as administrative expenses. Imagine a typical list of estate-paid professionals: the debtor’s counsel (plus conflicts counsel and local counsel), the creditors’ committee counsel (plus conflicts counsel and local counsel), investment banks and financial advisors (often for both the debtor and the committee), along with other, more specialized counsel. All of those professionals are working at warp speed, because large chapter 11 cases are literally bet-the-company actions. The fee applications themselves can run into the thousands of pages, per professional, with the time entries showing who worked on what, and for how long, on a day-by-day basis. There’s also often a lag between the work done and the submission of the fee applications, and few actors—other than the professionals themselves and some large institutional creditors—are repeat players. If the client isn’t familiar with the rhythm of chapter 11 bankruptcies, then that client has to take the professionals’ word for whether the tasks were both reasonable and necessary. Parsing the fee applications is a complicated task.
Let me be clear: I’m not suggesting that bankruptcy professionals try to gouge the estate by performing unnecessary tasks. Far from it. The professionals whose fees I’ve reviewed have genuinely been trying to work within the reasonableness guidelines. But the staffing choices that get made—which level of professional works on which tasks, how long it takes to do the work, how many people review that work, how often all of the professionals touch base on the case’s progress, and how a professional must react to actions taken by a different professional—often don’t have the luxury, on the front end, of data-driven planning to eke out the most efficient workflows. Add to that the fact that all of these professionals worry about missing something important, and it’s not hard to see how fees can mount up.
I’ve written a lot about how to think about fees in chapter 11 cases, including these articles (here, here, and here). Most recently, I’ve been working with a co-author, Joe Tiano of Legal Decoder, to imagine a world in which big data can help professionals perform more efficiently (here and here). (Full disclosure: Legal Decoder helped me review the fees and expenses in the Toys R Us cases.) In a recent piece for the American Bankruptcy Institute Law Review, I’ve taken what we know about how a company’s general counsel works with outside professionals outside bankruptcy and suggested that, in a chapter 11 context, many of those behaviors can help to control the size of the professional fees and expenses: by paying closer attention to staffing and monthly budget-to-actual reconciliations, by using legal analytics to measure efficiency, and by using artificial intelligence for certain types of tasks. The point is that paying attention to efficient behavior on the front end benefits everyone, including the professionals themselves, who won’t have to negotiate reductions of their already billed work. The ABI Law Review article is available here.
By Michael Ohlrogge (New York University School of Law)
In 2009, the Seventh Circuit ruled in U.S. v. Apex Oil that certain types of injunctions requiring firms to clean up previously released toxic chemicals were not dischargeable in bankruptcy. The result of this was to expose lenders, even those with security interests, to larger losses in the event a firm they extended credit to entered bankruptcy with significant outstanding environmental cleanup obligations. I document that lenders tightened the covenants on loans they extended to firms impacted the decision. In particular, lenders added new requirements that borrowers’ facilities and operations be inspected by outside environmental engineering firms in order to assess the safety with which they handle toxic chemicals.
Using an array of statistical tests and data from federal environmental agencies, I show that firms impacted by the decision responded to these new pressures from lenders by taking meaningful steps to reduce their risks of causing catastrophic pollution spills. In particular, firms reduced volume of toxic chemicals they release on-site by approximately 15%. In place of these releases, firms substituted off-site treatment by specialized facilities generally considered to be safer for the environment. These results point to important ways in which bankruptcy law and other legal rules that impact recovery for firms’ creditors can work to shape the positive or negative externalities those firms generate.
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.
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.