Reorganization without Bankruptcy: Untying the Gordian Knot That Destroys Firm Value

By Noam Sher (Assistant Professor of Law, Ono Academic College, Israel)

Noam Sher

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.

Hidden Wealth Transfers in Bankruptcy Asset Sales: A Real Option Analysis

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)

Jordan Neyland
Kathryn St. John

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.

Bankruptcy, Bailout, or Bust: Early Corporate Responses to the Business and Financial Challenges of COVID-19

By Diane Lourdes Dick (Professor of Law, Seattle University School of Law)

Diane Lourdes Dick

Over the last year, publicly traded companies have provided thoughtful commentary in their public company disclosures regarding the financial decisions they have made in response to the COVID-19 crisis. Meanwhile, public and private companies have filed for bankruptcy protection, providing detailed narrative accounts of the events leading up to the filing and the various steps they have taken to stem losses and maintain the company as a going concern.

In a recent article, I use public disclosures and declarations of this sort to take a closer look at the firm-level decision-making process in response to the sudden liquidity crisis caused by the pandemic. Specifically, I analyze the recapitalization and restructuring decisions made by twelve large and mid-sized companies in the cruise, airline, health care, and consumer sectors in the spring and summer of 2020. Although the case studies are mere snapshots in time, they help to shed further light on the key factors that have influenced firm-level bankruptcy, bailout, and other recapitalization decisions.

The case studies reveal that, outside of bankruptcy, corporate managers of the profiled companies have followed a remarkably similar decision pathway. First, firms slashed costs and reduced employee headcount. Of course, many of these cuts are the natural consequence of voluntarily or involuntarily scaling back operations; in other cases, firms likely chose to make reductions of this sort because there are typically few if any legal impediments to doing so. But whether voluntary or involuntary, the choice to scale back operations generally means allocating economic burdens to employees, vendors, suppliers, and, in the case of firms that provide an essential service, the broader communities they serve.

A firm’s subsequent choices appear to be constrained by its overall financial condition and its new or existing legal commitments. For instance, companies with substantial open lines of credit were able to draw down available funds to shore up cash. Meanwhile, those with stronger balance sheets were able to obtain new debt and equity financing from the capital markets. Virtually all of the profiled companies that were eligible to receive governmental bailouts accepted the assistance—in both grant and loan form—with little apparent concern for the conditions and restrictions attached to such funds. Participation in bailout programs, in turn, constrained the firm’s choices regarding how to allocate economic burdens. For instance, the restrictions and limitations in the CARES Act were designed to delay or prevent companies from allocating economic burdens to employees and, in the case of airlines and health care facilities providing essential services, their broader communities.

The case studies suggest that to the extent these other liquidity options are available, corporate managers may view bankruptcy primarily as a legal or strategic tool rather than as a true financial restructuring option. Perhaps because of certain underlying assumptions about bankruptcy, no company seems to have weighed participation in a governmental bailout—with or without strings attached—against the option of filing for bankruptcy. Rather, these alternatives—like all of the major decisions firms make in response to a sudden liquidity crisis—appear to have been independently examined at very different points in the lifecycle of the distressed firm.

The full article is available here.

Bankruptcy & Bailouts; Subsidies & Stimulus: The Government Toolset for Responding to Market Distress

By Anthony J. Casey (The University of Chicago Law School)

Anthony J. Casey

In the spring of 2020, as the Covid-19 pandemic shut down economies around the world, pressure arose for governments to respond to the growing threat of pandemic-related market distress. In the United States, the initial proposals for government action varied in nature and focus. Some proposals targeted the financial system while others targeted small businesses and individuals. Others were intended to bail out large businesses and specific industries. Still other proposals took a more institutional focus. In the context of bankruptcy law, many imagined building up the bankruptcy system as a primary bulwark against a seemingly imminent wave of economic and financial distress.

With the exception of measures related to financial markets, the actual responses formed a chaotic mix of disconnected half-measures that neither stabilized the economy nor provided meaningful relief to those most affected. While that failure may be attributed in part to general government dysfunction and legislative gridlock, a large part of the problem arises from the lack of a clearly identified framework to guide government responses.

The main lesson here is that the appropriateness of tools deployed to alleviate a crisis depends on the nature of the specific problem at hand, and scattershot approaches are unlikely to work. As obvious as that principle may seem, it was largely ignored in 2020. Much of the confusion in the pandemic responses is attributable to using the wrong tools and implementing measures that lacked any clear purpose.

In particular, governments and commentators lost sight of two important distinctions in deciding how to act. The first is the distinction between tools appropriate for addressing economic distress and those appropriate for addressing financial distress. The second is the distinction between a systemic crisis where distress is spreading and an instance of firm-specific distress where the harm—though perhaps large—is contained.

These distinctions present four types of market distress: specific economic, systemic economic, specific financial, and systemic financial. Each type is distinct from the others, and for each there is a category of appropriate government responses (respectively): direct subsidies, general stimulus, bankruptcy proceedings, and financial bailouts. We thus have this matrix:

Systemic Specific
Economic General Stimulus Direct Subsidies
Financial Financial Bailouts Bankruptcy Proceedings

(Chapter 11)

 

The importance of understanding these classifications is most evident in the flawed proposals for pandemic-related fixes to bankruptcy law and in the lack of a centralized economic plan to support failing small businesses around the country.

In a new article, I lay out this framework for identifying the right tools for responding to different forms of market distress.  I describe the relationship between the category of tools and the type of distress. Having presented the framework, I then use it to closely examine the interaction between pandemic responses and bankruptcy law. This analysis is particularly important because efforts to understand the bankruptcy system’s role during the pandemic provide the starkest example of confused analysis of appropriate responses to systemic crises, and because a striking decline in bankruptcy filings in 2020 has puzzled many commentators.

An Assessment of the UK Restructuring Moratorium

By Jennifer Payne (Linklaters Professor of Corporate Finance Law, University of Oxford)

Jennifer Payne

In a recent paper I analyze the introduction of a restructuring moratorium into the UK by the Corporate Insolvency and Governance Act 2020 (2020 Act). This is one of a number of permanent measures introduced by the 2020 Act that are intended to facilitate the rescue of financially distressed but viable companies. The introduction of these measures was prompted by the financial problems arising from the COVID-19 pandemic, but the restructuring moratorium has its foundations in a set of 2018 Government proposals and a 2016 Insolvency Service consultation paper.

A number of jurisdictions have introduced reforms to their debt restructuring regimes in recent years, often based on the US Chapter 11 procedure which many regard as the ‘gold standard’ of restructuring mechanisms. These include the 2017 debt restructuring reforms introduced in Singapore and the EU’s recent Restructuring Directive (Directive 2019/1023). The inclusion of a restructuring moratorium is a consistent feature in these reforms. This paper compares the UK restructuring moratorium with those introduced elsewhere and assesses whether it will be a valuable tool for financially distressed companies. This paper argues that the constraints and limitations placed on the UK restructuring moratorium, for creditor protection and other reasons, limit the potential value of this mechanism for financially distressed companies to a significant extent and that many companies will therefore have to continue to look elsewhere for protection from creditors seeking to disrupt their restructurings.

Moratoria have existed as integral aspects of mechanisms such as US Chapter 11 and UK administration for some time but the existence of a broad moratorium for use in conjunction with restructuring mechanisms is new in the UK. Moratoria are traditionally regarded as having two benefits. The first is to deal with the ‘common pool’ problem. If there is no stay, then creditors may seize assets that are useful for the carrying on of the debtor’s business and this could jeopardize the prospects of a successful restructuring. The second is that a moratorium can deal with the ‘anti-commons’ problem, i.e. it can block actions by individual creditors who are seeking to frustrate the wishes of the majority. A balance is required between the benefits to the company and the creditors as a whole on the one hand and the rights of the individual creditors on the other.

The 2020 Act introduces a new Part A1 into the Insolvency Act 1986. This provides a restructuring moratorium that is standalone and is not a precursor to an insolvency process, although it can be used in that way. It is available to be used alongside restructuring processes including schemes of arrangement, Company Voluntary Arrangement (CVAs) and the new restructuring plans (or ‘super schemes’) introduced into Part 26A of the Companies Act 2006 by the 2020 Act.  In contrast to the moratorium attached to administration, the UK restructuring moratorium is debtor-in-possession and allows directors to continue to run a company, subject to the appointment of a licensed insolvency practitioner (the monitor) and other restrictions. Broadly, the effect is to impose both a constraint on the ability of creditors to assert their debt claims against the company and a constraint on initiating insolvency proceedings and other legal processes, complemented by restraints on ipso facto clauses.

Given that moratoria involve a significant constraint on creditors’ legal rights, they can be justified only where the imposition can be regarded as beneficial to the creditors as a whole, in order to rescue a viable (albeit financially distressed) business. One concern is that they can be used by directors to prop up a company which is not economically viable and is not capable of rescue. Another is that directors may utilise a restructuring to shake off liabilities which the company is capable of meeting. A number of protections are introduced by the 2020 Act to deal with these concerns, including a limit on the length of the moratorium (20 days, extendable for a further 20 days without creditor consent), eligibility requirements, the appointment of an insolvency practitioner (a monitor), a restriction on the availability of the moratorium to certain companies, and the ability of creditors to challenge the moratorium in certain circumstances. While there is no doubt that restructuring mechanisms and the moratoria that attach to them can be misused by companies and powerful financial creditors, the balance may have tipped too far in these provisions, rendering the UK restructuring moratorium much less valuable for companies than might have been hoped.

A version of this note first appeared in the Oxford Business Law Blog.

 

Restructuring Corporate Debt – A Different Kind of Cycle

By Mike Harmon (Gaviota Advisors, LLC) and Claudia Robles-Garcia (Stanford Graduate School of Business)

Mike Harmon
Claudia Robles-Garcia

Corporate leveraged finance cycles have followed a predictable pattern in the forty years that have ensued since the invention of the junk bond in the late 1970s. They expand as investors’ risk appetites grow and recede as default rates rise. The recession of credit cycles has historically facilitated a healthy “creative destruction” in the form of restructuring transactions which have enabled over-leveraged companies to fix their burdened balance sheets. While the current credit cycle is positioned to share some of the characteristics of past cycles, it is also shaping up to differentiate itself in some meaningful ways. First, companies entered the current crisis with significantly more debt, and with that debt bearing a much higher blended risk profile, than in past cycles. Second, the restructuring “fix” has required much more additional financing than previous cycles, due to the economic nature of the crisis. Third, companies have had much more contractual leeway to avoid default, and to solve their liquidity problems with more leverage, than they have in previous cycles. Fourth, many investors have been aligned with borrowers on their desire to maintain elevated leverage levels. And finally, and probably most importantly, the Fed’s actions have facilitated, and even encouraged, the raising of more leverage. As a result of all of these factors, we believe that this restructuring cycle is more likely to see companies emerge with significantly more debt than we have seen in previous cycles. This will exacerbate the highly publicized “zombie” problem (where companies that are technically insolvent have no real catalyst to restructure), which could impact economic growth, and will increase the likelihood of a more protracted restructuring cycle in the years to come.

The full article is available here.

Bespoke Bankruptcy

By Laura N. Coordes (Associate Professor of Law, Sandra Day O’Connor College of Law)

Laura N. Coordes

The U.S. Bankruptcy Code is the primary source of bankruptcy relief for debtors in the United States. But it is not the only source. Over the years, Congress has occasionally created bespoke bankruptcy—customized debt relief designed for a particular group of debtors. Bespoke bankruptcy may provide desperately needed bankruptcy relief to entities that are ineligible or otherwise unable to access bankruptcy through the Bankruptcy Code. But bespoke bankruptcy is also fraught with difficulties. To what extent should bespoke bankruptcy be used or developed instead of the Bankruptcy Code?

In Bespoke Bankruptcy (forthcoming in the Florida Law Review), I take up this question. The Article begins by acknowledging the limitations of the Bankruptcy Code and highlighting instances where Code-based bankruptcy relief does not work. Some entities, which I term “bankruptcy misfits,” require such different relief mechanisms that using the Bankruptcy Code becomes difficult, impractical, or even impossible. To assist these entities, Congress has historically chosen either to amend the Bankruptcy Code or to create alternative debt relief processes through statutes outside of the Code. The Article then examines the extent to which bespoke bankruptcy, as opposed to Code amendments, should be used to provide other bankruptcy misfits debt relief.

To address this question, the Article devises a framework that policymakers can use to decide when and how to implement bespoke relief. In so doing, this Article sets the stage for a new direction in bankruptcy law and theory: one where bespoke bankruptcy performs a limited, but critical, role in providing relief to entities that the Bankruptcy Code either does not or cannot assist.

The full article is available here.

Delaware Corporate Law and the “End of History” in Creditor Protection

By Jared A. Ellias (University of California Hastings Law) and Robert J. Stark (Brown Rudnick LLP)

Jared A. Ellias
Robert J. Stark

We briefly survey the common law’s adventures with creditor protection over the course of American history with a special focus on Delaware, the most important jurisdiction for corporate law. We examine the evolution of the equitable doctrines that judges have used to answer a question that arises time and again: What help, if any, should the common law be to creditors that suffer losses due to the purported carelessness or disloyalty of corporate directors and officers? Judges have struggled to answer that question, first deploying Judge Story’s “trust fund doctrine” and then molding fiduciary duty law to fashion a remedy for creditors. In Delaware, the appetite of corporate law judges to protect creditors reached a high point in the early 2000s as judges flirted with recognizing a “deepening insolvency” tort cause of action. Suddenly, though, a new course was set, and Delaware’s judges effectively abandoned this project in a series of important decisions around the time of the financial crisis. In this “third generation” of jurisprudence, Delaware’s corporate law judges told creditors to look to other areas of law to protect themselves from opportunistic misconduct, such as bankruptcy law, fraudulent transfer law, and their loan contracts. However, the same question of whether the common law ought to protect creditors has arisen time and again and today’s “settled” law is unlikely to represent the end of history in creditor protection.

The full chapter is available here.

For related Roundtable posts, see Jared Ellias and Robert Stark, Bankruptcy Hardball.

Bail-outs and Bail-ins are better than Bankruptcy: A Comparative Assessment of Public Policy Responses to COVID-19 Distress

By Kristin van Zwieten (University of Oxford), Horst Eidenmüller (University of Oxford), and Oren Sussman (University of Oxford)

Kristin van Zwieten
Horst Eidenmüller
Oren Sussman

In a recent paper we argue that bail-outs or bail-ins are better than bankruptcy for the treatment of COVID-19 distress, even where there exists a reorganization procedure that functions well in normal conditions.

COVID-19 has severely disrupted the conduct of business around the globe. In jurisdictions that impose one or more “lockdowns,” multiple sectors of the real economy must endure prolonged periods of reduced trading or even total shutdowns. The associated revenue losses will push many businesses into bankruptcy. No public policy response can recover these losses. States can, however, act to reduce the amplification of the shock by the way in which they treat the cohort of newly bankrupt businesses.

In jurisdictions where a well-functioning reorganization procedure can produce value-maximizing outcomes in normal conditions, the temptation may be to subject this cohort to such procedures. This temptation should be resisted, not only because of the (significant) costs of these procedures, or because of concerns about institutional capacity to treat a high volume of cases, but also because such procedures are likely to be a poor “fit” for the treatment of COVID-19 distress. Distorting such procedures to accommodate the features of COVID-19 distress (or, in jurisdictions where there is not a reorganization procedure, introducing one designed with COVID-19 distress in mind) risks inhibiting the availability of credit for new projects in future, slowing the path to economic recovery.

The more attractive routes to relief are bail-ins (one-time orders to creditors or counterparties, or some class thereof, to forgive), bail-outs (offers to assume the debtor’s liabilities, or a class thereof), or some combination of the two.

In our paper, we explain why a public policy response is necessary to mitigate the amplification of the shock caused by trading shut-downs, and we compare treatment by the prevailing bankruptcy law with treatment by bail-ins or bail-outs along a range of dimensions. We conclude by developing principles to help guide the choice between bail-ins and bail-outs, and the design of either form of intervention.

We suggest that policymakers should intervene in ways that are proportionate, in the sense that they ought to confine themselves to that which is thought necessary to minimize the amplification of the economic shock caused by periods of trading shutdowns; that interventions should be designed to minimize distortions to efficient private bargains and private law rules; that transfers should be from the less financially constrained to the more financially constrained; that interventions should “fit” with the institutional apparatus responsible for administering them; and that the process of designing and delivering relief should be transparent.

We suggest these principles tentatively, mindful of the fact that policymakers may or may not be working with common conceptions of fairness and responsibility, and of the fact that some of our principles may only be able to be fully pursued at the partial expense of others. But we nevertheless hope that they offer a useful starting point for thinking about the design and delivery of novel forms of relief to debtors distressed by COVID-19 related revenue losses.

Chapter 15 and Bankruptcy Credit Events under Credit Default Swaps

By Corinne Ball, George Cahill, Kay Morley, Jay Tambe, Bruce Bennett, & Heather Lennox (Jones Day)

Corinne Ball
George Cahill
Kay Morley
Jay Tambe
Bruce Bennett
Heather Lennox

A recent spate of decisions by the EMEA Determinations Committee (“DC”) has provided clarity on when a chapter 15 filing will trigger a “Bankruptcy” credit event under credit default swaps.  Each of the relevant chapter 15 petitions sought recognition of an English scheme of arrangement, which is not a product of insolvency law and does not necessarily constitute a Bankruptcy, and each underlying scheme was considered narrow enough in scope to not be “with or for the benefit of its creditors generally” (triggering limb (c) of Bankruptcy).  As such, the primary issue in each determination was whether the relief sought in the chapter 15 was similar to a “judgment of insolvency or bankruptcy” and independently triggered limb (d) of Bankruptcy.

The DC found that Thomas Cook’s 2019 petition for recognition of its scheme as a foreign nonmain proceeding, which expressly waived the benefit of the stay courts can impose in such cases, was not similar to an insolvency judgement and did not constitute a Bankruptcy.  On the contrary, it held that Matalan’s August petition seeking recognition of a foreign main proceeding (involving an automatic stay) was similar and triggered a Bankruptcy.  In its October determination regarding Selecta, the DC addressed the intermediate scenario, a petition seeking a stay in connection with a foreign main proceeding, finding that this also triggered a Bankruptcy.  While every situation must be considered on its own facts, these determinations should prove instructive on when a chapter 15 filing will trigger a Bankruptcy credit event.

Disclaimer Statement: “The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of the law firm with which they are associated.”

The full article is available here.

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