By Andreas Kostøl (Arizona State University – W.P. Carey School of Business; Norges Bank), Morten Grindaker (Norwegian Business School; Norges Bank), and Kasper Roszbach (Norges Bank; University of Groningen)
Andreas KostølMorten GrindakerKasper Roszbach
Policymakers have long been concerned about the potential negative effects of bankruptcy for CEOs and business dynamics. Fear of reputational scarring caused by bankruptcy could lead managers to take less risk than desired by owners, which could manifest in lower performance and lower rates of entrepreneurship and job growth.
CEOs influence a wide range of decisions, such as organizational practices, debt financing and whether to file for corporate bankruptcy or not. Empirical studies of Chapter 11 bankruptcy show that CEOs of large bankrupt firms suffer significant financial losses. The prospect of individually-borne income loss due to a corporate bankruptcy carries in it a risk that CEOs take decisions that are not aligned with the interest of the owners.
It remains an open empirical question, however, whether the observed personal costs should be attributed to the selection of CEOs with lower managerial skills, firm-specific human capital, or stigma in the executive labor market.
Our analysis attempts to answer this question by disentangling the stigma and skill effects by examining the causal effects of corporate bankruptcy on the personal income and career of CEOs in small and medium-sized companies in Norway. To this end, we exploit that bankruptcy petitions in Norway are randomly assigned to judges who have different degrees of strictness in their approval of bankruptcy filings. This institutional feature generates variation in firms’ likelihood of being declared bankrupt that is unrelated to firm or CEO characteristics. We use administrative panel data that identifies CEO’s sources of wealth and income and corporate positions to examine the effects of bankruptcy on their careers.
Two broad conclusions emerge from our empirical analysis.
First, we find that corporate bankruptcy has a long-lasting impact on CEOs’ careers. CEOs whose firms are declared bankrupt are 25 percentage points more likely to exit the executive workforce. Displaced CEOs find new employment quickly but do so by moving to lower-ranked positions in new firms. Bankruptcy also has an economically significant impact on CEO remuneration; we document an annual fall in capital income equal to about five percent of annual gross income. While the net present value of the average decline in capital income over the remainder of a CEO’s working-age career is equal to 60 percent of pre-bankruptcy annual income, we find no enduring effect on CEOs’ labor income after five years.
Second, our analysis shows that the displacement effects are much larger when default rates in the firms’ industry are low. For example, a CEOs is five times less likely to remain in the executive workforce if her/his firm experiences a bankruptcy while the bankruptcy frequency in the same industry is low. By contrast, variation in CEO wages is not driven by industry conditions. Post-bankruptcy, we find a greater mobility of CEOs between industries and an increased tendency to move to more productive firms with a higher-paid workforce, suggesting that managerial skills are portable.
Taken together, our findings suggest that negative career effects of bankruptcy can be attributed to stigma. When we eliminate the risk of low-skilled CEOs sorting into bankrupt firms, we find that the executive labor market interprets bankruptcy as a signal of lower managerial talent. This stigma effect is greater during better economic times. More details can be found in the full paper that is available here.
By Amelia S. Ricketts (Harvard Law School) and Jin Lee (Harvard Law School)
Amelia RickettsJin 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.
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.
By Kenneth Ayotte (University of California – Berkeley School of Law) and Christina Scullly (University of California – Berkeley School of Law)
Kenneth AyotteChristina 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.
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 CanipekAxel KindSabine 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.
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. CohenMichael A. RosenthalMatthew 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.
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.
By Lindsey Simon (University of Georgia School 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
Lindsey Simon
Grifters take advantage of situations, latching on to others for benefits they do not deserve. Bankruptcy has many desirable benefits, especially for mass-tort defendants. Bankruptcy provides a centralized proceeding for resolving claims and a forum of last resort for many companies to aggregate and resolve mass-tort liability. For the debtor-defendant, this makes sense. A bankruptcy court’s tremendous power represents a well-considered balance between debtors who have a limited amount of money and many claimants seeking payment. But courts have also allowed the Bankruptcy Code’s mechanisms to be used by solvent, nondebtor companies and individuals facing mass-litigation exposure. These “bankruptcy grifters” act as parasites, receiving many of the substantive and procedural benefits of a host bankruptcy, but incurring only a fraction of the associated burdens. In exchange for the protections of bankruptcy, a debtor incurs the reputational cost and substantial scrutiny mandated by the bankruptcy process. Bankruptcy grifters do not. This dynamic has become evident in a number of recent, high-profile bankruptcies filed in the wake of pending mass-tort litigation, such as the Purdue Pharma and USA Gymnastics cases. This Article is the first to call attention to the growing prevalence of bankruptcy grifters in mass-tort cases. By charting the progression of nondebtor relief from asbestos and product-liability bankruptcies to cases arising out of the opioid epidemic and sex-abuse scandals, this Article explains how courts allowed piecemeal expansion to fundamentally change the scope of bankruptcy protections. This Article proposes specific procedural and substantive safeguards that would deter bankruptcy-grifter opportunism and increase transparency, thereby protecting victims as well as the bankruptcy process.
The full article is available here and is forthcoming in the Yale Law Journal.
The COVID pandemic put unprecedented pressure on all economies around the world. Many predicted that this economic dislocation would lead to an unprecedented number of corporate bankruptcies. This did not happen. The American government and other governments responded with extraordinary measures. While these measures allowed companies to ride out the worst of the pandemic, they did have consequences. Many large companies were left with unprecedentedly large amounts of debt on their balance sheets.
Perhaps a robust economy will allow companies to grow their way out from under their debt burden. But perhaps not. To prepare for the possible future increase in large companies filing for bankruptcy, Congress should act now to build up a bankruptcy infrastructure sufficient to handle an influx in cases. Specifically, Congress should require that every circuit create a “business bankruptcy panel” designed to administer the Chapter 11 filing of large companies. As is well-known, three bankruptcy districts currently serve as dominant venues for large cases – the District of Delaware, the Southern District of New York and the Southern District of Texas. It is by no means clear that these three courts could handle a significant increase in caseloads. Creating expertise across the country would help prepare the system for any future rise in cases. A secondary benefit of this reform is that it may also ameliorate some of the concerns that have been raised over the years by the dominance of a small number of venues for large corporate cases.
By Casey Watters (Bond University) and Wai Yee Wan (City University of Hong Kong)
Casey WattersWai Yee Wan
Creditors often face significant information asymmetry when debtor companies seek to restructure their debts. In the United Kingdom, it is mandatory for debtor companies seeking to invoke a court’s jurisdiction to restructure their debts via schemes of arrangement (schemes) to disclose material information in the explanatory statement. This information enables creditors to make an informed decision as to how to exercise their votes in creditors’ meetings.
English schemes have been transplanted into common law jurisdictions in Asia, including Hong Kong and Singapore. However, due to the differences in the shareholding structures and the kinds of debts prevalent in restructurings in the UK as compared to those in Hong Kong and Singapore, this transplantation gives rise to the question of whether the English-based scheme process adequately addresses information asymmetry in the local context. Drawing from the experiences of Hong Kong and Singapore, our paper, supported by the Research Grants Council of the Hong Kong SAR, argues that there are three principal concerns in the current disclosure regimes: how debtors disclose the liquidation analysis or alternative to restructuring via schemes; how debtors disclose advisors’ fees; and the equality of provision of information in the scheme process.
The key objective of mandatory disclosure for schemes parallels the objective of disclosure requirements for shareholder meetings under English corporate and securities laws: reducing information asymmetry faced by the shareholders. Failure to make adequate disclosures to creditors can lead courts to refuse to approve the scheme. Mandatory information disclosure in the course of securing a vote on the restructuring plan also features prominently in Article 8 of the EU Directive on Preventive Restructuring Frameworks 2019/1023.
However, there are specific risks in Hong Kong and Singapore that are either not present in the UK or not present to the same extent under traditional English schemes. First, shareholdings in listed companies in Hong Kong and Singapore are generally much more concentrated than in the UK. As a result, management’s interests are aligned with the controlling shareholders even when the company is “out of money.” In addition, schemes resolve all debts in Hong King and Singapore, rather than financial debts alone, as in the UK. Finally, retail investors have a significantly higher presence in debt instruments falling under the court’s jurisdiction. These different circumstances raise the question of whether the current disclosure regime sufficiently addresses risks arising from information asymmetry and provides the right incentives for debtors to disclose relevant and high-quality information for the creditors to make an informed decision when voting.
While Hong Kong’s scheme framework has largely remained unchanged since its enactment, Singapore has amended its scheme framework to include several debtor-in-possession features of Chapter 11 of the US Bankruptcy Code (Chapter 11), such as the availability of super-priority, cross-class cramdowns, and pre-packs. However, Singapore’s disclosure requirements continue to be largely based on English case law.
Drawing from the US approach towards disclosure in Chapter 11, we argue that disclosure of sufficient information on the company’s valuation should be a central focus of the explanatory statement and that the restructuring support agreement (RSA) should be carefully reviewed. We also argue for an ex ante approach to disclosure statements under schemes of arrangement at the stage in which the court decides rather to grant permission to convene the scheme meetings. As both Hong Kong and Singapore have sophisticated and experienced judiciaries, earlier involvement of the courts may provide greater confidence in the process for investors by compelling the disclosure of key financial information.
In our analysis of the practice of schemes, we reviewed approved schemes involving listed companies in Hong Kong and Singapore for the five-year period covering 2015-2019. We obtained information on disclosures from announcements made by listed companies, explanatory statements from publicly available sources, stock exchange websites, and information agents for bond documentation. Where possible, we compare the disclosures to creditors with the separate disclosures to shareholders published in shareholder circulars. We conclude that the disclosure requirements under the traditional English scheme model are insufficient to adequately address risks to investors and creditors in Hong Kong and Singapore. In order to provide investors with greater confidence in the scheme process, additional disclosure in the explanatory statement regarding the value of the company, and ex ante review of explanatory statements and RSAs are needed.
