By Laura N. Coordes (Associate Professor of Law, Arizona State University – Sandra Day O’Connor College of Law)
The United States and Canada have both seen significant litigation over the treatment of environmental obligations in bankruptcy proceedings. Both countries also have robust regulatory and statutory frameworks with respect to bankruptcy and environmental law, making the two jurisdictions ripe for comparison.
Although the U.S. legal landscape differs somewhat from Canada’s, courts in both countries have struggled to sort out the treatment of environmental obligations in bankruptcy. However, in 2019, the Supreme Court of Canada decided Orphan Well Association v. Grant Thornton Limited (“Redwater”), which characterized environmental obligations, not as claims, but as duties owed to the public that could not be compromised in bankruptcy. Meanwhile, U.S. courts continue to grapple with the question of how to treat a company’s environmental obligations in bankruptcy.
This article analyzes the impact of Redwater and highlights issues that U.S. scholars and policymakers should consider as they press for changes. In particular, the article focuses on three questions: (1) What is the role of the legislature as compared to the judiciary? (2) What is the role of federal law, as compared to provincial or state law? and (3) What is the role of the public interest?
These three questions implicate debates that go beyond the immediate issue of the role of environmental law in bankruptcy proceedings. However, considering environmental and bankruptcy law in light of these universal issues illuminates unresolved tensions that both the U.S. and Canada will likely continue to face on a larger scale.
By Sheila C. Neder Cerezetti (Professor of Law, University of São Paulo Law School)
As argued by prominent Brazilian scholars, some of the most relevant attributes of the corporate form – limited liability and asset partitioning – might be considered just a tale in Brazil, as they have been consistently and subsequently weakened by a variety of reasons.
In light of this and of the large number of corporate reorganization cases involving groups of companies, which gave way to a series of unsubstantiated applications of substantive consolidation, the article raises the debate on the correct use of the mechanism in the country.
I question whether the lenient approach to substantive consolidation by Brazilian courts (i) is a natural consequence of the weakening of limited liability and asset partitioning, and (ii) represents a better way to recognize the Brazilian corporate reality, bringing more truth to reorganizations.
In the attempt to answer these questions, the article introduces the basic aspects of corporate reorganization in Brazil, offering a comprehensive overview of the Brazilian Bankruptcy Act (Law No. 11,101/2005). The description addresses the broad use of procedural and substantive consolidation even if, at the time, the Brazilian Bankruptcy Act lacked provisions for proceedings with multiple debtors. It shows that the permissive approach first directed to procedural consolidation slowly unraveled into a silent acceptance of substantive consolidation.
Next, the article explores some of the uses of substantive consolidation in the USA (where the mechanism started and gained traction) and in the UNCITRAL Legislative Guide on Insolvency Law (an important indicator of what might be adopted in other jurisdiction in the future), with a brief reference to the status of the matter in the European Union. In these cases, a set of prerequisites have been established to determine when the exceptional measure of the mechanism is appropriate.
In contrast, I call a misuse the often-unsubstantiated acceptance of substantive consolidation in Brazil, that fails to note its exceptionally. In the vast majority of cases, substantive consolidation actually happened in proceedings where none of the parties and not even the court expressly addressed the issue and implicitly just treated a single plan as something normal, although it mixed assets and liabilities of different debtors. And in those cases where the matter has been expressly addressed, the criteria for ordering the consolidation (i) varied greatly, to the point that it could not be rationalized in the form of a test, and (ii) failed to treat the remedy as an exceptional tool.
In light of the mentioned “tale of limited liability in Brazil”, one could wonder if such a misuse of substantive consolidation is in fact inappropriate. However, I argue that this tale is not so severe as to justify the lenient approach described, in view of the rules on corporate groups as well as of the fact that strictly commercial and civil relationships are, for the most part, protected from the exceptions to limited liability.
The article contends that there still is a compelling case for a stricter use of substantive consolidation, considering, among other reasons, that accepting the lenient criteria for ordering substantive consolidation would mean further weakening the attributes of the corporate form. It concludes by pointing to other tools in bankruptcy law that can better deal with the exceptions to the limitation of liability, and argues that substantive consolidation should remain a remedy for abuses of the corporate form that turn it dysfunctional.
Finally, it should be noted that a recently approved bill included provisions on procedural and substantive consolidation in the Brazilian Bankruptcy Law, ratifying the lenient approach described in the article. The article also serves as an explanatory description of the pathways that led the Brazilian legal system to such a discipline and as a warning about the perils of following this route.
Over the past several years, certain circuits criticized the Equitable Mootness doctrine for its lack of statutory basis and effect of avoiding review of chapter 11 plans on the merits. However, the Third Circuit recently held in In re Nuverra Environmental Solutions, Inc. v. Hargreaves, Case No. 18-3084, 834 Fed. Appx. 729 (3d Cir. Jan. 6, 2021), that the Equitable Mootness doctrine is still alive and well.
The Third Circuit rejected the appeal of Hargreaves, a creditor who timely objected to the chapter 11 plan and timely appealed the bankruptcy court’s entry of the plan’s confirmation order, because the plan was already substantially consummated and could not be unwound. Further, the Third Circuit held that it could not grant Hargreaves “individualized relief” because such relief would violate Bankruptcy Code § 1123(a)(4)’s restriction on preferential treatment of class members and § 1129(b)(1)’s prohibition on unfair discrimination between classes.
In a concurring opinion, Judge Krause rejected the application of Equitable Mootness, finding the majority did not sufficiently analyze whether disparate treatment of creditors within a class is permissible on appeal when parties choose not to object to, or appeal confirmation of, the plan. Judge Krause also noted that denial of the appeal on Equitable Mootness grounds precluded consideration of substantive arguments and development of the Third Circuit’s bankruptcy jurisprudence.
While Judge Krause’s concurring opinion highlights difficulties plan objectors face when appealing plan confirmation, the majority opinion signals that Equitable Mootness is still a healthy doctrine in the Third Circuit.
By Daniel J. Merrett (Jones Day) and Mark G. Douglas (Jones Day)
The ability of a bankruptcy trustee or chapter 11 debtor-in-possession (“DIP”) to avoid fraudulent transfers is an important tool promoting the bankruptcy policies of equality of distribution among creditors and maximizing the property included in the estate. One limitation on this avoidance power is the statutory “look-back” period during which an allegedly fraudulent transfer can be avoided—two years for fraudulent transfer avoidance actions under section 548 of the Bankruptcy Code and, as generally understood, three to six years if the trustee or DIP seeks to avoid a fraudulent transfer under section 544(b) and state law by stepping into the shoes of a “triggering” creditor plaintiff.
The longer look-back periods governing avoidance actions under various state laws significantly expand the universe of transactions that may be subject to fraudulent transfer avoidance. Indeed, under a ruling recently handed down by the U.S. Bankruptcy Court for the Western District of North Carolina, the look-back period in avoidance actions under section 544(b) may be much longer—10 years—in bankruptcy cases where the Internal Revenue Service (“IRS”) or another governmental entity is the triggering creditor. In Mitchell v. Zagaroli (In re Zagaroli), 2020 WL 6495156 (Bankr. W.D.N.C. Nov. 3, 2020), the court, adopting the majority approach, held that a chapter 7 trustee could effectively circumvent North Carolina’s four-year statute of limitations for fraudulent transfer actions by stepping into the shoes of the IRS, which is bound not by North Carolina law but by the 10-year statute of limitations for collecting taxes specified in the Internal Revenue Code.
Zagaroli does not break new ground on the power of a bankruptcy trustee or DIP to bring avoidance actions under section 544(b) of the Bankruptcy Code. Nevertheless, the court’s endorsement of the majority approach on the availability of a longer look-back period in cases in which the IRS is a creditor is notable. Widespread adoption of this approach could significantly augment estate avoidance action recoveries.
By Allison Buccola (Independent) and Vince Buccola (Assistant Professor, The Wharton School)
Puerto Rico’s Title III proceedings under PROMESA mark the return of debt repudiation as a feature of the government debt restructuring landscape. Backed by an official committee, the Federal Oversight and Management Board has argued that some $6 billion of bonds the Commonwealth issued are void and worthless. According to the Board, the bonds were sold illegally, in contravention of a constitutional debt limit, so that (also according to the Board) they cannot bind the Commonwealth. A similar argument was lodged in Detroit’s bankruptcy. For the better part of a century before that, however, repudiation was mostly unheard of in the United States.
The invocation of ultra vires to escape bond obligations is nothing new, though. In the second half of the nineteenth century, municipal debtors frequently welched on their debts. In the 1850s and 1860s, cities, towns, and counties across the Midwest and West issued bonds to finance the construction of railroads and other infrastructure. Many ultimately defaulted. Rather than simply announce that they couldn’t or wouldn’t pay, however, they often contended that they needn’t pay: for one or another reason, the relevant bonds had been issued ultra vires and so were no obligation of the municipality at all. Litigation in the federal courts was common. Several hundred repudiation disputes made their way to the Supreme Court in the forty years starting 1859.
With an eye to the modern cases, we set out to understand how the Court reckoned with repudiation. We read every one of the 196 cases in which the Justices opined on bond validity (i.e. the enforceability of a bond in the hands of innocent purchasers). In a recently published article, we correct received wisdom about the cases and remark on the logical structure of the Court’s reasoning.
To the extent the municipal bond cases are remembered, modern scholars usually think of them as exemplary instances of a political model of judging. The caricature has the Court siding with bondholders even when the law called on them to rule for the repudiating municipalities. The Justices—or a majority of them—are imagined as staunch political allies of the capitalist class, set against the institutions of state government and their regard for agricultural interests. We find that this picture is inconsistent with reality. In fact, the Court ruled for the repudiating municipality in a third of all the validity cases. As importantly, the Court’s decisions reflected a readily articulable formal logic, a logic the Justices seem, to our eyes, to have applied soundly.
The Court’s analytical approach traded on a distinction between legal and factual bases for repudiation. A municipality might repudiate either on a theory that no legal authority permitted the contested bond to be issued under the circumstances the bondholder alleged or, alternatively, on a theory that the circumstances alleged did not in fact pertain. Where the theory of repudiation turned on a legal predicate, the Court simply proceeded to the merits, comparing the bond to the powers granted to the issuer by state law at the time of issuance. Repudiating municipalities often prevailed.
Where the theory of repudiation turned on a factual predicate, by contrast, bondholders fared much better. The defining theme in such cases was a procedural mechanism that precluded assessment of the merits, namely the adaptation of estoppel doctrine to the municipal context. It was, and still is, customary for bonds to recite circumstances relevant to issuance. Estoppel allowedbuyers in the secondary market to credit whatever facts—but only facts—the issuer declared true at the time of issuance. In a number of debt-limit cases reminiscent of Puerto Rico, this logic propelled bondholders to a judgment. Estoppel did not resolve all fact-based repudiation arguments. It did not foreclose a trial if, for example, the contested bond failed to recite a predicate fact. Nevertheless estoppel was an important feature of the bond cases, one which, given the profound asymmetry of information that prevailed with respect to matters of fact, probably helped to sustain the bond market as a source of capital for municipal development.
By Jared A. Ellias (Bion M. Gregory Chair in Business Law and Professor of Law, UC Hastings College of Law) and George Triantis (Professor of Law and Business, Stanford Law School)
It is widely recognized that bankruptcy law can stymie regulatory enforcement and present challenges for governments when regulated businesses file for Chapter 11. It is less-widely understood that bankruptcy law can present governments with opportunities to advance policy goals if they are willing to adopt tactics traditionally associated with activist investors, a strategy we call “government bankruptcy activism.” The bankruptcy filings by Chrysler and General Motors in 2009 are a famous example: the government of the United States used the bankruptcy process to help both auto manufacturers resolve their financial distress while promoting the policy objectives of protecting union workers and addressing climate change. A decade later, the government of California applied its bargaining power and used an innovative state law in the Pacific Gas & Electric Company’s Chapter 11 case to protect climate policies and the victims of wildfires. These examples illustrate that, by tapping into the bankruptcy system, governments gain access to the exceptional powers that a debtor enjoys under bankruptcy law, which can complement the traditional tools of appropriations and regulation to facilitate and accelerate policy outcomes. This strategy is especially useful in times of urgency and policy paralysis, when government bankruptcy activism can provide a pathway past veto players in the political system. However, making policy through the bankruptcy system presents potential downsides as well, as it may also allow governments to evade democratic accountability and obscure the financial losses that stakeholders are forced to absorb to help fund those policy outcomes.
By Noam Sher (Assistant Professor of Law, Ono Academic College, Israel)
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.
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)
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.
By Diane Lourdes Dick (Professor of Law, Seattle University School of Law)
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.
By Anthony J. Casey (The University of Chicago Law School)
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:
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.