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.

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.

Towards an Optimal Model of Directors’ Duties in the Zone of Insolvency: An Economic and Comparative Approach

By Aurelio Gurrea-Martínez (Singapore Management University)

Aurelio Gurrea-Martínez

When a company becomes factually insolvent but it is not yet subject to a formal insolvency proceeding, the shareholders—or the directors acting on their behalf—may engage, even in good faith, in various forms of behaviour that can divert or destroy value at the expense of the creditors. For this reason, most jurisdictions around the world provide a variety of legal strategies to respond to this form of shareholder opportunism. One of these strategies is the imposition of special directors’ duties in the zone of insolvency.

In a recent article, I analyse the primary regulatory models of directors’ duties in the zone of insolvency observed internationally. From a sample of more than 20 countries from Asia, Australia, Europe, Latin America, Africa, and North America, I distinguish six primary regulatory models: (i) the imposition of a duty to initiate insolvency proceedings, generally found in Europe; (ii) the imposition of a duty to recapitalise or liquidate the company, typically existing in Europe and Latin America; (iii) the imposition of duties towards the company’s creditors, including the duty to minimise losses for the creditors existing in the United Kingdom; (iv) the imposition of a duty to prevent the company from incurring new debts, existing in countries like Australia and South Africa; (v) the imposition of a duty to prevent the company from incurring new debts that cannot be paid in full, existing in Singapore and New Zealand; and (vi) the imposition of a duty to keep maximising the interest of the corporation, as it exists in Canada and the United States.

After analysing the features, advantages, and weaknesses of these models, my paper argues that the desirability of each regulatory model of directors’ duties in the zone of insolvency depends on a variety of country-specific factors including divergences in corporate ownership structures, debt structures, level of financial development, efficiency of the insolvency framework, and sophistication of the judiciary. For instance, in small and medium-sized enterprises (SMEs) as well as large controlled firms, there is a greater alignment of incentives between directors and shareholders. Therefore, in the event of insolvency, the directors will have more incentives to engage in a series of opportunistic behaviour that will advance the shareholders’ interests even if it is at the expense of the creditors. As a result, a more interventionist approach to protect the creditors, such as the duty to initiate insolvency proceedings, may make more sense in countries with a significant presence of SMEs and large controlled firms, as it happens in most jurisdictions around the world. By contrast, in countries like the United Kingdom and the United States, where large companies usually have dispersed ownership structures and therefore the directors are less influenced by the shareholders, a more flexible approach for the regulation of directors’ duties in the zone of insolvency may be more justified. Therefore, a duty to keep maximising the interest of the company or a duty to take steps to minimise potential losses for the creditors may make sense.

Nonetheless, country-specific factors other than corporate ownership structures can also affect the desirability of each regulatory model of directors’ duties in the zone of insolvency. For example, in countries without sophisticated courts, the discretion of courts should be reduced. Therefore, the imposition of clear rules (e.g., duty to initiate insolvency proceedings) may be more desirable than the use of standards (e.g., duty to minimise losses for the creditors or duty to keep maximising the interest of the corporation). Similarly, in countries with inefficient insolvency frameworks, initiating an insolvency proceeding can do more harm than good for both debtors and creditors. Therefore, these countries should not impose a duty to initiate insolvency proceedings even if, as it happens in many jurisdictions with inefficient frameworks (e.g., emerging economies), this solution makes more sense from the perspective of the corporate ownership structure prevailing in the country.

Based on a comparative, interdisciplinary, and country-specific analysis, my articles provides various policy recommendations to enhance the regulatory framework of directors’ duties in the zone of insolvency across jurisdictions taking into account international divergences in corporate ownership structures, debt structures, level of financial development, efficiency of the insolvency framework, and sophistication of the judiciary.

The full article is available here.

A modified version of this post was published on the Singapore Global Restructuring Initiative Blog.

When Arbitration Meets Bankruptcy: Considering Arbitration Options in the Wake of a Growing Rise in Corporate Insolvencies

By Shana A. Elberg, Christine A. Okike, & Jennifer Permesly (Skadden)

Shana A. Elberg
Christine A. Okike
Jennifer Permesly

The economic hardships brought about by the COVID-19 pandemic have impacted companies globally, leading many to consider both in-court and out-of-court restructurings. This trend will likely continue as the long-term effects of COVID-19 play out, and companies with arbitration clauses in their commercial agreements may wish to consider the impact of insolvency on their options for pursuing pending or future arbitrations. Under bankruptcy law, the initiation of insolvency proceedings results in an automatic stay of all civil proceedings brought against the debtor, including claims brought in arbitration. An arbitration counterparty may ask a bankruptcy court to lift the stay, which the court is permitted to do under the Bankruptcy Code “for cause.” The decision to lift the stay is ultimately a matter of the bankruptcy court’s discretion, though federal circuit courts have held that a stay of an arbitration involving a noncore matter generally must be lifted. The balance is particularly weighted in favor of arbitration in the international context.   Although the stay of arbitration is intended to apply extraterritorially, it is not always clear that arbitration tribunals seated outside the US, or counterparties located outside the US and not subject to the bankruptcy court’s jurisdiction, will consider themselves bound by the stay.  Companies considering their options for pursuing cross-border arbitrations against an insolvent debtor must therefore consider the relevant laws in at least three regimes: the seat of the arbitration, the place in which the debtor has declared insolvency and any countries in which enforcement of the award may ultimately be sought.

The full article is available here.

Bankruptcy Claim Dischargeability and Public Externalities: Evidence from a Natural Experiment

By Michael Ohlrogge (New York University School of Law)

Michael Ohlrogge

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.

The full article is available here.

This DIP Loan Brought to You by Someone Who CARES!

By Thomas J. Salerno, Gerald Weidner, Christopher Simpson, and Susan Ebner, (Stinson LLP)

Tom Salerno
Gerald Weidner
Chris Simpson
Susan Warshaw Ebner

 

 

 

 

 

 

 

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was enacted into law. The CARES Act is reported to be “twice as large as any relief ever signed,” and will provide $2.2 trillion in relief to US businesses (with another $1 trillion being promised in the near future). While bankruptcy lawyers are aware that CARES expanded the debt limitations for eligibility for the Small Business Bankruptcy Reorganization Act, there could (and should) be another substantial implication for the brave new bankruptcy world—a new potential source of DIP financing. It is in this context that the CARES financing provisions become particularly interesting.

The authors recognize that there are established underwriting guidelines for SBA loans. Moreover, the existing regulations (and revisions in process) will come into play as to availability of these loans. Accordingly, while there is no express prohibition for some of the loans referenced herein from being accessed in a Chapter 11 proceeding, a de facto prohibition likely comes from existing underwriting guidelines. If the overarching purpose of the CARES Act is to assist businesses in weathering the economic storm while the COVID 19 virus ravages the economy, the authors argue that such underwriting guidelines can, and must, be loosened in order to allow application of some of these programs in Chapter 11 proceedings so that they can be most effectively implemented to stabilize businesses, preserve jobs, continue to keep employees and businesses on the tax rolls, etc.

In this way the stimulus funds will be used where they can be most effectively deployed. If not, those funds will be the equivalent of the federal government sending rubber rafts to a drought stricken area—a sign that the government cares, perhaps, but of certainly no real use to address the problem at hand. The full article is available here.

Teams and Bankruptcy

Ramin Baghai (Stockholm School of Economics), Rui Silva (London Business School), Luofu Ye (London Business School)

Corporate bankruptcies constitute an important mechanism through which the economy rids itself of obsolete firms and allocates their constituent parts to alternative and potentially more productive uses. This process of reallocation of human and physical capital is an “essential fact about capitalism” (Schumpeter 1942).

While resources may on average be used more productively following a bankruptcy, this process is not deterministic and likely involves various imperfections. In addition to the potential loss in value to the firm’s redeployable physical capital stock (e.g., due to asset fire sales), bankruptcy may involve some deterioration of organizational and human capital. Moreover, frictions in the post-bankruptcy re-allocation of resources across firms may lead capital and labor to be idle for some time or even result in protracted sub-optimal uses. In the case of workers, unemployment spells could also accelerate the depreciation of skills. While prior studies have focused primarily on the reallocation of physical capital and individual workers, we are the first to systematically study how the human capital embedded in teams is affected by corporate bankruptcies.

Teamwork has become a prevalent way of organizing production in science, in patenting, and, more broadly, in the corporate sector. It has been documented, in a variety of settings, that teamwork has substantial benefits compared to work in hierarchical environments, in particular when complex tasks are involved. Despite the importance of teamwork, there is little systematic evidence on the economic drivers affecting the creation, stability, and dissolution of productive team configurations. Understanding these forces is crucial for the design of corporate and public policies that maximize productivity.

In our working paper, we use employer-employee matched data on U.S. inventors to study how the human capital embedded in teams is reallocated in corporate bankruptcies; our data span the period 1980 to 2010. Our results paint a nuanced picture of the reallocation of human capital through bankruptcy. Team dissolution increases around bankruptcy and team inventors subsequently become less productive than their less team-dependent colleagues. However, the labor market and the market for corporate control promote the preservation of team-specific human capital. Therefore, on balance, the productivity losses associated with bankruptcy are modest for team-dependent inventors. In addition, inventors who do not work in teams may even experience an increase in their post-bankruptcy productivity (although these effects have limited statistical significance). This suggests that bankruptcies have the capacity to release resources to more productive uses. Overall, we conclude that frictions that limit the efficiency of asset reallocation through bankruptcy may be limited in the case of highly skilled labor.

The full article is available here.

Corporate Governance, Bankruptcy Waivers and Consolidation in Bankruptcy

By Daniel J. Bussel (UCLA School of Law)

Bankruptcy law—once the vanguard of enterprise liability —has increasingly tended to kowtow to formalities of corporate law standing in the way of effective reorganization.

In two areas in particular, corporate law is seen by some courts and commentators as imposing rigid and substantive limitations on bankruptcy rights.

First, although bankruptcy courts have long held that access to bankruptcy relief may not be waived in a contract, recent decisions have enforced state corporate law’s choice to defer to contractual governance arrangements baked into corporate charters that hinder or preclude an entity from filing for bankruptcy relief.

Second, influential appellate decisions have pushed bankruptcy courts to respect the legal boundaries between affiliated entities within a corporate group for substantive insolvency law purposes, even as those boundaries are routinely ignored for operational, financial, tax and regulatory purposes.

Professors Baird and Casey, expanding upon earlier work by Professor LoPucki, have noted and embraced this judicial trend toward respecting corporate law formalities.  They have coined the term “withdrawal rights” to describe the phenomenon of prebankruptcy contractual arrangements enforceable under state corporate law that operate to allow a particular creditor to opt-out of the bankruptcy process by segregating key operating assets in entities that are effectively precluded from obtaining bankruptcy relief without the creditor’s express consent.

In CORPORATE GOVERNANCE, BANKRUPTCY WAIVERS AND CONSOLIDATION IN BANKRUPTCY, I argue that these techniques, however clever, run smack into traditional and still vibrant bankruptcy doctrines that find contractual waivers of access to bankruptcy relief void as against public policy, and that permit consolidation of entities whose formal separateness is inconsistent with the actual and effective operation of the corporate enterprise under reorganization.

Thus “Golden Share” arrangements in which a creditor is issued a special class of equity (the Golden Share) and the debtor’s charter is amended to preclude bankruptcy filing absent the Golden Shareholder’s consent, fail as unenforceable contractual waivers of bankruptcy rights.

Moreover, constituents with claims against affiliated companies in bankruptcy proceedings that effectively operate as a unified enterprise should not be surprised when they are treated as a claimant against that unified enterprise, except to the extent that the bankruptcy equities themselves demand otherwise, and so long as the value of their rights in property are adequately protected, even if the formalities of entity separateness are otherwise respected.  The restrictive approach to substantive consolidation adopted by some appellate courts, notably the Third Circuit in Owens-Corning, that encourages reliance on formal entity separation, should be rejected.

Bankruptcy courts are destined to struggle with the problem of withdrawal rights forever. Powerful creditors have never fully accepted the concept that they can be compelled to participate in a collective proceeding in the event of the common debtor’s insolvency and have sought ways to opt out of those proceedings when it is to their advantage to do so. They show no signs of flagging in efforts to structure bankruptcy-remote relations through statutory exceptions and preferences, the creation of property rights in their favor, and contractual strictures. If they have the political strength to carve out express exemptions in the Bankruptcy Code, courts may have little flexibility to prevent the opt-out.

But absent a federal statutory exemption, to the extent that state law corporate formalities manipulated to the advantage of certain constituencies through special contractual arrangements become impediments to effective bankruptcy reorganizations, those formalities are quite properly overridden by bankruptcy law.  Bankruptcy law limits the efficacy of the “Golden Share” and other contractual arrangements incorporated into company charters, and the entity partition techniques observed by LoPucki, Baird and Casey (among others).  Those limits should be factored into market expectations surrounding asset securitization and other structuring techniques designed to avoid the ordinary operation of bankruptcy law upon a particular creditor’s claim. If they are properly factored in, it is difficult to believe that securitization of core assets of non-financial operating companies will remain a cost-effective alternative to more traditional financing arrangements. The market should place little value on a bankruptcy withdrawal right that is likely to prove illusory when it matters most.

The full article is available here.

Disagreement and Capital Structure Complexity

By Kenneth Ayotte (University of California, Berkeley School of Law)

Complex capital structures are prevalent in many recent high-profile Chapter 11 bankruptcy cases.  One recent example is Toys ‘R’ Us, whose debt structure included dozens of subsidiary entities, with separate debt facilities against entities owning the intellectual property, the real estate, and international operations, among other asset groups.  Why do capital structures become fragmented and complex in this way, and what are the implications for bankruptcy law?

In my working paper, I suggest one reason why a firm’s owners may have the incentive to engineer fragmented capital structures, using the idea that investors may disagree about the values of the various assets that make up the firm.  Fragmenting the capital structure horizontally—that is, pledging different assets and asset groups to different creditor classes—allows the firm to sell asset-based claims that are targeted to the investors who value those assets most highly. This targeting is good for the firm’s owners, because it minimizes the firm’s overall cost of capital.

This complexity can become costly, however, when firms encounter financial distress.  The same disagreement-driven fragmentation that allows the company to borrow more cheaply up front can lead to costly valuation disputes in and around bankruptcy, since creditors place a higher valuation on their own collateral than do the other creditors.  This can lead to valuation disputes that are socially costly in terms of professional fees, delays, and lost opportunities.  An example of this is the Energy Future Holdings case.  Following it’s 2007 leveraged buyout, the capital structure was divided into two silos, with one silo of entities (called the “E” side) holding regulated power assets, and a separate silo of entities holding the non-regulated power assets (the “T” side), with separate creditor groups on each side.  The initial plan to avoid bankruptcy by converting E- and T-side debt into parent-level equity failed after more than a year of negotiations, as the two sides could not come to agreement about the relative value of the two sides.  The resulting bankruptcy took over four years to reach plan confirmation and generated over $500 million in professional fees, to the detriment of creditor recoveries.

The theory has several implications.  One is that disagreement about valuation can lead to inefficient liquidation of viable firms, as creditors may prefer to walk away with the collateral they value highly, rather than fight for that value in a reorganization where the other creditors (from their perspective) are clinging to inflated valuations of their own collateral.  These kinds of forces may have been at play in the Toys ‘R’ Us case.  The B-4 term lenders, including the hedge fund Solus Alternative Asset Management, believed they were better off monetizing their intellectual property collateral in a liquidation of Toys ‘R’ Us than backing a deal to keep existing stores open.  The recent cancellation of the auction of this collateral suggests that these lenders may have held optimistic beliefs than the marketplace about the value of these assets.

From an academic standpoint, the theory provides a new answer to a long-standing question in the literature: why do we need a corporate reorganization mechanism in the first place? Traditional answers to this question revolve around the need to solve illiquidity problems.  In the presence of disagreement, I suggest an alternative benefit.  A traditional Chapter 11 reorganization allows parties to walk away with securities backed by the assets they financed before bankruptcy, about which the creditors are likely to be more optimistic.  Thus, the creditors can continue “agreeing to disagree” about the values of their respective pieces, thus promoting settlement and avoiding socially costly valuation disputes.  This is not possible when the firm is sold as a going concern for cash, since cash has a commonly known value.

Finally, my model emphasizes that when capital structures are fragmented, bankruptcy costs can be driven by haggling and litigation over the value of the parties’ entitlements, even when the parties agree about what to do with the bankrupt firm.  This suggests that the time may be ripe for rethinking and improving the resolution of valuation disputes in bankruptcy.  In a related paper, published in University of Pennsylvania Law Review, Edward Morrison and I review valuation opinions in bankruptcy cases.

The full article is available here.

Financially Distressed Companies, Restructuring and Creditors’ Interests: What is a Director to Do?

By Andrew Keay (University of Leeds)

Out of court restructuring is a popular and, according to many, optimal way of resolving the circumstances of insolvent companies in the UK, and probably more so since the advent in the UK of the Enterprises Act 2002. One concern that some commentators have raised is the fact that the opportunities to engage in such restructuring are likely to be reduced given the way that the courts have approached claims that directors who have initiated restructuring strategies are liable for breach of duty in failing to take into account the interests of company creditors when their company is insolvent or near to it (as applied by section 172(3) of the Companies Act 2006 in the UK). Allied to this is the concern that if directors are not granted freedom to use their discretion in entering into a restructuring process companies might be placed into administration or liquidation when they have some prospect of continuing to trade and to do so profitably, because directors may choose to be risk averse in placing a company into administration or liquidation rather than take the risk of being held liable for breach of the duty if they attempt restructuring. This paper examines whether the aforementioned concerns are realistic, given the law, and, if they are, what directors should be doing to ensure that they do not breach the obligation in relation to creditors. These are important issues as little consideration has been given in the UK to the issue of liability of directors for breach of duty in the wake of a restructuring. The issues are considered in light of section 172(3) of the Companies Act 2006 which makes the director’s duty to promote the success of the company for the benefit of the shareholders (as under section 172(1) and providing for what is known as ‘enlightened shareholder value’) subject to any rule of law that requires directors to consider the interests of creditors. It is a rule of law in the UK (and in many Commonwealth countries and Ireland) that when their company is insolvent or in dire financial distress directors must take into account the interests of creditors.

The paper finds that while directors might be subject to liability in entering into restructuring attempts, this is only going to occur in limited cases and so there should not be particular concern over liability. This is because first of all courts will not hold directors liable if they acted in good faith and took into account the interests of creditors, and regarded these interests as paramount in their considerations. Even if the directors failed to take into account the interests of creditors or failed to make them paramount, they will not be liable where the court finds that the honest and intelligent director, taking into account creditors’ interests, would have entered into the restructuring in any event on the basis that it would benefit creditors. Obviously if directors restructure in such a way as to benefit themselves or specific creditors, or they have improper motives, then liability is more likely to ensue. But, where the directors have acted reasonably then they should be safe from challenge.

The full article is available here.

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