It has been recognized that corporations themselves are designed to promote collective action, and thus “a primary function of corporate law is to coordinate and constrain individual behavior – even profit-motivated behavior.” Given that corporate debt instruments largely serve a governance function amongst creditors, it is not surprising that they, like corporations themselves, tend to quash individual action in favor of the group. But the divergence between individual and group interests comes to the fore in times of stress.
An individual creditor can be either an oppressed minority investor or a holdout. Majority holders can be either the group seeking an efficient and beneficial restructuring, or effectively an insider group that collaborates with more formal insiders to extract value from minority creditors. Which reality is genuine is highly dependent on the particular facts of the case at hand, and may be quite difficult for an outsider to discern.
Restructuring law attempts to balance this uncertainty by providing a series of checks and balances. In general, restructuring law begins with a preference for the collective, but encircles the collective with a series of rules that protect individual creditors from abuse.
Some of the balance comes from the agreements that create the creditor relationship or duties related to those agreements; however, other aspects of balance are external and come from outside structures like the Bankruptcy Code or the Trust Indenture Act. In general, the basic challenge here is to find the point at which the illegitimate power of holdouts is reduced without trampling on the legitimate rights of minority creditors. It is very easy to avoid holdouts if the majority always wins.
My paper explores the ways in which modern restructuring practice has moved toward that “majority always wins” extreme. This change was not part of some grand plan, but rather the result of a series of incremental decisions, each reacting to perceived abuses by holdouts. But in indulging our fears of holdouts, we have lost the essential balance of the system.
Take the example of the RSA – or restructuring support agreement – that, in a variety of ways, can represent a generalized assault on the requirement in section 1123(a)(4) that a chapter 11 plan must “provide the same treatment for each claim or interest of a particular class.” RSAs achieve this end by providing for backstop fees paid to a select group that will never have to backstop anything or DIP loans that the debtor does not really need.
In one recent case, pre-bankruptcy the debtor contracted with a sub-group of its secured noteholders to have those noteholders make an interest payment on the notes. That is, some of the secured noteholders paid the interest payment due to all the secured noteholders.
In exchange, these distinctive noteholders received new “super-priority secured notes” secured by a lien that surpassed the old secured notes’ liens, while also carrying a hefty 10% coupon. When the debtor filed for chapter 11 later that same year, to implement its own RSA-driven plan, the new super-priority notes were paid in full, with interest and “make whole call” fees. In short, the select lenders made a small, six-month loan for a very high return at low risk. This opportunity was not available to everyone in the original class of noteholders.
In short, I conclude that the modern American restructuring system has evolved to favor the interests of the majority to the point where a debtor and a majority of its lenders can inflict serious harm on minority creditors. At some point, this reality is bound to have consequences for both the debt markets and the utility of chapter 11.
By Niklas Hüther (Indiana University) and Kristoph Kleiner (Indiana University)
Niklas HütherKristoph Kleiner
”The bankruptcy system is supposed to work for everyone, but in many cases it works only for the powerful.” – House Judiciary Committee Chairman Jerrold Nadler, July 28th, 2021
Researchers have long recognized that judicial outcomes are subject to the biases of the ruling judge. To alleviate concerns of fairness, courts in both the U.S. and abroad claim to assign judges to individual court cases randomly. From a policy perspective, randomization promotes public confidence in the judicial process by limiting forum shopping and the individual influence of any individual judge. From an academic perspective, recent empirical research in economics and finance exploits the random assignment of judges to causally identify of a wide range of legal outcomes.
This paper revisits the claim of randomized judicial assignment in the context of U.S. Bankruptcy Court. Our research is motivated by legal scholarship arguing that debtors in recent cases are influencing judicial assignments (Levitin, 2021), as well as renewed interest in these issues from policy makers and the public (Merle and Bernstein, 2019; Randles 2020). Despite these arguments, there are reasons to believe assignment is random. For instance, after contacting all U.S. Bankruptcy Courts, Iverson et al. (2017) found that only one court (the Eastern District of Wisconsin) reports assigning cases to judges non-randomly. In addition, a range of research including Bernstein et al. (2019)provides convincing evidence that debtor characteristics fail to predict judicial assignments. Missing from this literature is any large-scale empirical evidence of non-random assignment.
Analyzing U.S. corporate bankruptcy filings between 2010 and 2020, we provide new evidence that assignment is not random, but predicted by the lending decisions of hedge funds. By focusing on investments made before the assignment of a bankruptcy judge, our technique is not suspect to standard critiques that predictability is merely an outcome of ex-post data mining; instead, in order for investors to systemically invest in firms that are later assigned a preferred judge, it must be possible to infer future judicial assignments. In addition, we focus on hedge funds, as they routinely influence a wide range of bankruptcy outcomes including emergence and debt restructurings. The prevalence of these investors allows us to explore a new channel of activism in the distress debt market: activist influence in judicial assignment process prior to filing.
In our setting, judges can decide whether to convert a Chapter 11 bankruptcy to a Chapter 7 liquidation; while secured creditors may have a preference for liquidation, unsecured creditors recover more under reorganization. Exploiting this distinction, we confirm unsecured hedge fund creditors (relative to secured hedge funds) are significantly less likely to be assigned a judge with a tendency to convert Chapter 11 cases. We also extend our analysis to an alternate bankruptcy outcome measure: the unsecured creditor recovery rate according to the confirmed plan. We find unsecured hedge funds are far more likely to be assigned a judge with a high past unsecured recovery rate.
We next test whether these estimates differ across the filings in our sample. First, we find that unsecured hedge fund claimants are assigned a preferable judge more commonly when the hedge fund invested shortly before the bankruptcy filing, suggesting hedge funds choose to invest explicitly to influence the filing. Second, we show the effects are greatest when the hedge fund is on the board of directors of the debtor at the time of filing, providing further support for the role of communication between debtor and creditor.
Finally, we conduct three robustness tests. First, we find no evidence that a judge’s future conversion rate (after controlling for the past conversion rate) is predicted by hedge fund investment, suggesting hedge funds are explicitly influencing judicial assignment based on information regarding past information. Second, focusing on the subset of districts that explicitly state random assignment within their district, we continue to find hedge fund investments predict assignment. Third, we include district-office-year fixed effects in our analysis and continue to find a relationship between hedge fund investments and assignment.
Moving forward, we believe there are two potential policies that can alleviate these issues. The first, and simplest, is for policy makers to develop a truly randomized process. Alternatively, policy makers can instead increase the number of bankruptcy judges, leading to lower predictability even if assignment is not fully randomized. Policy makers intent on a fairer judicial system should consider both proposals.
On July 9, 2021, Southern District of New York Judge J. Paul Oetken held that §503(c) of the Bankruptcy Code prohibits board-appointed officers from receiving payments under a key employee retention plan (KERP) “absent a particularly strong showing that they do not perform a significant role in management,” as such officers are “insiders” within the definition of §101(31)(B)(ii). In re LSC Communications, Inc., 631 B.R. 818 (S.D.N.Y. 2021). This was the case even though the Bankruptcy Court found that the employees in question were officers “in title only.” Id. at 820. Judge Oetken’s ruling affects six employees who received KERP payments under the reorganization plan of LSC Communications, Inc. (“LSC”), which filed for Chapter 11 relief in April 2020.
In its initial order, the Bankruptcy Court approved payments under the KERP for all 190 covered employees. U.S. Trustee William K. Harrington appealed the decision to the District Court, claiming that, as LSC was incorporated in Delaware, the court should apply Delaware state law, which provides that any person appointed by a corporation’s board of directors is an officer. In response, LSC countered that the employees could not be considered insiders because they lacked any significant decision-making authority.
Judge Oetken wrote that case law regarding who constitutes an “officer” is “less than clear,” noting that the Bankruptcy Code does not define the term or provide any insight regarding its meaning. Id. at 824. Although Judge Oetken rejected the Trustee’s argument that state law exclusively applies when determining whether an employee is an officer under the Bankruptcy Code, he concluded that the Bankruptcy Court erred by looking beyond the fact that the six employees were appointed by LSC’s board. Even if a court chooses to undertake a more expansive analysis, he wrote, the fact that the six employees were appointed by the board and would be deemed officers under Delaware corporate law should “weigh heavily in concluding that the employees are officers for Bankruptcy Code purposes.” Id. at 826. In supporting his position, Judge Oetken claimed that giving more weight to objective criterion like appointment by the board provides greater clarity to the parties than the kind of “functional, non-exhaustive test” used by the Bankruptcy Court, although he noted that this kind of test may still be appropriate in some cases. Id. at 825.
This case, and its somewhat unusual holding, seems to present a scenario that has become exceedingly rare. In September, the Government Accountability Office (GAO) published a report finding that debtors regularly avoid restrictions in the Bankruptcy Code by paying bonuses before or after filing for bankruptcy or by designating bonuses during bankruptcy as “incentive” payments. The report stated that fewer than 1% of debtors requested court approval to pay employee bonuses during 2020 and, when debtors did seek court approval, the courts approved “nearly all” of those requests. Maria Chutchian wrote in a recent Reuters article that creditors rarely challenge such bonus payments in court, noting debtors will often arrange private deals with creditors before filing for bankruptcy. In the same article, she discusses the Mallinckrodt restructuring, in which the pharmaceutical company’s creditors chose to challenge bonus payments to executives facing accusations of misconduct related to the opioid epidemic. The judge allowed the payments, stating that “mere allegations” of misconduct did not suffice to render them inappropriate.
Finally, Jared Elias concluded in an article published in 2019 that, although fewer companies have used court-approved bonus plans in the years since the Bankruptcy Code’s bonus provisions were reformed in 2005, the overall level of executive compensation has remained the same. This lends support to the GAO’s analysis and the anecdotes collected by Reuters that KERPs are rarely used because parties have ample opportunity to achieve the same end while avoiding the scrutiny of §503(c). He argues that bankruptcy and district court judges are poorly equipped to police payments made before or after a debtor files for bankruptcy, and that the U.S. Trustee’s office and creditors struggle to do so due to information asymmetries and limited resources.
Given the above, it appears that Judge Oetken’s decision this past summer may ultimately prove to be an anomaly. In most cases, these bonus payments simply will not become a part of the bankruptcy plan. Debtors can avoid scrutiny by making payments before or after filing for bankruptcy. If they decide they must make the payments during bankruptcy, they can reduce the scrutiny they will incur by recharacterizing them as incentive payments, thereby avoiding the heightened restrictions that apply to KERPs. And, even if they decide to include the payments in their restructuring plan, it seems unlikely that creditors will challenge the payments—particularly if counsel has chosen to arrange a deal behind the scenes to avoid a dispute in court.
By Jonathan C. Lipson (Temple University Beasley School of Law), Adam J. Levitin (Georgetown Law Center), Stephen J. Lubben (Seton Hall University School of Law)
Jonathan C. LipsonAdam J. LevitinStephen J. Lubben
Recently, we (along with colleagues at other law schools) asked that an examiner be appointed in the Purdue Pharma chapter 11 bankruptcy case, pending in the Southern District of New York. Although the Bankruptcy Court has not yet acted on that request (technically, it was in the form of a letter to the United States Trustee), it has generated controversy and media attention (e.g., WSJ, WaPo, Rachel Maddow), which will likely persist until there are credible answers to the questions that motivated our request:
What was the role of the Sackler family (the owners of Purdue) in Purdue’s role in the opioid crisis? and
To what extent did the Sacklers or other insiders strip assets out of Purdue in anticipation of bankruptcy?
Chapter 11 of the Bankruptcy Code governs corporate reorganizations, such as Purdue Pharma’s, and provides that an examiner can be appointed if, among other things, it is in the interests of creditors and the debtor’s bankruptcy estate. Here, we argued that there is an overwhelming public interest which overlaps with the estate’s interest. This makes the need for an independent report on these two questions compelling.
As is well known, Purdue Pharma is at the center of the opioid crisis in America, having developed and marketed Oxycontin (among other drugs). This crisis has generated more than 2600 lawsuits against Purdue and the Sacklers, many brought by state and local governments that have had to bear the costs of drug addiction. The debtors and the Sacklers have proposed a settlement under which the Sacklers would cede the company to a “public trust” and make additional contributions, in exchange for releases. The settlement is alleged to be between $10 and $12 billion, with $3 billion of that coming from the Sacklers directly. While some plaintiffs have agreed to the settlement, others have not, and are fighting the bankruptcy process.
Like many mass tort debtors—from Johns-Manville to PG&E—Purdue seeks to channel and control its liability through bankruptcy reorganization. Bankruptcy Judge Robert Drain, of the Southern District of New York, has stayed the lawsuits, not just against Purdue, but also against the Sacklers, even though they are not debtors in bankruptcy—in order to permit the debtors to negotiate a plan of reorganization that would embody the proposed settlement.
We argued that an independent examination would answer the two key questions more credibly and efficiently than other mechanisms in bankruptcy for three reasons.
First, unlike many mass-tort bankruptcies, these cases appear to shield non-debtors (the Sacklers) from discovery and potential liability, even though there are credible allegations that they may have actively contributed to the opioid crisis and/or stripped assets from the debtors. The important question is not whether the Sacklers are making a contribution to a bankruptcy plan in exchange for a release from future liability, but whether their contribution is appropriate in light of the answers to our two questions. It will be very difficult to assess that without an independent examiner’s report.
Second, because Purdue Pharma is privately held, it is hard to know what happened at the company before bankruptcy. The debtors have appointed a special committee of the board to look into the pre-bankruptcy transfers, but because the Sacklers apparently still control the debtors, it is hard to know how independent this committee was, or can be. The committee is, for example, represented by the same counsel as Purdue Pharma, which may hamper the committee’s independence. In any case, even where other high profile debtors, such as Enron, have used independent committees to investigate allegations of wrongdoing, courts have nevertheless appointed bankruptcy examiners to assess, verify, and supplement the work of those committees. It is hard to see why Purdue should be different.
Third, and perhaps most important, the opioid crisis is not like other mass torts because it has generated extraordinary public interest. Victims of the opioid crisis understandably want their day in court—which is something that bankruptcy tends to eliminate. While thousands of lawsuits would be wasteful, failing to take seriously the dignitary interests of victims of the opioid crisis could threaten the legitimacy and integrity of the bankruptcy system. At the same time, if an independent examiner exonerates the Sacklers, this may help provide the redemption that they presumably want.
Although the United States Trustee has not yet sought an examiner, there have been three interesting developments since we sent the letter:
On November 6, 2019 Marshall Huebner, counsel to the debtor in possession, emailed us to say that “the Debtors (likely along with other core stakeholders) intend to strongly oppose the request, which, with apologies to its authors, contains many misstatements of fact.” However, Huebner identified no “misstatements of fact” (much less “many”).
On November 15, 2019, ten days after we sent the letter, the debtors filed a stipulation with counsel to the creditors committee and certain members of the Sackler family. The debtors and the Sacklers agreed to produce certain information to the committee (on a “professional eyes’ only basis”) that may respond to certain of the questions we asked, but in exchange the committee relinquished its right to seek an examiner until mid-April 2020. It is not clear how estate fiduciaries can properly cede such rights.
On December 16, 2019, the debtors filed a redacted version of the “independent” report noted above. It indicates that the Sacklers took about $10 billion in cash out of the debtors since 2008. This is not surprising, since the total value of the proposed settlement would have a face amount of about $10 billion (but a substantially lower present value given its payment schedule, and would not cover interest on the $10 billion).
The takeaway seems to be that, even though no examiner has been appointed, the Sacklers and the debtors in possession have begun to produce some information that may help to answer the questions we believe are central to this case. In this regard, the mere threat of an examiner might be having an effect. However, the ability to assess and verify this information is limited, at least for the time being.
That no one has actually requested an examiner is, at one level, not surprising. It is easy to imagine that managing this case is exceedingly difficult. The insiders in the case—especially counsel to the debtors and the official committee, and Judge Drain—may view an examiner as a wrench in the delicate machinery of the proposed settlement. Parties might therefore prefer to maintain the threat of an examiner, even as they are reluctant to pull the trigger on a motion.
The Purdue bankruptcy is, however, bigger than the financial claims of any of Purdue’s creditors. Purdue is a not a case that can be run like a standard chapter 11 because there is a strong public interest in establishing a clear and independent record of what Purdue and the Sacklers knew and did about the dangers of opioids, and the extent of the Sacklers’ transactions with Purdue. Establishing these facts credibly is important not just for the dignitary interests of opioid victims and their families, but also so that creditors can properly evaluate any settlement that emerges as part of the reorganization process.
Without credible answers to the questions we asked, there will be a shadow over these cases, one that may ultimately threaten the integrity of the reorganization process.
By Andrew Verstein (Wake Forest University School of Law)
Are insolvent firms different from solvent firms with respect to insider trading law and policy? One difference is the level of regulation of trading in the residual claims of the firm. In solvent firms, the residual claims are equity securities, and equity securities are subject to the full ambit of trading restrictions. In insolvent firms, non-equity claims are typically residual claims that are subject to less stringent regulation precisely because they are not equity and they may not even be securities. As a result, insider trading regulations apply with lesser force to the most economically significant and informationally-sensitive interests in an insolvent company. Insolvency is therefore deregulatory.
While insolvency deregulates, it also expands the reach of other aspects of federal insider trading law. That is because bankruptcy law creates new roles and new duties. Since insider trading law hinges on duties, these new relationships expand the coverage of insider trading restrictions.
I consider these tradeoffs in a forthcoming article, and I offer two tentative conclusions.
First, we should not rush to close the “loopholes” in insider trading law that open with regards to the residual claims. Deregulating insider trading is a Faustian bargain—greater price accuracy at the risk of lesser liquidity, fairness, and managerial integrity—but we should be more willing to accept the bargain with respect to insolvent firms than solvent ones.
Second, we should be solicitous of efforts to shield members of creditors’ committees from extensive insider trading regulation because these creditors occupy a position without analogue in the solvent firm: they both receive and contribute material, nonpublic information. Traditional insider trading law theory may not have the resources to manage a two-way flow of information, requiring new and accommodating thought.
The appellate courts have issued at least three provocative, if not questionable, business bankruptcy decisions in the past six months.
Lakeridge: In March, 2018, the U.S. Supreme Court avoided the substantive merits of a 2016 split decision by the Ninth Circuit that had permitted a Chapter 11 debtor to manipulate the reorganization plan process. Despite the Court’s narrow holding approving the Ninth Circuit’s “clear error” standard for reviewing a bankruptcy court’s fact findings, four Justices wrote two separate opinions challenging the Court’s limited review of the Ninth Circuit’s stunning decision in the face of a powerful dissent.
In re Anderson: The Second Circuit, on March 7, 2018, held that an asserted bankruptcy discharge violation was not arbitrable due to a conflict between the Federal Arbitration Act and the Bankruptcy Code. Two months later, though, the Supreme Court stressed that it had rejected every effort to “conjure” conflicts between the Arbitration Act and a raft of other Federal statutes.
In re Temptnology: the First Circuit, on January 12, 2018, in a split decision, wiped out the rights of a trademark licensee, explicitly rejecting a 2012 decision by the Seventh Circuit. The First Circuit’s majority opinion relied on a heavily criticized 1985 Fourth Circuit decision, premising its holding on the primacy of Federal bankruptcy law over Federal trademark law and distinguishing between a statutory breach and a common law breach.
The losing parties in the First and Second Circuit cases filed petitions for certiorari in June, 2018. Given the Circuit split in one case and the later Supreme Court arbitration ruling in the other, both cases warrant Supreme Court review.
We at the Bankruptcy Roundtable will take a break from posting this August and hope that you too will be able to get away from your desk at work. We’ll be back after Labor Day.
By Ronit J. Berkovich and David Li (Weil, Gotshal & Manges LLP).
The U.S. Supreme Court, in U.S. Bank Nat’l Ass’n v. Village at Lakeridge, LLC, 583 U.S. ___ (2018), offered plenty of hints on an important topic while simultaneously ruling very little about it. In chapter 11, whether a creditor qualifies as an “insider” can have enormous implications on a range of issues, including plan confirmation, fraudulent transfer and preference analyses, and severance payment and employee incentive/retention plan (KEIP/KERP) approvals. Lakeridge involved a dispute as to whether the bankruptcy court properly determined in confirming a plan that the sole impaired accepting creditor (the romantic partner of one of the debtor’s officers) was not a “non-statutory” insider. If the creditor actually were such an insider, then the chapter 11 plan should not have been confirmed.
In granting cert to hear the case, the Supreme Court expressly declined the opportunity to address whether the Ninth Circuit articulated the correct legal test to determine if a person qualifies as a non-statutory insider. Instead, the Supreme Court granted cert only to answer the narrow question of whether the Ninth Circuit applied the correct standard of review to the lower court’s determination. Justice Kagan, writing for the Court, kept to that script by simply affirming the Ninth Circuit’s decision to apply a clear error standard of review. Concurrences by Justices Kennedy and Sotomayor, however, each acknowledged shortcomings in the legal test the Ninth Circuit applied and each appeared to invite lower courts to consider alternative approaches. As a whole, Lakeridge provides little binding guidance, and practitioners can expect further development in non-statutory insider law by the Courts of Appeals.
