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 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 (University of California Hastings Law) and Robert J. Stark (Brown Rudnick LLP)
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.
On January 13, 2020, the United States Bankruptcy Court for the District of Delaware issued an opinion in In re La Paloma Generating Company, LLC., Case No. 16-12700 [Adv. Pro. No.19-50110], which examined the implied covenant of good faith and fair dealing in the context of an intercreditor agreement (ICA) governing the relationship between the First Lien Lender (First Lien Lender) and the Second Lien Lenders (Second Lien Lenders) to the Debtors. The bankruptcy court held a party cannot be in breach of the covenant of good faith and fair dealing under New York law when merely enforcing a contractual right, in this case the First Lien Lender enforcing the ICA.
By Jay Rao (University of California, Berkeley, School of Law)
This Article examines the application of equitable subordination under Title 11 of the United States Code to bankruptcy claims purchasing transactions that transpire after the occurrence of inequitable conduct by a third party. Although a significant issue with practical consequences, it has drawn relatively scant commentary. To the author’s knowledge, no scholarship to date has attempted to comprehensively discuss the issue or describe the indirect cleansing and washing of tainted claims resulting therefrom. While analyzing and criticizing the current state of the law, this Article introduces the concepts of the “subordination benefit,” “subordination benefit elimination theory,” and “limited subordination benefit theory” to facilitate and further conversations related to the intersection of equitable subordination and bankruptcy claims trading.
This Article primarily aims to promote an active, fluid bankruptcy claims trading market to, on an ex post basis, benefit creditors and, on an ex ante basis, reduce the cost, and induce the extension, of credit in the primary capital markets, thereby supporting the broader economy. Additionally, this Article seeks to reduce indirect cleansing of tainted claims and indirect claims washing through the bankruptcy claims market.
The subject matter is particularly timely and relevant, given the recent publication of the Final Report and Recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, the significant growth of the claims trading market and increasing activity and sophistication of distressed investors, and the recent formation of the American Bankruptcy Institute’s Claims Trading Committee.
This Article argues that subordination benefit elimination theory, which represents the dominant theory propagated by courts and commentators, finds support in a misguided reading of caselaw and conflicts with sound economic policy and logic. Further, while acknowledging limited subordination benefit theory is a superior approach to subordination benefit elimination theory, this Article argues that limited subordination benefit theory also runs contrary to sound economic policy and logic. This Article requests commentators and courts halt and reverse the propagation of subordination benefit elimination theory and avoid disseminating limited subordination benefit theory. Instead, this Article proposes post-misconduct discounted claims purchasers be entitled to participate in the subordination benefit to the same extent as pre-misconduct claimholders.
If commentators and courts are unready to abandon both theories and if required to make a suboptimal binary choice, this Article suggests limited subordination benefit theory be propagated and utilized in lieu of subordination benefit elimination theory.
By Samuel Antill (Stanford Graduate School of Business)
In Chapter 11 bankruptcies, a court-supervised negotiation among creditors leads to one of two possible forms of exit, liquidation or emergence. In a liquidation, the bankrupt firm’s assets are sold (piecemeal or in a going-concern sale). Alternatively, if creditors agree to restructure the firm’s liabilities, the firm emerges and continues operating. I estimate a structural model of the choice between emergence and liquidation. In my sample of large-firm bankruptcies, I estimate that creditor recovery was substantially reduced by inefficient decisions to liquidate.
According to the “creditor’s bargain” theory of bankruptcy, the efficient form of exit (liquidation or emergence) from Chapter 11 is that which optimizes total expected creditor recovery. Beyond the importance to creditor recovery, an efficient approach to choosing between liquidation and emergence benefits pre-bankruptcy equity holders through lower costs of credit. The efficient form of exit from bankruptcy should be achieved, under the conditions of the Coase Theorem, by the bargaining among creditors that Chapter 11 is supposed to promote. Without this bargaining, potential coordination failures arise when each creditor pursues the form of exit that maximizes its own payoff.
In contrast to the view that Coasian bargaining in Chapter 11 successfully preserves viable firms, I estimate that inefficient decisions to liquidate are frequent. However, very few of the firms in my sample were inefficiently selected to emerge. I provide an explanation for this asymmetry. Exiting Chapter 11 through a confirmed plan of reorganization requires creditor consent under established voting rules. In contrast, Section 363(b) of the bankruptcy code allows managers to sell assets, or entire firms, without creditor approval. This procedure circumvents the bargaining among creditors that Chapter 11 supposedly promotes. I show that inefficient liquidations are concentrated in cases involving “363 sales.” This statistical association suggests that Section 363(b) enables the sort of coordination failure that Chapter 11 was designed to prevent. For example, these results are consistent with a view that managers may be inefficiently liquidating firms in order to benefit senior lenders or to obtain a job for themselves at a purchasing company.
Finally, I find that inefficient liquidations are largely avoidable. Using my estimated model, I consider the following counterfactual: how would expected creditor recovery change if form-of-exit decisions had been made by a statistical model? In this counterfactual scenario, the courts would hire a statistician to compare the expected potential recovery rates implied by my fitted model and recommend either liquidation or emergence. Each recommendation depends only on data available at the start of a given bankruptcy. I find that such a court statistician could dramatically improve average recovery.
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.
By Vincent S.J. Buccola (University of Pennsylvania – The Wharton School)
What good can a corporate bankruptcy regime do in the modern economy? The question bears asking because the environment in which distressed companies find themselves is so markedly different from the environment of just twenty years ago—to say nothing of the days of the equity receiverships, of sections 77 and 77B, of Chapters X and XI. The most important changes are well known: increased depth and liquidity of financial markets and, especially, increased capacity of financial contracting to say ex ante how distress will be resolved ex post. Recent efforts to take stock of contemporary bankruptcy practice, most notably the ABI’s Chapter 11 reform project, grapple implicitly with the significance of a changing environment. But by leaving the matter implicit, they underscore a lacuna about what the law’s marginal contribution to the economic order might be.
In a forthcoming article, Bankruptcy’s Cathedral, I hazard a general answer and elaborate its implications for a few prominent uses of bankruptcy in today’s practice.
The characteristic function of bankruptcy law, I say, is to recharacterize the mode in which an investor’s relationship to a distressed firm is governed. In particular, bankruptcy frequently toggles the protection of an investor’s economic interests from a property rule, in the Calabresi and Melamed sense, to a liability rule. It swaps out the investor’s unilateral right upon default to withdraw her investment, when such a right would ordinarily prevail, in favor of a judicially mediated procedure designed to give her the official value of her right. The automatic stay furnishes an example. It extinguishes a secured creditor’s power to repossess and sell collateral, and supplies instead a right only to what the bankruptcy judge determines to be “adequate protection” of its interest in the collateral.
This toggling function can be useful, Property rules are often more efficient during a company’s financial health than during distress. A state-contingent meta rule that switches between the two thus might be optimal. But what about financial contracting? Why can’t investors stipulate state-contingent meta rules if indeed they can maximize surplus by doing so? The short answer is that in some cases contract is sufficient, but in other cases legal or practical impediments are insuperable. The marginal contribution of bankruptcy law, then, is to supply toggling rules where investors cannot practically do so on their own.
One implication of my approach is to index the justifiable scope of bankruptcy to contingent facts about the efficacy of financial contracting. In environments where it is difficult for investors to specify state-contingent toggling rules, whether because of legal prohibition or practical impossibility, the compass for bankruptcy law is wider. As contract becomes more efficacious, bankruptcy’s brief grows correspondingly shorter.
This normative schema can be used to assess one-by-one the many actual interventions of bankruptcy laws. I scrutinize three uses of bankruptcy that are important in today’s practice: to confirm prepackaged plans, to effect going-concern sales, and to take advantage of the automatic stay. I find plausible justifications for a legal institution to bind holdout creditors and to extinguish in rem claims against a debtor’s assets. The automatic stay, on the other hand, is harder to justify. (The curious must read within to find out why.) More generally, though, my approach shows how one can weigh the contributions of a bankruptcy regime against its redundant or even counterproductive in light of contracting innovations.
The complete article is available for download here.
By Anthony J. Casey (University of Chicago Law School)
The prevailing theory of corporate bankruptcy law states that its purpose is to vindicate or mimic the agreement that creditors would have reached if they had bargained with each other to write their own rules. That idea – the Creditors’ Bargain theory – has held a central place in the minds of lawyers, judges, and scholars for almost forty years. At the same time, Creditors’ Bargain theorists have struggled to explain what actually prevents creditors from bargaining with each other and how efficient rules that interfere with creditors’ bargained-for rights fit into the theory.
Meanwhile, in other areas of the law, scholars have long recognized the limits of hypothetical contract theories. Notably, scholars have shown that when parties have limited or asymmetric information and incentives to bargain strategically, their contracts will be incomplete in ways that the law cannot remedy with a hypothetical contract. Bankruptcy scholars have never squarely addressed this challenge.
Taking aim at these issues, my article, The New Bargaining Theory of Corporate Bankruptcy and Chapter 11’s Renegotiation Framework, proposes a new law-and-economics theory of corporate bankruptcy. Financial distress routinely presents uncertainty that is not contractible. By its very nature – given the number of parties engaged in strategic bargaining and the number of contingencies – financial distress poses questions that are impossible to predict, define, and negotiate in an ex ante contract. As a result, relationships involving a distressed firm are governed by incomplete contracts that allow parties to hold each other up.
Corporate bankruptcy law’s purpose is to solve this hold-up problem. The problem is familiar in law, but its frequency in the distress context invites a special bankruptcy solution. The noncontractible uncertainty associated with financial distress is a recurring characteristic across all firms. Because every relationship of this type is incomplete and requires judicial intervention upon the occurrence of the same event, a uniform bankruptcy system that deals with those relationships will produce consistency, efficiency, and market predictability.
In Chapter 11 that uniform system takes the form of a structured renegotiation framework. Because of the high level of ex ante uncertainty, the system relies mostly on procedural protection rather than specific substantive prescriptions. The framework allows parties to renegotiate their relationships within a system that imposes prices and burdens on the bargaining process and then subjects the results to high-level judicial oversight. The specifics of this framework are targeted at reducing the worst and most likely instances of hold up that block renegotiation efforts.
Bankruptcy, then, is not about mimicking a hypothetical ex ante bargain. It is about facilitating an actual ex post bargain. The normative claim of my article is that bankruptcy law’s core purpose is to solve the hold-up problem. The descriptive claim is that the ex post renegotiation framework is the fundamental attribute of Chapter 11. The remaining normative question is whether Chapter 11 succeeds at its purpose. This New Bargaining Theory of corporate bankruptcy can help identify the metrics by which to answer that question.
By Bruce Grohsgal (Delaware Law School Widener University)
Bankruptcy’s absolute priority rule arose 150 years ago to prevent insiders from using their control over an enterprise – often coupled with hypothetical valuations, contrived sales, and collusion with other parties – to obtain a greater distribution or “control premium” from estate assets. This premium came at the expense of parties who had a higher distributional priority but were not “in on the deal.” The Supreme Court again considered this issue in Jevic in 2017, when it held that a chapter 11 case-ending settlement called a “structured dismissal” must comply with the same absolute priority rule that applies to the similarly case-ending confirmation of a chapter 11 cramdown plan. The Court emphasized that insider control and collusion can endanger bankruptcy’s core principle of an orderly distribution in accordance with statutory priorities.
The Jevic Court explicitly left open, though, the extent to which a pre-plan settlement or court-ordered “first-day” distribution in chapter 11 may deviate from the absolute priority rule. It suggested only that a court approving these pre-plan distributions must show some respect for – or a “proper solicitude” to – the statutory distributional priorities.
I propose in this paper that, for a proposed pre-plan, priority-skipping settlement with an insider, secured lender or other party who exercises some control over the debtor, the absolute priority rule is sufficiently respected when a bankruptcy court subjects to an auction the claim proposed to be settled. If at the auction, a third party bids the same or a higher price for the claim absent the priority-skipping, then it will be clear that the initially proposed transaction included a control premium. If instead a higher third-party bid is not obtained, it will be clear that the settling insider is not paying a discounted settlement price based on its control and that the priority-skipping has a legitimate basis that does not implicate the problem of insider control. The auction, by displacing suspect hypothetical valuations, can address the precise mischief sought to be remedied by the absolute priority rule.
I further contend that a market test for a “first-day” distribution to a critical vendor, employee or other creditor that is challenged as priority-skipping will be limited to whether the debtor sought and failed to obtain in the market the same good, service, or credit from an alternative supplier on the same or better terms than those proposed in the first-day motion. The reason for this is simple – a bankruptcy court will not be able in most cases to obtain, at the time of the first-day hearing, a market determination of case-ending distributions to creditors. Any hypothetical valuation at a first-day hearing of the end-of-case distributions to creditors will be highly unreliable. Because of these obstacles, I suggest that the question of whether a first-day payment will comport with end-of-case distributional priorities should be replaced with the question of whether the debtor sought and failed to obtain an alternative supply in the market on the same or better terms, and by a rebuttable presumption that preserving the going concern value of the chapter 11 debtor likely will benefit even the disfavored creditors. This approach – which essentially adopts the occasionally maligned “doctrine of necessity” and rejects the Seventh Circuit’s Kmart rule – recognizes the disturbing weakness of a hypothetical determination, made at the first day hearing, of end-of-case distributions in a chapter 11 case.