By Daniel S. Shamah, Jeff Norton, Jennifer Taylor, Sung Pak, and Joshua Chow (O’Melveny & Myers LLP)
“Lender liability” is an umbrella term often used to describe claims against lenders who overstep their boundaries when seeking to enforce a loan. It embraces both contractual and tort-based theories of liability, including claims for breach of contract, breach of the covenant of good faith and fair dealing, and fiduciary duty claims, as well as bankruptcy-based theories like equitable subordination. While courts have historically held that lender liability claims are difficult to sustain, there are cases that give guidance on how lenders cross the line and the consequences of doing so. In this recent article, the authors highlight one recent Texas bankruptcy court decision in which a court determined that a lender engaged in the kind of egregious conduct that could lead to disallowance of a loan and an award of damages and interest. Lenders in particular should study this case closely for tips on how to avoid these landmines.
By Dan B. Prieto (Jones Day) and Mark G. Douglas (Jones Day)
In In re Fencepost Productions Inc., 629 B.R. 289 (Bankr. D. Kan. 2021), the U.S. Bankruptcy Court for the District of Kansas recently addressed the enforceability of a provision in a pre-bankruptcy subordination agreement under which a subordinated creditor assigned to a senior creditor its right to vote on any chapter 11 plan proposed for the borrower. The bankruptcy court ruled that such a provision is not enforceable because it conflicts with the Bankruptcy Code. In a twist, however, the court concluded that the subordinated creditor lacked “prudential standing” to participate in the confirmation process because it was extremely out-of-the-money and therefore had no stake in the outcome of the case, but was attempting to assert the rights of third parties.
Courts disagree over whether an assignment of plan voting rights in an intercreditor or subordination agreement is enforceable. Regardless of the particular approach adopted by a court on this issue, the growing consensus is that agreements that seek to limit or waive junior creditors’ voting rights must contain express language to that effect. The ruling in Fencepost adds yet another chapter to the ongoing debate on this issue.
The Fencepost court’s conclusion that the subordinated creditor lacked prudential standing would appear to be driven in part by the facts of the case, which involved a subordinated, clearly out-of-the-money creditor intent upon impeding an otherwise consensual reorganization.
The Bankruptcy Code, however, expressly provides to the contrary by, among other things, giving every “party in interest” (including creditors and interest holders, without making an exception in cases where there is no value available for distribution to them), the right to appear and be heard “on any issue” in a chapter 11 case, the right to vote on a chapter 11 plan, and the right to object to confirmation of a plan. These provisions arguably indicate that Congress intended to modify or abrogate prudential standing requirements when it enacted the Bankruptcy Code. Moreover, the “rights” any out-of-the-money creditor or shareholder would be seeking to enforce by participating in the confirmation process are arguably their own, rather than the rights of third parties.
A logical extension of the rationale articulated in Fencepost is that clearly out-of-the-money creditors or shareholders of an insolvent corporation would never have prudential standing to participate in the chapter 11 plan confirmation process. That approach would be contrary to court rulings and general practice in many chapter 11 cases.
In a recent decision, In re Energy Future Holdings Corp., 2021 U.S. App. LEXIS 7400 (3d Cir. 2021) (“EFH II”), the Third Circuit held that a stalking horse may assert an administrative expense claim under section 503(b)(1)(A) of the Bankruptcy Code for certain transactional expenses, even when it is not entitled to a termination fee.
In EFH II, the debtors terminated a merger agreement with a stalking horse and the stalking horse applied for payment of a termination fee. After the application was denied, the stalking horse filed an administrative expense application for costs incurred in attempting to complete the merger. In response, various bondholders jointly filed a motion to dismiss and a motion for summary judgment. After the Delaware Bankruptcy Court granted the bondholders’ motions, the Third Circuit ruled that the administrative claim should not have been denied without further factual inquiry because the stalking horse plausibly alleged that it benefited the estate by providing information, accepting risks, and paving the way for a later successful deal.
In so holding, the Third Circuit applied a broad standard for pleading a plausible administrative claim under section 503(b)(1)(A). Going forward, it may be harder to obtain denial of an administrative expense application in the Third Circuit without a discovery process and evidentiary hearing. While this decision establishes an alternative means for stalking horses to recover certain transactional expenses, its actual impact remains to be seen, as parties can draft provisions in transactional documents to address the scope of recoverable administrative claims.
By Edward J. Janger (Professor, Brooklyn Law School) and Stephan Madaus (Professor, Martin-Luther-University Halle-Wittenberg)
The Nortel bankruptcy case is simultaneously the biggest success and biggest failure in the recent history of cross-border restructuring practice. On the plus side, the coordinated sale of an insolvent telecom firm’s key assets created a pool of value worth $7 billion—much larger than could have been accomplished through piecemeal local liquidation of spectrum licenses and intellectual property rights. On the minus side, the fights over value allocation swallowed up a gargantuan part of that value—an estimated $2.6 billion.
This article suggests a simple, perhaps naïve, solution to this problem. The fights centered on alleged entitlements to priority—upward deviations from equal treatment and pro rata distribution. These fights were complicated by Nortel’s structure as a global corporate group. The claims were based on, among other things: (1) liens; (2) corporate structure; (3) territorial jurisdiction; and (4) local statutory priorities. Interactions among these claims to priority made it virtually impossible to unscramble the egg. In our view, a straightforward solution to this problem is to remember that a creditor asserting priority has the burden of establishing the realizable value of its claim to priority in excess of its pro rata distribution.
The article proceeds in three steps.
First, it describes the current architecture for dealing with the insolvency of corporate groups and the problem posed by cases like Nortel and Lehman.
Second, it details the various types of claims to priority that can exist within a corporate group and explores the nature of priority. It then develops the concept of “homeless value” and the “rump estate.” Claims to priority may be hierarchical or they may be plural. They may be traceable to assets, countries, or entities, or they may inhere in the group. Regardless, when a firm continues to operate in bankruptcy (or is sold as a going concern), the relative position of the claimants must be fixed at the outset. Thereafter, subject to respecting the priority of the newly fixed claims, governance should be situated with the variable claimants to this unsituated value—the “rump estate.” These claimants are the ones who will benefit from any increase in value and pay for any decrease.
Third, the article suggests an approach to value allocation that would vastly simplify cases like Nortel, but which also provides a mechanism to allocate value in rescue cases where the firm continues to operate. The simple point is that priority claimants should have the burden of establishing the realizable value of their priority. This requirement establishes an entitlement floor for, and limits the veto rights of, these priority claimants. As such, it provides a legal default for allocating value in going concern sale cases, and a cram-down standard for restructurings.
By Anthony J. Casey (Professor of Law, The University of Chicago Law School), Joshua C. Macey (Assistant Professor of Law, The University of Chicago Law School)
On June 11, 2020, the Hertz Corporation attempted to become the first corporate debtor to finance a bankruptcy proceeding by issuing new shares of common stock to the public. Though many thought Hertz’s equity was worthless, its stock was trading at a positive value on the secondary markets, and Hertz was attempting to tap into that market value. When the bankruptcy court blessed the plan, many observers responded with outrage on behalf of retail investors who, they argued, were being duped into a worthless investment. They suggested that the law should prevent retail investors from buying these shares. Ultimately, the Securities Exchange Commission signaled that it had similar concerns and effectively killed the proposal.
This essay explores the questions raised by this incident. It argues that commentators were focused on the wrong bankruptcy problem. Contrary to the view of the commentators, Hertz’s bankruptcy does not show that retail investors require bankruptcy-specific protections. The Hertz maneuver does, however, highlight distortions created by bankruptcy law’s distribution rule, known as the absolute priority rule. That rule cuts off future opportunities for those holding equity (or junior claims) in a debtor firm and makes it difficult for stockholders and unsecured creditors to make long-term investments in the firm’s future value. From this perspective, existing proposals to alter bankruptcy’s priority rules begin to look like a form of investor protection that could facilitate investment in a firm’s long-term value.
By Axel Krohn (Martin-Luther-University Halle-Wittenberg, Germany)
The European Directive on restructuring and insolvency (“Directive”), which came into force in July 2019, has triggered a series of interesting debates. The possibility for EU Member States to subject the cram-down from Article 11 to a “relative priority rule” (“EU RPR”) when implementing the Directive into national law has proven to be particularly controversial.
Despite a confusing conceptual overlap with approaches presented in the U.S., the European interpretation of “relative priority” breaks new ground. The rule stipulates that, under a restructuring plan, dissenting voting classes have to be treated merely more favorably than any junior class. Although the Directive allows national lawmakers to refrain from the EU RPR and introduce a familiar “absolute priority rule” (“APR”)—that is, that a dissenting class of creditors must be paid in full before junior parties may receive any distributions—the EU RPR has already found supporters in various jurisdictions and should therefore be thoroughly examined.
This article identifies one aspect of the cram-down that has received little attention to date. In addition to the EU RPR, the European legislature has introduced a new “best interest of creditors” test (“EU BIT”), which does not—as in 11 U.S.C. § 1129(a)(7)(ii)—use the value that a party could expect in a hypothetical liquidation as a comparator, but refers to the “next-best-alternative scenario.” Although the concept of combining the EU RPR and the EU BIT is coherent in theory and may even eliminate some misconceptions about the EU RPR, the interaction of the two cram-down elements is likely to raise problems in practice.
First, this article discusses the concepts of the two priority rules and traces the motives of the European legislature for introducing the EU RPR.
Three aspects in particular appear to have motivated the legislature in drawing up the rule. For one, the legislature wished to create more flexibility in plan negotiations and thus respond in particular to special needs in the restructuring of smaller businesses. The rule may bring advantages, especially when it is reasonable to enable existing shareholders to participate in the continued business by means of an equity interest. Second, with regard to some Member States, the desire has arisen to create an instrument to overcome structural blocking positions of certain preferential (priority) creditors, in particular tax authorities. Finally, there is a trend in Europe which sees in the Directive a procedure that enables a structured contractual renegotiation of debts and detaches itself from the “traditional laws of insolvency law,” including the APR.
This article then deals with the new EU BIT and examines its interaction with the EU RPR.
It is worth noting that the EU BIT plays a much more important role in an EU RPR cram-down than under an APR. By moving away from the traditional liquidation benchmark and instead linking to the “next-best-alternative scenario,” the test protects precisely the value that can be achieved from the perspective of a creditor outside insolvency without cooperating with other parties. The then remaining reorganization surplus, which is subject to the EU RPR, is that fraction of the going concern surplus which can only be achieved through the combined efforts of all parties involved, but which creditors cannot claim in an individual case of enforcement.
Despite this harmonious interaction in theory, doubts may be expressed as to whether the combination of the EU RPR and the EU BIT would work in practice. The new focus on the hypothetical next-best-alternative scenario value will likely lead to an additional stress point in plan negotiations. The EU RPR, which does not itself contain a clear guideline for the distribution of the remaining surplus, is then to be applied between two unclear values, namely the hypothetical next-best-alternative value and the presumed reorganization value. It is reasonable to assume that the resulting distributional uncertainty will cause new hold-up potential and render it difficult to realize consensual plans, especially in larger restructuring cases. Also, it seems likely that unsophisticated junior creditors will face difficulties in defending their rights adequately in view of the potentially unclear next-best-alternative scenario value, and that others will try to use this to their advantage in complex negotiations.
By Shana A. Elberg, Seth E. Jacobson, & George R. Howard (Skadden)
Today, U.S. borrowers are more indebted than ever before. Borrowers have become increasingly aggressive in using secured leverage, and in taking advantage of “cov-lite” loan documents to engage in creative (and sometimes controversial) transactions to transfer assets beyond the reach of existing secured lenders by way of distributions to shareholders or contributions to unrestricted subsidiaries and then utilize those assets to raise additional secured financing. While the debt levels and cov-lite structures of leveraged loans may create risks for many stakeholders, lenders under asset-based loan facilities (“ABL facilities”) should be well-positioned to weather any storm. ABL facilities typically offer lenders greater protections in a liquidation scenario. In addition, ABL facilities often are a critical lynchpin of debtor-in-possession financing facilities when borrowers are looking to effectuate comprehensive restructurings through chapter 11. There are several tools available to ABL lenders to protect their credit position in the event that a borrower finds itself in a distressed situation. Lenders should position themselves to understand and use the chapter 11 process to ensure their debt claims retain, and even gain, protections in bankruptcy.
On November 26, 2019, the Fifth Circuit granted a petition for rehearing en banc and issued a revised opinion in In re Ultra Petroleum Corp., No. 17-20793 (5th Cir. Nov. 26, 2019). The new opinion reaffirmed the court’s prior holding that the alternation of a claim by the Bankruptcy Code does not render a claim impaired under 11 U.S.C. § 1124(1), while withdrew the court’s earlier guidance that make-whole premium was the “economic equivalent of ‘interest’” together with its prior suggestion on setting the appropriate post-petition interest rate via reference to general post-judgment interest statute or bankruptcy court’s equitable discretion.
Noting that issues relating to make-whole premiums is a common dispute in modern bankruptcy, the Fifth Circuit retracted its dicta and emphasized in the revised opinion that specific facts are essential in determining the difficult question of whether any premiums are effectively unmatured interest. The court concluded that “[t]he bankruptcy court is often best equipped to understand these individual dynamics – at least in the first instance.”
Firms took notice of the issues remain unsolved and offered perspectives on implications of this case. Morgan Lewis specifically notes that the revised opinion did not alter the original opinion’s reversal of the bankruptcy court’s ruling that creditors who are unimpaired in a bankruptcy plan pursuant to section 1124(a)(1) must receive the full amount of their claim under state law. Weil finds the opinion “does not answer the question of whether, or when, a make-whole may be payable in the Fifth Circuit”, but acknowledges that the ruling is “viewed by some as a victory” for certain creditors. Cleary highlights that the court’s revised opinion “withdrew essentially all of the guidance it had offered in its prior opinion” which had cast doubt on the enforceability of make-whole claims in bankruptcy. “Given the legal and economic significance of the questions left to be resolved”, debtors and creditors alike are likely to watch closely how the questions will proceed at the bankruptcy court, says Mayer Brown.
In In re Energy Future Holdings Corp., 773 Fed. Appx. 89, 2019 WL 2535700 (3d Cir. June 19, 2019), a panel of the U.S. Court of Appeals for the Third Circuit ruled that adequate protection payments made during a bankruptcy case and distributions under a chapter 11 plan are not distributions of collateral for purposes of a “waterfall” provision in an intercreditor agreement. The ruling is a reminder that intercreditor agreements will apply only in accordance with their terms.Although the parties could have drafted the intercreditor agreement to apply to any consideration received from the debtor by the noteholders, they did not. Therefore, the intercreditor agreement did not apply to the adequate protection payments and plan distributions made to the noteholders.Creditors have recently learned similar lessons in other cases. Because the ruling was unpublished, the decision is not binding on courts in the Third Circuit.
Happily, ultimate resolution of the Blackjewel case later in autumn saw the employees made whole and the company investigated for fraud. But this solution was anything but assured before it was reached, and employees in any event suffered substantial harm in the form of disrupted family budgets and substantial uncertainty as to ultimate recovery for months – including, critically, just as a new school year was commencing for employee families’ children.
It would seem well advised, then, to put in place a more permanent and reliable process for cases like that of Blackjewel and its employees. What is needed is a solution that is uniformly applicable, reliable, and known in advance such that all concerned parties can bargain and plan ‘in the shadow’ of the regime. Our present arrangements are subject to vagaries of state law and state budgets that vary across state jurisdictional space and fiscal time. The obvious solution to the difficulties raised by such variance is to subject this realm, like that of bankruptcy itself, to federal legislation.
A bill I have recently drafted and advocated aims to ‘fit the bill’ in effect called-for by the Blackjewel affair. It does so by (a) assigning the Department of Labor (‘DOL’) a permanent representation role in future employer insolvencies; (b) federalizing the employer bonding requirements now found only in inconsistently administered state laws; (c) establishing an Employee Liquidity Support Fund to tide employees over while bankruptcy proceedings are pending; and (d) holding employing-firms’ executive officers personally liable for violations of the Act’s requirements.
The reason for DOL representation and oversight is to ensure that employees have a coherent and powerful representative ‘at the table’ during insolvency proceedings – one that is endowed with oversight authority not only during, but in advance of insolvencies.
The reason for federalizing employer bonding requirements is that states often vary over time in respect of the seriousness with which they administer such requirements, presumably in part for reasons sounding in lobbying pressures and ideology but also for reasons of basic capacity – large employers, after all, often are ‘bigger’ than the states that would supervise them.
The reason for establishing an Employee Liquidity Support Fund is presumably obvious. What made Blackjewel’s travails so hard on employees was precisely the fact that ultimate resolution was long in coming, while employee families’ daily living expenses couldn’t ‘wait.’ Against such a backdrop it makes sense for DOL to do for employees what our Federal Reserve does for financial institutions while insolvency and consolidation proceedings are underway – viz., provide tide-over funding.
Finally, the reason for holding executive officers personally liable for compliance with the Act’s requirements should be obvious as well. For again as in the case of financial institutions, so here the only surefire way of ‘incentivizing’ firms to comply is to incentivize those through whom all firms act – their executives, as the term ‘executive’ (derived from ‘execute’) itself suggests. Diffuse shareholders, who often lack power over corporate officers, and insider shareholders, who often have interests at odds with the interests of non-executive employees in any event, simply aren’t up to the task.
Employing firms, their executives and their owners have enjoyed multiple forms of state patronage for decades in our nation, while employees have in general enjoyed only sporadic assistance from public sector institutions and, less now than any time since the early 20th century, labor unions. This Act will help further a cause that’s increasingly now recognized once again to be both morally and economically compelling: That is the task of protecting the interests of our own productive citizenry – our labor force.