By Laura Coordes (Arizona State University Sandra Day O’Connor College of Law)
Over the past few years, a growing number of scholars have sought to diagnose what is wrong with the U.S. bankruptcy system. Congress has held hearings in search of an answer. And many answers have emerged, ranging from lack of balance to outright lawlessness. In my article, Bankruptcy Overload, I contend that these problems are part of a larger issue: the bankruptcy system is overloaded. Those who use it, whether debtors or non-debtors, frequently seek to extract more out of a bankruptcy than the process can, practically and legally, provide.
We have always asked the bankruptcy system to do a lot—indeed, the system’s flexibility and adaptability to new challenges and situations are often described as features rather than bugs. As our current system approaches its 45th birthday, however, it has become increasingly clear that users of the bankruptcy system are putting enormous pressure on it to do more, to resolve more issues, and to satisfy the needs and wants of a growing number of players. In the face of this increasing pressure, the system is beginning to buckle—and this buckling results in many of the problems scholars have identified with modern bankruptcy practice.
The goals and boundaries of bankruptcy law have always been subject to debate, making the system particularly susceptible to taking on more than it can bear. Over the years, many have embraced the resulting uncertainty of the limitations of bankruptcy as a necessary byproduct of bankruptcy’s built-in flexibility. However, even a system with significant capacity can be overloaded, and this Article’s core claim is that the bankruptcy system has reached that point.
This Article defines and explains the concept of bankruptcy overload, illustrating that many of the problems currently plaguing the bankruptcy system derive from overloading it. In addition, although overloading the system may create problems in individual cases, this Article shows that bankruptcy overload is systemically harmful, and that failure to recognize and address it will undermine the system’s long-term utility. Those seeking changes to bankruptcy law must be aware of the system’s capacity constraints. In addition to defining bankruptcy overload and identifying its harms, the Article illuminates ways to address many of the issues present in bankruptcy today while being cognizant of the effect of changes to bankruptcy law on the system as a whole.
By Mark G. Douglas and Oliver S. Zeltner (Jones Day)
Valuation is a critical and indispensable part of the bankruptcy process. How collateral and other estate assets (and even creditor claims) are valued determines a wide range of issues, from a secured creditor’s right to adequate protection, postpetition interest, or relief from the automatic stay to a proposed chapter 11 plan’s satisfaction of the “best interests” test or whether a “cramdown” plan can be confirmed despite the objections of dissenting creditors. Depending on the context, bankruptcy courts rely on numerous different standards to value estate assets, including book, retail, wholesale, liquidation, forced-sale, going-concern, and reorganization value.
The U.S. Court of Appeals for the Second Circuit recently examined collateral valuation in a chapter 11 case for the purpose of determining whether junior secured creditors were entitled to “super-priority” administrative claims to compensate them for alleged diminution in the value of their collateral after the petition date and before the bankruptcy court approved a sale of the debtors’ business as a going concern. In ESL Investments, Inc. v. Sears Holdings Corp. (In re Sears Holdings Corp.), 51 F.4th 53 (2d Cir. 2022), cert. denied sub nom. Cyrus Capital Partners, L.P. v. Sears Holdings Corp., No. 22-765 (U.S. Mar. 20, 2023), the Second Circuit held that, given the uncertainty surrounding the retail debtors’ fate at the time they filed for bankruptcy, the bankruptcy court did not err in valuing inventory collateral at its “net orderly liquidation value,” rather than book value, going-out-of-business sale value, or forced liquidation value. The Second Circuit also found no fault with the bankruptcy court’s decision to value non-borrowing base inventory at zero and to ascribe full face value to undrawn letters of credit where, among other things, the junior lenders failed to meet their evidentiary burden of suggesting a reasonable alternative.
There are several key takeaways from the Second Circuit’s ruling in Sears Holding.
First, valuation in bankruptcy is a fact-specific inquiry, and the selection of an appropriate valuation method, guided by section 506(a) of the Bankruptcy Code, is committed to the sound discretion of the Bankruptcy Court.
Second, Sears Holding is a testament to the consequences of failing to satisfy evidentiary burdens. The Second Circuit found no error in the bankruptcy court’s decision to ascribe no value to certain inventory and to discount to zero the full face value of undrawn letters of credit because the junior lenders had the burden of proposing a reasonable alternative but repeatedly failed to do so.
Third, the Second Circuit reaffirmed in Sears Holding that applicable U.S. Supreme Court precedent regarding valuation in a chapter 13 case also applies in chapter 11, requiring the bankruptcy court to be guided in its valuation by the use or disposition likely for the subject collateral, rather than some hypothetical use or disposition.
The Supreme Court denied the junior lenders’ petition for review of the Second Circuit’s decision on March 20, 2023.
Corporate bankruptcy cases have recently undergone a shift. After decades where creditors exercised outsized control, equity sponsors have now ascended the throne. This new group exploits contractual loopholes and employs coercive tactics to initiate creditor-on-creditor violence. The result is the ability to dictate outcomes in distress situations where equity sponsors would normally be idle passengers. The unwritten rules have been rewritten.
This new disequilibrium has the potential to fundamentally harm the financial ecosystem. Scholars have successfully chronicled the new tactics, but formulating the means to mitigate market distortion has been elusive. Most scholars have appealed to the judiciary to intervene. Unfortunately, the judiciary has rejected this call, arguing that sophisticated parties should address coercion through contracts. What if that is not possible? An efficient public debt market relies on some sort of check on outright exploitation. The inability to manage bad actors renders these markets more volatile and amplifies contagion risk for national and global economies. Further, coercive measures allow a company that should have sought bankruptcy protection or some other substantive restructuring to artificially limp along. There is a significant risk that this iniquitousness destroys value and there is little left to salvage by the time the company actually lands in bankruptcy.
This Article argues that a significant movement towards equilibrium is attainable by adjusting two aspects of this ecosystem. Primarily, I advocate for amendment of section 546(e) of the Bankruptcy Code to exclude leveraged buyouts from the fraudulent transfer safe harbors. My proposal aligns the section with its historical underpinnings and acts as a natural check on debt levels in overly aggressive acquisitions. This proposal reduces the need for coercive restructuring measures when a corporation experiences financial distress. On the backend, Delaware courts have limited creditors to derivative breach-of-fiduciary-duty actions, even when a corporation is insolvent and directors are actively attacking certain stakeholders. Delaware case law protects the mechanism by which equity sponsors implement coercion. I argue that when a corporation is insolvent, directors and officers who undertake hostile actions against specific creditors to whom they owe fiduciary duties should be subject to direct claims by those creditors. Unable to act with impunity, directors would be forced to properly consider all key stakeholders in formulating rehabilitation measures.
This series is being managed by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] sjd [dot] law [dot] harvard [dot] edu.
Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and practitioners from institutions across the country.
Bankruptcy has a public and a private side. The reorganization of a private company in chapter 11 has implications for the public, and, in some reorganizations, the public interest is quite substantial. The recent bankruptcy of the third largest crypto exchange in the world, FTX, represents just the kind of corporate restructuring where the public interest is front and center. Yet the public priority embedded in these proceedings has the potential to be overlooked. In this work, we aim to change that by shining light on the stakes, the costs, and the allocative decisions to be made in what will no doubt be described as one of the most consequential legal proceedings to happen in the world of crypto. Specifically, the outcome of these proceedings will help clear up what it means to hold crypto as a form of property, as well as the custodial v. proprietary nature of the relationship between crypto exchange companies and their customers as to rights in crypto assets. The answers to these questions will not only help resolve this bankruptcy but they will also guide lawmakers and regulators as they seek a way to regulate and police the crypto market in the future. As such, we question whether the private value capturing model that is chapter 11 is the right framework—particularly when it comes to the allocation of who bears the costs—for these largely public-oriented matters.
By Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux (Cadwalader Wickersham & Taft LLP)
Note: This post is the second post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. The first post can be read here (by Megan McDermott).
This series is being managed by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] sjd [dot] law [dot] harvard [dot] edu.
Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and practitioners from institutions across the country.
Crypto-watchers and bankruptcy lawyers alike have speculated how customer claims based on digital assets such as cryptocurrencies should be valued and measured under bankruptcy law. However, a crypto-centric approach to valuing claims raises a number of issues. For example, measuring customer claims in cryptocurrency and making “in-kind” distributions of these assets could lead to creditors within the same class receiving recoveries of disparate USD value due to fluctuation in cryptocurrency prices. Moreover, the administrative burden associated with maintaining, accounting for, and distributing a wide variety of cryptocurrencies as part of a recovery scheme or plan may prove costly and complex. Equity holders also might challenge the confirmability of a plan where valuations and recoveries are based on cryptocurrency rather than USD, as a dramatic rise in cryptocurrency values may allow for a return of value to equity.
A recent dispute in the Celsius bankruptcy proceedings as to whether a debtor is required to schedule claims in USD, or whether cryptocurrency claims can be scheduled “in-kind,” may serve as a preview of things to come on these issues. In Celsius, each Debtor’s schedule of unsecured creditors’ claims (Schedule E/F) listed customer claims by the number of various forms of cryptocurrency coins and account types, rather than in USD. Subsequently, a group of Celsius preferred shareholders filed a motion directing the Debtors to amend their Schedules to reflect customer claims valued in USD, in addition to cryptocurrency coin counts.
Ultimately, the Debtors and the Series B Preferred Holders were able to consensually resolve the motion by the Debtors agreeing to amend their schedules by filing a conversion table reflecting the Debtors’ view of the rate of conversion of all cryptocurrencies listed in the Debtors’ schedules to USD as of the petition date. However, it remains to be seen whether scheduling of claims in cryptocurrency and providing conversion tables will become the norm in similar cases involving primarily crypto-assets. Practitioners and creditors should expect further issues to arise in the claims resolution process in crypto-related cases as claimants and liquidation trustees (or plan administrators) wrestle with how to value claims based on such a volatile asset, subject to ever-increasing regulatory scrutiny. For now, the bankruptcy process continues to run on USD.
Reorganization proceedings, in contrast to liquidation sales, constitute a rather recent development in insolvency law. Embodied by Chapter 11 in the US, this trend has been further brought to light by the European Directive 2019/1023 of 20 June, 2019 on restructuring and insolvency, that requires EU Member States to set up a preventive reorganization framework. Reorganization plans typically involve complex interplays between competing stakeholders’ interests, and the classification of claims for the purpose of voting on the reorganization plan is both an illustration of these tensions and a mechanism designed to address them. Choices of European policymakers, especially in France where the classification of claims represents a major change, can offer new perspectives on best practices for modern reorganization plans. The classification of claims is an important feature of reorganization proceedings. First, it appears as a countermeasure to the debtor-in-possession and other debtor-friendly rules. Second, it promotes the adoption of a plan against hold-out problems from hostile minority or out-of-the-money creditors. Third, it provides guarantees of fairness and viability of the plan, through the consent of a representative majority of creditors.
Given the importance of claims’ classification, the design of classes has drawn a lot of attention during the implementation of the EU Directive in France. Debtor-in-possession proceedings leave the debtor with significant power over classification, with the potential for abuse through “gerrymandering”, i.e., the strategic classification of claims to create an artificially accepting impaired class, ensuring the adoption of a potentially unfair plan. Bankruptcy statutes fail to provide clear and binding criteria to restrict such strategies. Similarly, Chapter 11 case law – although precedents, notably Matter of Greystone III Joint Venture out of the 5th Circuit, have suggested a ban on gerrymandering – has been reluctant to challenge debtors’ classifications. Instead, policymakers have set protective rules for creditors, mainly the best-interest-of-creditors test and the absolute priority rule. However, these protections may be circumvented and difficult to enforce.
In this context, procedural design is suggested as a means of reconciling debtor-friendly rules with effective protections for creditors, thus ensuring a balance of interests in reorganization proceedings. First, effective judicial review over the classification of claims appears desirable and is addressed under French law with (i) the appointment of a trustee, with limited powers, assisting the debtor in possession, and (ii) an early, dedicated and fast-tracked appeal against the classification of claims, allowing the judicial resolution of disputes over classification before the adoption of the plan. A similar result may be achieved through a reinforcement of classification hearings. Second, hostile classification strategies could be avoided through prepackaged plans, in which the debtor negotiates with its creditors prior to filing for Chapter 11. French law provides for a dedicated two-stage framework through conciliation proceedings – confidential negotiations under the supervision of a court-appointed professional – followed by fast-tracked reorganization proceedings, where the plan can be adopted through a vote in classes that have been designed within the conciliation negotiations. Such proceedings are consistent with the modern negotiated, deal-approach to reorganizations while making use of insolvency mechanisms against hold-out problems, thus favoring a preventive and pragmatic solution to distressed situations.
By Brigid K. Ndege (Lewis Brisbois Bisgaard & Smith LLP) and Christian Conway (Clark Hill PLC)
Parties have long questioned whether the existence of two programs—the Bankruptcy Administrator program and the U.S. Trustee program—to administer bankruptcy cases fails to meet the U.S. Constitutional requirement for uniformity in bankruptcy law. In 2017, an increase in quarterly fees by Congress brought this dormant constitutional issue to the forefront because it illustrated the lack of uniformity between these two programs. After the fee hike, debtors in regions administered by the U.S. Trustee program paid significantly more in quarterly fees than debtors in regions administered by the Bankruptcy Administrator program. The drastic difference in fees for debtors in the two programs resulted in legal challenges to the constitutional uniformity of the fee hike. This eventually led to a circuit split, with the Fifth and Fourth circuits holding that the fee increase was constitutional and the Second and Third circuits holding that the fee increase was not constitutional. Although the U.S. Supreme Court resolved this ensuing circuit split in Siegel v. Fitzgerald, by unanimously holding that the fee hike was unconstitutional, the Court declined to address whether the dual bankruptcy system was constitutional and the appropriate remedy for debtors who paid more fees under the fee increase.
By Mark Roe and William Organek (Harvard Law School)
Note: This is the seventh in a series of posts on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies. Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.
Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts), here (by Jonathan C. Lipson), here (by Jared A. Ellias), here (by Anthony Casey and Joshua Macey), here (by David Skeel), and here (by Ralph Brubaker).
Considerable attention is now being paid to the Texas Two-Step in bankruptcy. The Two-Step anticipates the movement of assets and liabilities from one corporate entity to another, via a divisive merger that splits the assets and liabilities of the original entity. After the movement of the assets and liabilities, the liabilities sit in one entity (often a subsidiary of a larger enterprise). Meanwhile, the liabilities are separated from many of the assets (in the most controversial form of the Two-Steps), which sit in another entity. The entity with the bulk of the liabilities then files for bankruptcy. The Two-Step is central to the Johnson & Johnson (“J&J”) bankruptcy of a subsidiary, aiming to separate the talc liabilities from J&J’s extensive assets.
When assets are transferred from a firm that is thereby rendered insolvent, or when the assets are transferred with actual intent to hinder, delay or defraud creditors, the transferred assets can, of course, be recovered by the transferring firm as a fraudulent transfer. Bankr. Code § 548. Similar transactions are regularly accomplished under corporate structures as spinoffs: the firm moves assets into a subsidiary, for example, and then “spins” off the subsidiary’s stock to the firm’s stockholders. After the spinoff the old stockholders own two companies, one with the assets (and possibly some of the liabilities of the just-created subsidiary) and the other with the liabilities (and any remaining assets) of the original company.
The Texas divisive merger statute creates a fraudulent transfer conundrum, because it says movements of assets pursuant to a divisive merger are not transfers. If there’s no transfer, there’s no fraudulent transfer liability, as there must first be a transfer for there to be liability.
If the bankruptcy process were ousted of power to control fraudulent transfers, then the debtor firm would have more freedom to move assets and liabilities in ways that would allow the firm to escape liability. No judge would get to the meaty issues (e.g., was the transferring firm insolvent? were the transfers done with intent to hinder, delay, or defraud creditors? is the bankrupt firm with the bulk of the liabilities an alter ego or successor of the original firm?) because there’d never have been a triggering transfer.
The Texas statute itself is clear on its face that there’s no transfer under Texas law:
When a merger takes effect . . . all rights, title and interests to all . . . property owned by each . . . party to the merger is allocated . . . as provided in the plan of merger without . . . any transfer or assignment having occurred . . .
Commentatorshavenoted that a Two-Stepping debtor might make such an argument. While it has not yet been explicitly raised in the LTL bankruptcy, the commentators anticipated correctly that such an argument was coming. In another pending Texas Two-Step bankruptcy, In re DBMP, the debtor made this argument at length. In an oral ruling1 delivered a little more than a week ago, on July 7, Judge Craig Whitley agreed with the key plain meaning premises of the Two-Step argument but ultimately rejected it as facilitating “wholesale fraud.”
The court began by accepting the debtor’s interpretation that, under a plain meaning reading of the Texas statute, no transfer occurred; and under a plain meaning reading of section 548 of the Bankruptcy Code, a transfer is a necessary predicate for a fraudulent transfer to have occurred. Hence, a plain meaning construction of section 548 and the Texas statute means no fraudulent transfer exposure.
Judge Whitley saw where such a plain meaning reading led, but refused to go there, rejecting the debtor’s conclusion. Going down the plain meaning route would, he said, lead to absurd results, leaving plaintiffs with “no recourse whatsoever.” And such a reading would contradict another provision of the Texas statute, which states that a divisive merger is not meant to “abridge any . . . rights of any creditor under existing law,” Tex. Bus. Orgs. Code § 10.901. Finally, Judge Whitley went deep: such a plain language reading of the Texas statute would run contrary to longstanding general principles of Anglo-American fraudulent transfer law.
Judge Whitley’s conclusion was in our view correct. But the conclusion can be reached more directly—by a plain meaning reading of the Bankruptcy Code.
The bankruptcy courts have already been instructed by Congress not to pay attention to the Texas statute, even when the state statute declares that an asset disposition in a divisive merger is not a transfer. True, considerable policy issues (e.g., supremacy of federal law, the extent to which state property and contract law is incorporated into the bankruptcy process) could well be brought to bear if the Bankruptcy Code were unclear here. But the most straightforward way to answer the question raised in DBMP comes from a parsimonious textual analysis of the Code.
Here’s the Bankruptcy Code’s two-step ouster of the Texas Two-Step:
The text of the fraudulent transfer statute, section 548, begins: “The trustee may avoid any transfer . . . of an interest of the debtor in property . . . ” (emphasis added). If we stop there, a basis might be had for examining state law for whether a transfer cognizable under the Bankruptcy Code has taken place. Property is, after all, transferred under state law.
But the Code does not say that state law governs whether a movement of property is a bankruptcy transfer. The Code itself defines the term “transfer” and does so independently of state laws’ appellations, leading to Step 2 of the ouster.
Section 101(54) defines what a “transfer” is for bankruptcy purposes, such as section 548 (governing fraudulent transfers). It states: “The term ‘transfer’ means . . . each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property.”
The Code thereby instructs bankruptcy courts to conclude that a transfer has occurred for each “mode . . . of disposing of . . . property . . . .” A divisive merger under Texas law is surely a “mode . . . of disposing of . . . property. . . .” As a result, for bankruptcy purposes a Texas two-step is a transfer, whatever the Texas authorities decide to call it. And, therefore, the Texas Two-Step should have no import in bankruptcy for determining whether there’s been a transfer for bankruptcy purposes. Property has been disposed of. Thus, for Code purposes there is a “transfer.” The first statutory predicate to considering whether there has been a fraudulent transfer has been satisfied and the court could then go on to the other, meaty fraudulent transfer issues. The Texas Two-Step is a transfer because the Bankruptcy Code says it is.
While we reach an identical conclusion to that of Judge Whitley, and we do not fault his reasoning from the bench, our analytic path is better in the long run for bankruptcy decisionmaking. The court’s reliance upon the best way to interpret the potential contradictions of the Texas Business Organizations Code is a precarious foundation for the ruling. One could imagine another bankruptcy court, faced with the Texas statute’s contradictions (“it’s not a transfer” vs. “it’s not in derogation of any other right”), interpreting and concluding differently.2Another judge might not consider such a result as absurd as Judge Whitley and we do. And yet another bankruptcy court could feel compelled to certify questions to the Texas Supreme Court on how to interpret the Texas divisive merger statute and its impact.
The new mass tort bankruptcies present major issues of policy and statutory construction for which answers will not be assured and apparent. But the question of whether there is a transfer for bankruptcy purposes is clear. A divisive merger is a disposition of property and, hence, the Code says it’s a transfer, thereby triggering the opening prerequisite to there being a fraudulent transfer.
The Code says so. Plainly.
1: A recording of the hearing is embedded in the linked PDF, which PDF may need to be downloaded in order to access the recording; the relevant portion of the hearing begins around 20:15 in the recording.
2: See Curtis W. Huff, The New Texas Business Corporation Act Merger Provisions, 21 St. Mary’s L.J. 109, 122-25 (1989).
By Kelly DiBlasi and Jason George (Weil, Gotshal & Manges LLP)
Increased competition, rising fuel costs, and the lingering effects of the COVID-19 pandemic have caused financial distress for airlines and other aviation companies and led to an increase in their use of Chapter 11 to address these issues. Chapter 11’s many tools, including the automatic stay, DIP financing, and the ability to reject burdensome contracts or bind dissenting creditors, are available to both domestic and foreign companies. However, one underappreciated aspect of Chapter 11 is its flexibility in different stages of a restructuring with varying levels of stakeholder consent. For example, a company at imminent risk of running out of cash, defaulting on obligations, and/or confronting creditors collecting significant overdue payables can use Chapter 11 to prevent creditors from exercising remedies against the company and its property. Other companies may already have agreement with key stakeholders on the major components of a reorganization plan, only needing an in-court process to implement certain aspects of the plan that cannot be accomplished out of court, such as binding dissenting creditors. Chapter 11 can accommodate all such scenarios. This flexibility, combined with the tools and benefits described above, makes Chapter 11 an attractive option for airlines and other aviation companies in distress. As the aviation industry continues to experience financial distress, it is anticipated that more companies in the industry will look at Chapter 11 as a viable option to pursue a restructuring.
Financially distressed companies often seek refuge in federal bankruptcy court to auction valuable assets and pay creditor claims. Mass tort defendants – including Purdue Pharma, Johnson & Johnson, Boy Scouts of America, and USA Gymnastics – introduce new complexities to customary chapter 11 dynamics. Many mass tort defendants engage in criminality that inflicts widescale harm. These debtors fuel public scorn and earn a scarlet letter that can ultimately destroy the value of an otherwise profitable business. Scarlet-lettered companies could file for bankruptcy and quickly sell their assets to fund victims’ settlement trusts. This Article argues, however, that this traditional resolution option would eviscerate victim recoveries. Harsh public scrutiny has diminished the value of the resources necessary to satisfy claims, creating a discount that must be borne by victims.
My public benefit proposal charts a new course. Instead of accepting fire sale prices and an underfunded settlement trust, the scarlet-lettered company emerges from bankruptcy as a corporation for the public benefit. This modified reorganization offers victims the greatest recovery. The continued operation preserves value during a transition period, after which the going concern can be sold efficiently. Further, assets that have been tainted by corporate criminality are cleansed behind a philanthropy shield and sold to capture the value rebound. The victims’ collective is the owner of the new company and can participate in a shareholder windfall if the reorganized company experiences strong post-bankruptcy performance.
At the forefront of a new trend in aggregate litigation, this Article proposes a public benefit alternative to traditional resolution mechanisms. This approach delivers utility that will support application in a variety of contexts, assuming certain governance safeguards are maintained. In our new age of greater personal and corporate accountability, more scarlet-lettered companies will emerge and ultimately land in bankruptcy. The need to address the disposition of tainted assets will be paramount in compensating mass tort victims trying to reassemble fractured pieces. This Article explains a new phenomenon and reconceptualizes resolution dynamics in a way that will have policy implications that transcend aggregate litigation.
The full article will be available at 117 Nw. U. L. Rev. ___ (forthcoming 2022) and can be accessed here.