The Agglomeration of Bankruptcy
By Efraim Benmelech, Nittai Bergman, Anna Milanez, & Vladimir Mukharlyamov
In “The Agglomeration of Bankruptcy,” Professor Benmelech and his coauthors examine the spread of bankruptcy by analyzing the ways in which bankrupt firms impose costs on nearby non-bankrupt competitors. The authors argue that the normally positive economies of agglomeration created by stores in close proximity to one another can become detrimental during downturns. When a store is in distress, proximity works to amplify the negative effects of distress. The result is that retail stores in distress impose costs, such as decreasing sales, on nearby peers, which can ultimately lead to store closures and ultimately bankruptcy.
The authors use a novel and detailed dataset of all national chain store locations and closures across the United States from 2005 to 2010. The authors show that stores located in proximity to those of national chains that are liquidated are more likely to close themselves. Importantly, this effect is stronger for stores in the same industry as the liquidating national chain as compared to stores in industries different from that of the liquidating chain. Further, the geographical effect of store closures on neighboring stores is more pronounced in financially weaker firms.
For the full article, navigate here.
This summary was drafted by Robert Niles (J.D./M.B.A. ’16)
The HLS Bankruptcy Roundtable will be off-line for the holidays. We will be back in January.
House Passes Financial Institution Bankruptcy Act
On December 1, 2014, the House of Representatives passed, with bipartisan support, H.R. 5421—the Financial Institution Bankruptcy Act of 2014 (FIBA), a bill that would amend the Bankruptcy Code to better allow for the resolution of systemically important financial institutions (SIFIs). FIBA (previously discussed in Roundtable posts here and here) is similar in many respects to the bankruptcy amendments proposed in another bill introduced in the Senate (previously covered here) and to the “chapter 14” proposal from the Hoover Institution, but there are some key differences among these proposals.
First of all, the Senate version would entirely repeal the Orderly Liquidation Authority (OLA), the current regulatory receivership alternative to traditional bankruptcy (and to some, the only current viable option) to resolve failed SIFIs. Both FIBA and the Hoover Institution’s version, however, would keep the OLA in place as an alternative.
Additionally, each proposal takes a different approach to the issue of federal funding in a SIFI resolution, which is provided in an OLA resolution. The Hoover Institution’s version does not explicitly provide for such federal funding, but it does contemplate it and condition it upon a showing that no private funding is available. FIBA is silent on the matter, and the Senate version explicitly prohibits it.
Lastly, both FIBA and the Senate proposal solely focus on facilitating a single-point-of-entry (SPOE) resolution of a SIFI, whereas the Hoover Institution’s proposal seeks to accommodate both an SPOE recapitalization and a conventional reorganization of a SIFI. An SPOE recapitalization would make debt and equity at the financial holding company take the brunt of losses, while substantially all of the holding company’s assets would be transferred to a new bridge institution and cash would be pushed down into shaky subsidiaries to prevent their bankruptcy. A conventional reorganization (or liquidation) of a SIFI would largely track traditional bankruptcy approaches, with the troubled subsidiaries entering bankruptcy.
These and other differences among the proposals are some of the most debated aspects in the SIFI resolution reform discussion. Moreover, which version (if any) ultimately passes through both houses of Congress and is signed by President Obama may set significant precedent in resolution regimes worldwide.
For previous HLS Bankruptcy Roundtable coverage of the viability and limits of an SPOE approach in bankruptcy, click here and here.
This post was composed by Stephanie Massman (J.D. ’15)
The Duty to Maximize Value of an Insolvent Enterprise
By Brad Eric Scheler, Steven Epstein, Robert C. Schwenkel, and Gail Weinsten of Fried, Frank, Harris, Shriver & Jacobson LLP
In the recent Delaware Chancery Court decision of Quadrant Structured Products Company, Ltd. v. Vertin (October 1, 2014), the Court clarified its approach to breach of fiduciary duty derivative actions brought by creditors against the directors of an insolvent corporation. Importantly, the Court applied business judgment rule deference to the non-independent directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy—even though the creditors bore the full risk of the strategy’s failing, while the corporation’s sole stockholder would benefit if the strategy succeeded. By contrast, the court viewed the directors’ decisions not to exercise their right to defer interest on the notes held by the controller and to pay above-market fees to an affiliate of the controller as having been “transfers of value” from the insolvent corporation to the controller, which were subject to entire fairness review.
This decision appears to stand for the proposition that, under all but the most egregious circumstances, the business judgment rule will apply to directors’ decisions that relate to efforts to maximize the value of an insolvent corporation. Thus, even decisions made by a non-independent board for a high-risk business plan that favors the sole equity holder over the creditors, as in Quadrant, will be subject to business judgment deference. The court also distinguished decisions involving direct transfers of value from the insolvent corporation to the controller, holding that these decisions would be subject to entire fairness review because the controller stood on both sides of such transactions.
See here for a more detailed discussion of this case.
Fair and Unfair Discrimination in Municipal Bankruptcy
By Richard M. Hynes and Steven D. Walt, University of Virginia School of Law
Some bankrupt municipalities have proposed plans of reorganization that offer substantially greater recoveries to their active workers and retirees than those offered to other creditors. Because these greater recoveries are not mandated by a priority enjoyed by the active workers and retirees, a judge can only approve such a plan if it does not “discriminate unfairly” against a class of disfavored creditors that votes against the plan. This Article describes the law defining the unfair discrimination standard, identifies the categories of circumstances in which discrimination between co-equal classes is permitted, and argues that the claims of retirees and active workers do not fall into any of these categories. The Article concludes that current law does not allow a judge to approve a reorganization plan that provides retirees and active workers with a greater recovery.
The full version of the article can be found here.
Court of Appeals Vacates DIP Financing Order for Lender’s Lack of Good Faith
By Michael L. Cook, Schulte Roth & Zabel LLP
The Bankruptcy Code encourages lenders to make debtor-in-possession (“DIP”) loans to Chapter 11 debtors. Because of Bankruptcy Code § 364(e), an appeal from a financing order will ordinarily be moot when the lender acted “in good faith” unless the appellant obtains a stay pending appeal. It is hence noteworthy when appellate courts overturn DIP financing orders that were not stayed pending the appeal.
The Fifth Circuit, on September 3, 2014, vacated five bankruptcy court and district court DIP financing orders due to (1) the lender’s lack of good faith in relying on a third party’s shares of stock as collateral; and (2) the bankruptcy court’s lack of subject matter jurisdiction to authorize a lien on third party collateral subject to disputed ownership claims. In re TMT Procurement Corp., 2014 WL 4364894 (5th Cir. Sept. 3, 2014). On October 23, 2014 the Fifth Circuit denied the petition for panel rehearing.
The Fifth Circuit rejected the debtors’ argument that the appeals were moot because of the lower courts’ repeated findings that the lender had made the loan in good faith. TMT provides a new test regarding the Code’s “good faith” requirement for lenders, based on the lender’s knowledge of possible insider manipulation of the bankruptcy process. The court also found a lack of subject matter jurisdiction because the debtors’ insiders used the bankruptcy financing process to “interfere with” unrelated state court litigation against the debtors’ controlling shareholder.
The full version of the article was recently published in The Bankruptcy Strategist. It is available online here.
Chapter 22 Roundtable in the WSJ Bankruptcy Beat
Last week, the Wall Street Journal’s Bankruptcy Beat posted several pieces on the causes and consequences of so-called “Chapter 22” repeat bankruptcy filings. In the first three posts of the series, bankruptcy experts offered a range of views on the topic.
In the first post, Harvey Miller, of Weil, Gotshal & Manges, said that increased recidivism in Chapter 11 filings was largely due to distressed debt and securities investors, who effectively gain control of the debtor and its plan formulation process and do all that is necessary to expedite the plan confirmation. Because nobody in this coordinated effort will challenge the plan’s feasibility and because the judge is not well placed to independently investigate, feasibility issues may go unaddressed.
Marshall Huebner, of Davis Polk & Wardwell LLP, in the second post, noted other factors that could trigger subsequent Chapter 11 filings, including a company’s underestimation of the broader industry’s decline, creditor pressure on the debtor to remain overleveraged, and a debtor’s inability to shed legacy liabilities.
In the third post, Mark Roe, professor at Harvard Law School reasoned that, regardless of the cause, recidivism is both not that common—less than 20% of Chapter 11 debtors—and not that bad of a trade-off if it stems from getting companies through the bankruptcy process quickly, as long as most of them recover and grow. Enforcing a strict zero-tolerance feasibility standard could do more damage to debtors by keeping them in bankruptcy longer.
Visit the Bankruptcy Beat website to see the rest of the experts’ views on Chapter 22 filings.
Visit the HLS Bankruptcy Roundtable’s prior coverage of Ed Altman’s study of the frequency and nature of Chapter 22 filings, posted in June, here.
This summary was drafted by Stephanie Massman (J.D. 2015)
Derivatives and Collateral: Balancing Remedies and Systemic Risk
By Steven L. Schwarcz, Duke University School of Law
Professor Schwarcz examines whether the bankruptcy “safe harbor” for derivatives is necessary or even appropriate to protect against systemic risk—such protection being the safe harbor’s articulated justification. The article examines the most important function of the safe harbor: allowing derivatives counterparties to exercise their contractual enforcement remedies against a debtor or its property notwithstanding bankruptcy law’s stay of enforcement actions. A threshold question is whether there is anything inherently risky about derivatives that might cause a systemic failure.
The standard answer is volatility. But, the article observes, regulation could reduce that potential for systemic risk in a more limited fashion. The article next addresses the safe harbor from the standpoint of its impact on avoiding contagion. The safe harbor is supposed to enable large derivatives dealers to enforce their remedies against a failed counterparty, thereby minimizing the dealer’s losses and reducing its chance of collapse. There are, however, several flaws in the safe harbor’s design to accomplish that. First, the safe harbor incentivizes systemically risky market concentration by enabling dealers and other parties to virtually ignore counterparty risk. Second, the safe harbor operates independently of the size of the counterparty or its portfolio. The article then examines how the Lehman bankruptcy might inform the safe harbor debate. The article offers a final caution: To the extent the safe harbor might amplify, rather than protect against, systemic risk, its negative impact would transcend the traditional derivatives market.
The full version of this article is forthcoming from the University of Illinois Law Review and is available in draft form here.
Update on Directors’ and Officers’ Insurance in Bankruptcy
By Douglas K. Mayer, Martin J.E. Arms, and Emil A. Kleinhaus of Wachtell, Lipton, Rosen & Katz
D&O insurance policies typically combine coverage for certain liabilities and defense costs of individual directors and officers (“A” coverage) and of their companies (“B” and “C” coverage). In recent years D&O policies also typically state that payments to insured individuals under their A coverage take priority over payments of B or C coverage to the insured company.
After commodities broker MF Global filed for bankruptcy in 2011, insured individual directors and officers asked the bankruptcy court to allow them to request payment of their A coverage for their defense costs in ongoing litigation, but were opposed by the contention that all access to the D&O insurance policy, including the individuals’ A coverage, was subject to the automatic bankruptcy stay due to the policy’s B and C coverages. [The B and C coverage of the company was directly subject to the stay; the personal A coverage was argued to be sufficiently related to the B and C coverage that it was also stayed.]
The bankruptcy court ultimately allowed the individuals to access their A coverage by honoring the policy’s priority of payment language, but in the interim granted the individuals only limited access to insurance money while the coverage litigation was ongoing. The MF Global D&O insurance dispute illustrates the significant risk that individuals may be barred, or at least significantly delayed, in gaining access to their personal A coverage under a typical directors and officers insurance policy issued to a company that subsequently enters bankruptcy, and highlights the usefulness of separate A-only or Difference in Condition coverage for individual directors and officers.
For the full memo, navigate here.
The Evolution of European Insolvency Law Part 3: The EU Parliament’s Report on the Amendment of the European Insolvency Regulation (EIR)
By Robert Arts and Dr. Björn Laukemann (Maîtr. en droit)
After the external evaluation of European Insolvency Law (Part 1) and the European Commission’s proposal for the amendment of the EIR (Part 2), the report of the European Parliament (EP) on this proposal marked the latest stage of the reform process.
While the Parliament generally supports the changes proposed by the Commission and many of its amendments simply clarify wording or align the text with the existing legislation, the draft report made some noteworthy revisions:
- To prevent abusive venue-shopping, the draft requires the factual circumstances of the debtor’s centre of main interests to be established three months prior to the opening of insolvency proceedings.
- While welcoming the introduction of synthetic proceedings (i.e. the granting of special rights to groups of local creditors in order to avoid the opening of secondary insolvency proceedings) the EP strengthens the procedural standing of the local creditors by:
(i) granting them the power to challenge any decision to postpone or refuse the opening of secondary proceedings;
(ii) allowing them to petition the court conducting the main proceeding to take protective measures, e.g. by prohibiting the removal of assets or the distribution of proceeds, or by ordering the administrator to provide security; and
(iii) empowering the court to appoint a trustee to safeguard their interests.
- The coordination and cooperation between administrators appointed in different proceedings within a group of companies is further enhanced by the implementation of an independent coordinator who, for instance, is empowered to present a non-binding, court-approved group coordination plan, to mediate in disputes between insolvency representatives of group members, or to request a stay of proceedings with respect to any member of the group.
As a result, the Parliament report aims to strengthen the role of main insolvency proceedings while still sufficiently considering interests of local creditors and to improve coordination within groups of companies. The draft is expected to pass the European Council by the end of this year.
See the full report here.
The Article III Problem in Bankruptcy
By Anthony J. Casey and Aziz Z. Huq, University of Chicago Law School
The Supreme Court has struggled for the last three decades in defining the permissible scope of bankruptcy courts’ power. This question poses difficult federalism and separations-of-powers problems under Article III of the Constitution. Divided opinions in Northern Pipeline Construction v. Marathon Pipe Line, and more recently, in Stern v. Marshall, have produced confusion and litigation for practitioners and lower courts. This is true in large part because the Court’s Article III decisions lack any foundational account of why bankruptcy judges implicate a constitutional problem. As the Court prepares to confront the issue once again later this term, Aziz Huq and I provide such an account in a new article. This account more concretely identifies the precise stakes in this debate. We argue that a tractable, economically sophisticated constraint on delegations to the bankruptcy courts can be derived from what should be an obvious source: the well-tested creditors’ bargain theory of bankruptcy. Working from this account of bankruptcy’s necessary domain minimizes Article III and federalism harms while also enabling bankruptcy’s core operations to continue unhindered. To illustrate its utility, we then apply our framework to a range of common bankruptcy disputes, demonstrating that many of the Court’s existing jurisprudence is sound in result, if not in reasoning.
The article is forthcoming in the University of Chicago Law Review, and is available here.