Authors: Oscar Couwenberg & Stephen J. Lubben
In every economy, the question of what to do with financially distressed businesses is a matter of concern. The United States has a long history of corporate restructuring law, starting with the reorganization of railroads in the nineteenth century and continuing through chapter 11 in its current form. This naturally leads to a tendency to adopt chapter 11, or something like it.
But why? In particular, chapter 11 is a rather ornate system of corporate reorganization, and it has been adorned with elements that reflect little more than particular creditors’ ability to lobby Congress.
We reexamine chapter 11 to understand its core. In short, what, if any, are the essential elements of corporate bankruptcy law?
We point to two facets of chapter 11: asset stabilization and asset separation. These two aspects of chapter 11 could not be established other than by statute, and jurisdictions looking to reform their corporate bankruptcy processes should focus there.
Asset stabilization is the ability to temporarily protect assets as a coherent whole. It includes obvious things like the stay on individual creditor collection, provision of post-bankruptcy liquidity and delays on termination of contracts with the debtor.
Asset separation captures the ability to separate assets from their concomitant liabilities. This might take the form of a discharge, but is not necessary. Essential is that the system provides clean title to a new owner of the assets, which may or may not be the post-bankruptcy firm.
As this is the core of any sensible corporate insolvency system, features beyond that are a matter of policy, and politics.
The full article can be found here.
By James H. M. Sprayregen, Christopher T. Greco, and Neal Paul Donnelly, Kirkland & Ellis
Setting compensation for senior management can be among the most contentious issues facing companies reorganizing under Chapter 11 of the US Bankruptcy Code. Corporate debtors argue that such compensation—often in the form of base salary, bonuses, or stock of the reorganized company—helps retain and incentivize management, whose services are believed necessary to achieve a successful reorganization. Creditors, by contrast, may be loath to support compensation packages that they perceive as enriching the very managers who led the company into bankruptcy.
This tension over management compensation, though long present in corporate bankruptcy cases, has been more pronounced since 2005, when the US Congress added Section 503(c) to the Bankruptcy Code. Section 503(c) limits bankrupt companies’ freedom to give management retention bonuses, severance payments, or other ancillary compensation. For instance, under the current regime, a company cannot pay managers retention bonuses unless it proves to a bankruptcy court that the managers both provide essential services to the reorganizing business and that they have alternative job offers in hand. Even then, the Bankruptcy Code caps the amount of the retention bonuses. Severance payments to managers are similarly restricted by Section 503(c).…Read more here.
[This article first appeared in the March 2013 issue of Financier Worldwide magazine. Copyright Financier Worldwide 2014 all rights reserved. Reprinted with publishers permission. www.financierworldwide.com]
Authors: Prof. Burkhard Hess (Luxembourg/Heidelberg), Univ.-Prof. Paul Oberhammer (Vienna/London/St. Gallen) and Prof. Thomas Pfeiffer (Heidelberg), summarized by team member Robert Arts
The first step towards the upcoming amendment of the European Insolvency Regulation was an evaluation of its application since its adoption in 2002. The Regulation itself required the evaluation to make sure that European Insolvency Law keeps up with the constant changes to the multitude of national insolvency regimes. A team from the Max Planck Institute Luxembourg (Hess), Heidelberg University (Pfeiffer), and the University of Vienna (Oberhammer) conducted the research and collected empirical data in all 26 concerned Member States.
The evaluation shows that the defining principle of the Regulation, that of universality (single proceeding and single insolvency statute with universal effect and recognition) has proven to be a great boon for the procedural handling of cross-border insolvencies in Europe. The report consequently proposes to further strengthen universality by reducing the possibility of separate, territorial proceedings.
Moreover, the report finds that widening the scope of application (by inclusion of pre-, hybrid and annex proceedings and by providing – for the first time ever – a framework for collaboration within group of company insolvencies), is necessary to keep the Regulation in line with the ongoing shift from liquidation towards the reorganization of companies.
The report also addresses technical difficulties arising from cross border insolvencies – e.g., the lodging of claims, the need for communication amongst judges and administrators and the information deficit of foreign creditors.
Authors: Jasmine Ball, Richard F. Hahn, M. Natasha Labovitz, George E.B. Maguire, Shannon Rose Selden, My Chi To, Michael E. Wiles, Debevoise & Plimpton LLP
In a recent opinion on an issue of first impression in Drawbridge Special Opportunities Fund LP v Barnet (In re Barnet), 2013 WL 6482499 (2d Cir. Dec 11, 2013), the United States Court of Appeals for the Second Circuit held that foreign entities seeking recognition under Chapter 15 of the Bankruptcy Code must, in addition to satisfying the requirements for recognition set forth in that chapter, have a residence, domicile, place of business or assets in the United States. The Second Circuit’s decision reversed an earlier Bankruptcy Court ruling that granted recognition under Chapter 15 to an Australian company that had not introduced evidence of any assets or operations in the U.S. and conflicts with a recent ruling of the Bankruptcy Court for the District of Delaware in In re Bemarmara Consulting a.s., Case No. 13-13037 (KG) (Bankr. D. Del. Dec. 17, 2013), holding that a Chapter 15 debtor is not required to have assets in the U.S. In so doing, the Second Circuit has added an additional barrier to Chapter 15 recognition, which could be problematic for foreign companies looking to benefit from the advantages of the U.S. bankruptcy system. For additional detail on the Second Circuit’s decision, see Second Circuit Limits Availability of Chapter 15.
Author: Vicki R. Harding, Pepper Hamilton LLP
Imagine a $2 million property that secures a $1.75 million senior loan and a $500,000 junior loan. The owner files bankruptcy, and during the 90 days prior to bankruptcy the senior lender received payments totaling $250,000. Does the senior lender have preference exposure?
A typical assessment is that because the senior lender is over-secured, it did not receive a preference because it did not receive more than it would have in a chapter 7. However, it can be argued that the payments constitute a preference to the junior lender since it will receive more than in a chapter 7 as a result: Without the payments, only $250,000 would be left after payment of the senior lender, but with the payments, $500,000 is left. And the senior lender could be liable in a recovery action as the transferee of the preference under Section 550.
But wait, isn’t that a Deprizio argument, and didn’t Congress fix the Code to preclude this result? The answer is no: Deprizio and Section 550(c) address transfers benefitting insiders made between 90 days and a year prior to bankruptcy. It does not protect a lender for claims based on transfers made during the 90 days prior to bankruptcy. Unfortunately for senior lenders, this is not a fanciful hypothetical, but rather the approach taken in Gladstone v. Bank of America, N.A. (In re Vassau), 499 B.R. 864 (Bankr. S.D. Cal. 2013), discussed more in Preferences: Surprise – Being Fully Secured May Not Be A Complete Defense.
Post by Frederick Tung, Professor at Boston University School of Law
In “Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, Mark Roe and I question the stability of bankruptcy’s priority structure and suggest a new conceptualization of bankruptcy reorganization that challenges the long-standing creditors’ bargain view. Bankruptcy scholarship has long conceptualized bankruptcy’s reallocation of value as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of statutory and agreed-to contractual priorities.
In “Breaking Priority,” we propose an alternative view. No hypothetical bargain is ever fully fixed because creditors continually attempt to alter the priority rules, pursuing categorical rule changes to jump ahead of competing creditors. These moves are often successful, so creditors must continually adjust to other creditors’ successful jumps. Because priority is always up for grabs, bankruptcy should be reconceptualized as an ongoing rent-seeking contest, fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps.
We highlight a number of recent and historical priority jumps. We explain how priority jumping interacts with finance theory and how it should lead us to view bankruptcy as a dynamic process. Breaking priority, reestablishing it, and adapting to new priorities is part of the normal science of Chapter 11 reorganization, where bankruptcy lawyers and judges expend a large part of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.
The paper is available here.
By Rick Antonoff, Mark Pesso, Timothy Bennett and Leah Edelboim, Clifford Chance US LLP
Recent decisions on claims trading in bankruptcy cases further develop the Second Circuit’s seminal ruling in Dish Network Corp. v. DBSD North America, Inc. that if the primary motive for a secondary market purchase of bankruptcy claims is control of the Chapter 11 process, cause may exist to “designate,” or not count, the votes cast by the purchasers in connection with a Chapter 11 plan. Read together, these decisions demonstrate the willingness of courts to scrutinize secondary market claim transactions when determining disputes over classification, treatment and, ultimately, the value claims purchasers realize on account of purchased claims.
In our Client Memorandum we discuss four decisions issued in the last year as additional examples of courts examining claims transfers under a microscope. A Third Circuit Court of Appeals decision affirmed that the purchaser of trade claims is subject to the defenses that a debtor would have against the original creditor. In another case, the bankruptcy court permitted the debtor to treat a claim differently solely because the claim was assigned to a secondary market purchaser. A Ninth Circuit appellate panel ruled that insider status does not travel with a claim that is assigned. And finally, a court sustained a debtor’s objection to an assigned claim because the assignee was unable to produce sufficient evidence of its right to assert the claim.
These cases show that courts increasingly look into relationships between the parties and their respective motives when deciding how purchased claims are treated. The full Client Memorandum is available for download here.
By Victoria Ivashina, Ben Iverson, and David C. Smith
The role that active investors play in Chapter 11 reorganization is hotly debated in bankruptcy circles. In our paper, “The Ownership and Trading of Debt Claims in Chapter 11 Restructurings,” we collect comprehensive data on individual claims for 136 large firms that filed for Chapter 11 protection to empirically test how active investors might influence the bankruptcy process. Our data allows us to observe the identities of over 77,000 claimants and precisely measure both ownership concentration as well as claims trading for these cases.
We find evidence that firms with more concentrated capital structures are more likely to enter bankruptcy with pre-negotiated or pre-packaged bankruptcy plans, suggesting that negotiations are easier when creditors are not dispersed. In addition, even if they do not have a pre-packaged plan, firms with more concentrated ownership tend to exit bankruptcy more quickly and are more likely to emerge from Ch. 11 intact rather than being sold or liquidated piecemeal.
In the second half of the paper, we turn to the question of how claims trading in bankruptcy affects the resolution of the case. We find that trading during bankruptcy tends to concentrate ownership even further, and that the bulk of claims purchasing is done by hedge funds and other active investors. Interestingly, as these active investors enter the capital structure the overall recovery rate for the case tends to decrease, suggesting that perhaps active investors shrink the size of the overall “pie” in their efforts to obtain a larger piece of it.
The full-length article can be found here.
Author: Stephen D. Adams
The House Judiciary Subcommittee on Regulatory Reform, Commercial, and Antitrust Law has held two sets of hearings in recent months on the bankruptcy safe harbors for repos and derivatives from the automatic stay, from preference and fraudulent conveyance law, and from the limitations on ipso facto clauses.
This past Wednesday, March 26, Judge Christopher Sontchi, Seth Grosshandler, Jane Vris, Thomas Jackson, and Michelle Harner testified. Last December, Jeffrey Lacker, Donald Bernstein, and Mark Roe testified.
Judge Sontchi argued that the 546(e)’s exception for all settlement transactions is too broad and also urged Congress to narrow the safe harbors for repos. Seth Grosshandler, of Cleary Gottlieb, reported on the work of the ABI safe harbors advisory committee (which includes both Judge Sontchi and Prof. Roe) and warned that the safe harbors are complex and potentially costly to alter. Jane Vris, representing the National Bankruptcy Conference (NBC), and Thomas Jackson, professor at the University of Rochester, testified on bankruptcy of SIFIs as an alternative to Dodd Frank resolution of bail-out. Michelle Harner, professor at University of Maryland School of Law, testified in her role as the Reporter to the ABI Commission on Bankruptcy Reform about the Commission.
Mark Roe, professor at Harvard Law School, testified that the safe harbors facilitate excessive short-term funding of financial institutions and impede effective resolution of large financial failures, like that of Lehman in 2008. Donald Bernstein, of Davis Polk, a member of the ABI bankruptcy commission, testified about the bankruptcy adjustments needed to adapt bankruptcy law to the FDIC’s Single Point of Entry resolution mechanisms. Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, testified about the importance of bankruptcy reform to reduce the problem of too-big-to-fail and reduce reliance on short-term debt.
For more on the bankruptcy safe harbors for derivatives and repurchase agreements, please see the post by Steven L. Schwarcz and Ori Sharon summarizing their recent paper, The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, and the post by Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, and John Thompson, entitled Lehman Bankruptcy Court Issues Safe Harbor Decision, summarizing a recent Lehman case decision on the safe harbors, both published Tuesday.
Authors: Steven L. Schwarcz and Ori Sharon
Bankruptcy law gives creditors in derivatives transactions a “safe harbor” in the form of special rights and immunities. In The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, available on SSRN here, we argue that this safe harbor grew incrementally from industry lobbying, without a rigorous vetting of its consequences. This type of legislative accretion is path dependent, in that its outcome is shaped by its historical path.
Path-dependent legislation is not necessarily bad; but if it’s not fully vetted, its significance and utility should not be taken for granted. For example, advocates of the safe harbor contend that the collapse of a highly connected derivatives counterparty might systemically disrupt the derivatives market, impacting the broader financial system. But there’s little evidence to support this.
Scholars also seriously question the safe harbor, estimating that the net exposure of the major derivatives dealers to their counterparties is small. They also argue that the safe harbor may not be focused on the right parties because it operates independently of the size of the counterparty and applies to non-financial firms. Thus a bank that makes a secured loan cannot enforce its collateral against a bankrupt borrower, but an ordinary company can enforce its collateral against a bankrupt derivatives counterparty. The safe harbor is also overly broad, tempting parties to try to document ordinary financial transactions as derivatives transactions.
Because the derivatives safe harbor has important consequences for systemic risk, there should be a more fully informed discussion of its merits.
[Editor’s note: Please stay tuned for a special post later this week on hearings on bankruptcy reform, financial institution insolvency, and derivatives in front of the U.S. House of Representatives Subcommittee on Regulatory Reform, Commercial, and Antitrust Law.]