Holdout Panic

By Stephen J. Lubben (Seton Hall Law School)

Stephen J. Lubben

It has been recognized that corporations themselves are designed to promote collective action, and thus “a primary function of corporate law is to coordinate and constrain individual behavior – even profit-motivated behavior.”  Given that corporate debt instruments largely serve a governance function amongst creditors, it is not surprising that they, like corporations themselves, tend to quash individual action in favor of the group.  But the divergence between individual and group interests comes to the fore in times of stress.

An individual creditor can be either an oppressed minority investor or a holdout.  Majority holders can be either the group seeking an efficient and beneficial restructuring, or effectively an insider group that collaborates with more formal insiders to extract value from minority creditors.  Which reality is genuine is highly dependent on the particular facts of the case at hand, and may be quite difficult for an outsider to discern.

Restructuring law attempts to balance this uncertainty by providing a series of checks and balances.  In general, restructuring law begins with a preference for the collective, but encircles the collective with a series of rules that protect individual creditors from abuse.  

Some of the balance comes from the agreements that create the creditor relationship or duties related to those agreements; however, other aspects of balance are external and come from outside structures like the Bankruptcy Code or the Trust Indenture Act.  In general, the basic challenge here is to find the point at which the illegitimate power of holdouts is reduced without trampling on the legitimate rights of minority creditors.  It is very easy to avoid holdouts if the majority always wins.

My paper explores the ways in which modern restructuring practice has moved toward that “majority always wins” extreme.  This change was not part of some grand plan, but rather the result of a series of incremental decisions, each reacting to perceived abuses by holdouts.  But in indulging our fears of holdouts, we have lost the essential balance of the system.

Take the example of the RSA – or restructuring support agreement – that, in a variety of ways, can represent a generalized assault on the requirement in section 1123(a)(4) that a chapter 11 plan must “provide the same treatment for each claim or interest of a particular class.”  RSAs achieve this end by providing for backstop fees paid to a select group that will never have to backstop anything or DIP loans that the debtor does not really need.

In one recent case, pre-bankruptcy the debtor contracted with a sub-group of its secured noteholders to have those noteholders make an interest payment on the notes.   That is, some of the secured noteholders paid the interest payment due to all the secured noteholders.

In exchange, these distinctive noteholders received new “super-priority secured notes” secured by a lien that surpassed the old secured notes’ liens, while also carrying a hefty 10% coupon.  When the debtor filed for chapter 11 later that same year, to implement its own RSA-driven plan, the new super-priority notes were paid in full, with interest and “make whole call” fees.  In short, the select lenders made a small, six-month loan for a very high return at low risk.  This opportunity was not available to everyone in the original class of noteholders.

In short, I conclude that the modern American restructuring system has evolved to favor the interests of the majority to the point where a debtor and a majority of its lenders can inflict serious harm on minority creditors.  At some point, this reality is bound to have consequences for both the debt markets and the utility of chapter 11.

The full article is available here.

Texas Two-Stepping Out of Bankruptcy

By Michael A. Francus (Harvard Law School)

Michael Francus

Johnson & Johnson’s use of the Texas Two-Step to manage its talc liabilities has put the company, and the Two-Step, front and center in the roiling debates over aggressive uses of the bankruptcy system. Those debates have led to scholarly criticism, congressional hearings, and proposed legislation that would curtail debtors’ ability to so use the bankruptcy courts.

My Essay details the mechanics of the Two-Step. Beginning with the Texas divisive merger, the funding agreement, and forum shopping for the Fourth Circuit, the Essay fleshes out precisely how the Two-Step boxes in tort claimants. Like other scholarship, this Essay identifies the risk that such maneuvering effects a fraudulent transfer. It also goes a step further, arguing that the point of the Two-Step is not to succeed, but to delay. Fraudulent-transfer litigation in a bankruptcy consumes time because it requires an adversary proceeding, and that delay pressures tort claimants to settle. So the Two-Step can succeed as long as claimants cannot wait out the course of the bankruptcy, even if a court never declares the particular Two-Step to be a proper use of divisive merger law rather than an improper fraudulent transfer.

Instead of playing into this delay game, this Essay argues, courts should evaluate the Texas Two-Step for good faith. Tort claimants can raise such challenges as a motion to dismiss (as some have) and thus avoid the need for a fraudulent-transfer adversary proceeding. And under current doctrine, the Two-Step likely qualifies as a bad-faith filing: In most cases, the Two-Step is a litigation tactic. And the Two-Step, invariably, is filed by an entity created solely to file for bankruptcy. Both of those are doctrinal hallmarks of bad-faith bankruptcies.

More broadly, the Essay explains, the Two-Step and good-faith challenges to it underscore the continuing role of common law in bankruptcy. The Code does not define good-faith filing, so courts have developed the doctrine case by case. They may yet find an acceptable form of Two-Step, one which yields tort claimants the rights they would receive in, say, a Johnson & Johnson bankruptcy, without hurting Johnson & Johnson’s ability to do business by forcing the whole company into bankruptcy. Along the way, though, a vigilant common-law gatekeeping is warranted, and judges should not hesitate to dismiss Two-Steps thinking that a later ruling on a fraudulent-transfer adversary proceeding can adequately safeguard tort claimants from an improper use of the bankruptcy system.

The full essay will be available at 121 Mich. L. Rev. Online __ (forthcoming 2022) and can be accessed here.

The Ninth Circuit Affirms Creditors’ Ability to Block ‘Cramdown’ by Purchasing Claims

By George P. Angelich and Annie Y. Stoops (Arent Fox).

The Ninth Circuit affirmed the creditor’s ability to block “cramdown” by purchasing junior debt for the purpose of protecting its own existing claim.  In re Fagerdala USA-Lompoc, Inc., 891 F.3d 848 (9th Cir. 2018).  In reversing the bankruptcy court’s decision to designate claims for bad faith under 11 U.S.C. § 1126(e), the Ninth Circuit held that the creditor acting in its self-interest by purchasing unsecured claims to block “cramdown” did not constitute bad faith unless evidence showed the creditor acted with a motive ulterior to the purpose of protecting its economic interest in a bankruptcy proceeding.  Examples of “ulterior motive” included a creditor purchasing claims for the purpose of blocking litigation against it or a debtor arranging to have an insider purchase claims.

Fagerdala clarifies that creditors may purchase claims in defense of their economic interests in bankruptcy proceedings.  In holding that the bad faith inquiry under 11 U.S.C.  § 1126(e) requires evidence of an “ulterior motive,” the Ninth Circuit sets the stage for designation where a non-creditor or strategic investor purchases claims as an offensive move to gain an advantage over the Chapter 11 debtor.

The full article is available here.

A New Risk to Bankruptcy Sales – Unwinding of the Sale Due to a Bad Faith Filing

posted in: Valuation | 0

Authors: Lenard M. Parkins and Karl D. Burrer of Haynes and Boone, LLP

Parkins_Lenny HeadshotBurrer_Karl headshotRecently, the Eleventh Circuit rendered its decision in the Wortley v. Chrispus Venture Capital, LLC case unwinding a four-year old sale order based on a finding that the underlying bankruptcy case was filed in bad faith. The decision injects a new risk for buyers of distressed assets – the potential reversal of a sale order years after the closing of the transaction.

While the Wortley opinion clearly provides that a finding of “bad faith” with respect to the filing of a bankruptcy case can result in its dismissal (even) years later, it is unclear whether the holding requires the unwinding of all sales that transpired prior to dismissal of a bankruptcy case subsequently deemed to have been filed in bad faith. As a general matter, a dismissal for a bad-faith filing is a matter of court discretion under section 1112(b) – not a matter of jurisdiction.  Further, section 349 seems to provide that dismissals are not per se intended to unwind sales to good faith purchasers in a bankruptcy case. Accordingly, it can be argued that the Wortley holding should be limited to circumstances in which the purchaser is also the party found to have unclean hands with respect to the debtor’s bankruptcy filing.  Notwithstanding this analysis, the decision will require a new (and potentially amorphous) aspect of diligence for bankruptcy purchasers: the original motivation for the bankruptcy filing.

See here for a more detailed discussion of the Wortley decision.