Hidden Wealth Transfers in Bankruptcy Asset Sales: A Real Option Analysis

By Jordan Neyland (Assistant Professor of Law, Antonin Scalia Law School at George Mason University) and Kathryn St. John (Legal Associate, Supreme Court of Victoria)

Jordan Neyland
Kathryn St. John

One of the most important decisions that firms and courts face in bankruptcy is how to dispose of company assets. The differences between the available options are not trivial. A popular mechanism is contained in §363 of the bankruptcy code, which enables the sale of a firm’s assets with court approval. This allows for a quick sale of a firm without the need for developing and approving a plan of reorganization under Chapter 11, which can save both time and money, as the firm’s assets may otherwise sit idle or depreciate. 

Despite the benefits of a quicker resolution, 363 sales are contentious because certain classes of claimants, particularly shareholders and unsecured creditors, may lose a valuable opportunity to “wait and see” if the value of the assets will increase. Given that unsecured creditors and shareholders are last in line to get paid, they may gain if the asset value increases, whereas secured creditors prefer a quick sale to cash out before any value is potentially lost. But how much shareholder and unsecured creditor wealth is lost as the lottery-like opportunity, or “option” to wait, disappears? Without an active market for these rights, this value is unseen, yet very real.

In a recent article, we investigate the value of this option and how it affects the wealth of the parties to the bankruptcy. We use well-established financial models (i.e., Black-Scholes-Merton) to put a dollar value on how much shareholders lose with the approval of a 363 sale. We take numerical values from the seminal case In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), which provides an ideal case study because most of the firm value was from equity holdings in a publicly traded company. 

The results are dramatic. Under certain conditions, shareholders stand to lose value worth more than one quarter of total firm assets from a 363 sale. That is, by forgoing the “wait and see” option, shareholder value decreases from around one quarter of the firm’s assets to close to zero. In the Lionel case, where the value of the firm’s assets was about $170 million, this decline in value equates to wiping out nearly $45 million in shareholder wealth. Higher priority claimants capture that value.

Even under more conservative estimates, we show that shareholder and lower-priority creditor wealth is dramatically affected by the loss of the “wait and see” option. Large amounts of wealth may be transferred from shareholders to creditors by bringing forward assets sales by just a few months.

We identify factors that are likely to influence the magnitude of the “hidden” shareholder and lower-priority creditor wealth loss. These include the volatility and value of the asset to be sold, in addition to the difference between the time required to arrange an asset sale and the time it may take to finalize a plan of reorganization. We note that the current common law rules governing 363 sales do not require consideration of this set of factors, which are potentially more value-relevant than factors, such as asset depreciation, that courts currently use to determine whether a business justification for a sale exists.

We suggest that courts consider the factors identified in our analysis and the “hidden” wealth effects when deciding whether to approve a 363 sale. This consideration should improve courts’ understanding of parties’ stakes and incentives, leading to better informed decision-making.

The full article is available here.

Bankruptcy & Bailouts; Subsidies & Stimulus: The Government Toolset for Responding to Market Distress

By Anthony J. Casey (The University of Chicago Law School)

Anthony J. Casey

In the spring of 2020, as the Covid-19 pandemic shut down economies around the world, pressure arose for governments to respond to the growing threat of pandemic-related market distress. In the United States, the initial proposals for government action varied in nature and focus. Some proposals targeted the financial system while others targeted small businesses and individuals. Others were intended to bail out large businesses and specific industries. Still other proposals took a more institutional focus. In the context of bankruptcy law, many imagined building up the bankruptcy system as a primary bulwark against a seemingly imminent wave of economic and financial distress.

With the exception of measures related to financial markets, the actual responses formed a chaotic mix of disconnected half-measures that neither stabilized the economy nor provided meaningful relief to those most affected. While that failure may be attributed in part to general government dysfunction and legislative gridlock, a large part of the problem arises from the lack of a clearly identified framework to guide government responses.

The main lesson here is that the appropriateness of tools deployed to alleviate a crisis depends on the nature of the specific problem at hand, and scattershot approaches are unlikely to work. As obvious as that principle may seem, it was largely ignored in 2020. Much of the confusion in the pandemic responses is attributable to using the wrong tools and implementing measures that lacked any clear purpose.

In particular, governments and commentators lost sight of two important distinctions in deciding how to act. The first is the distinction between tools appropriate for addressing economic distress and those appropriate for addressing financial distress. The second is the distinction between a systemic crisis where distress is spreading and an instance of firm-specific distress where the harm—though perhaps large—is contained.

These distinctions present four types of market distress: specific economic, systemic economic, specific financial, and systemic financial. Each type is distinct from the others, and for each there is a category of appropriate government responses (respectively): direct subsidies, general stimulus, bankruptcy proceedings, and financial bailouts. We thus have this matrix:

Systemic Specific
Economic General Stimulus Direct Subsidies
Financial Financial Bailouts Bankruptcy Proceedings

(Chapter 11)

 

The importance of understanding these classifications is most evident in the flawed proposals for pandemic-related fixes to bankruptcy law and in the lack of a centralized economic plan to support failing small businesses around the country.

In a new article, I lay out this framework for identifying the right tools for responding to different forms of market distress.  I describe the relationship between the category of tools and the type of distress. Having presented the framework, I then use it to closely examine the interaction between pandemic responses and bankruptcy law. This analysis is particularly important because efforts to understand the bankruptcy system’s role during the pandemic provide the starkest example of confused analysis of appropriate responses to systemic crises, and because a striking decline in bankruptcy filings in 2020 has puzzled many commentators.

Chapter 15 and Bankruptcy Credit Events under Credit Default Swaps

By Corinne Ball, George Cahill, Kay Morley, Jay Tambe, Bruce Bennett, & Heather Lennox (Jones Day)

Corinne Ball
George Cahill
Kay Morley
Jay Tambe
Bruce Bennett
Heather Lennox

A recent spate of decisions by the EMEA Determinations Committee (“DC”) has provided clarity on when a chapter 15 filing will trigger a “Bankruptcy” credit event under credit default swaps.  Each of the relevant chapter 15 petitions sought recognition of an English scheme of arrangement, which is not a product of insolvency law and does not necessarily constitute a Bankruptcy, and each underlying scheme was considered narrow enough in scope to not be “with or for the benefit of its creditors generally” (triggering limb (c) of Bankruptcy).  As such, the primary issue in each determination was whether the relief sought in the chapter 15 was similar to a “judgment of insolvency or bankruptcy” and independently triggered limb (d) of Bankruptcy.

The DC found that Thomas Cook’s 2019 petition for recognition of its scheme as a foreign nonmain proceeding, which expressly waived the benefit of the stay courts can impose in such cases, was not similar to an insolvency judgement and did not constitute a Bankruptcy.  On the contrary, it held that Matalan’s August petition seeking recognition of a foreign main proceeding (involving an automatic stay) was similar and triggered a Bankruptcy.  In its October determination regarding Selecta, the DC addressed the intermediate scenario, a petition seeking a stay in connection with a foreign main proceeding, finding that this also triggered a Bankruptcy.  While every situation must be considered on its own facts, these determinations should prove instructive on when a chapter 15 filing will trigger a Bankruptcy credit event.

Disclaimer Statement: “The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of the law firm with which they are associated.”

The full article is available here.

Delaware Bankruptcy Court Rules That Midstream Gathering Agreements Failed to Create Covenants Running with the Land

By Duston K. McFaul & Juliana Hoffman (Sidley)

Duston K. McFaul
Juliana Hoffman

On October 14, 2020, the honorable Christopher Sontchi, Chief Judge of the Delaware Bankruptcy Court, issued an opinion in the Extraction Oil and Gas bankruptcy case finding that certain oil, gas and water gathering agreements (the “Agreements”) did not create covenants running with the land under Colorado law and are thus subject to rejection in Extraction’s chapter 11 proceedings. The Bankruptcy Court applied Colorado law, which requires that the following three elements be satisfied: (1) the parties must intend to create a covenant running with the land; (2) the covenant must touch and concern the land with which it runs; and (3) there must be privity of estate between the covenanting parties. The Bankruptcy Court analyzed these elements relative to the debtor’s leasehold interest.

The Extraction decision is the Delaware Bankruptcy Court’s first published foray into a recent thicket of gathering agreement litigation that was reignited in 2016 with the Bankruptcy Court for the Southern District of New York authorizing the rejection of certain gathering agreements in the Sabine Oil & Gas bankruptcy case. Following Sabine, various oil and gas producers in chapter 11 attempted to use Sabine as a basis for invalidating dedications and shedding minimum volume and other commitments in their own gathering agreements. Such efforts were rebuffed in 2019 by the Colorado Bankruptcy Court in Badlands and by the Bankruptcy Court for the Southern District of Texas in Alta Mesa, each of which analyzed the elements of the asserted covenants running with the land relative to the debtor’s leasehold interest.  The courts in Badlands and Alta Mesa each found that the agreements at issue created valid real property covenants under applicable state law and were thus not executory contracts that could be rejected in bankruptcy.

The Extraction case diverged from Badlands and Alta Mesa in its narrow holding, which analyzed the purported covenants in the context of only the debtor’s mineral estate, and ultimately concluded the midstream agreements did not contain an enforceable covenant running with the land.  The Extraction rulings are currently on appeal before the Delaware District Court.

The full article is available here.

The Development of Collateral Stripping by Distressed Borrowers

By Mitchell Mengden (Law Clerk, Delaware Court of Chancery)

Mitchell Mengden

In the past decade, private equity sponsors have taken a more aggressive stance against creditors of their portfolio companies, the most recent iteration of which has come in the form of collateral stripping. Sponsors have been using creative lawyering to transfer valuable collateral out of the reach of creditors. This Article delves deeper into the issue by examining the contract terms and litigation claims raised by these transactions.

The lack of protective covenants and ease of manipulating EBITDA and asset valuations are key conditions that permit collateral stripping. Each of these conditions were present in the past decade, primarily due to the protracted expansionary stage of the credit cycle. Lenders, however, can protect themselves from collateral stripping by negotiating stricter covenants and tighter EBITDA definitions, as well as pursuing ex post litigation for fraudulent transfers, illegal distributions, and claims for breach of fiduciary duty.

Contractual opportunism and creative lawyering will almost certainly continue to pervade credit markets. This Article provides a roadmap of ways that lenders can protect themselves from opportunism during contracting and throughout the course of the loan. As this Article concludes, ex post litigation claims are often an inadequate remedy, so lenders should seek to tighten EBITDA definitions and broaden protective covenants—even if to do so requires other concessions—to avoid litigation.

The full article is available here.

The Hertz Maneuver (and the Limits of Bankruptcy Law)

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)

Anthony J. Casey
Joshua C. Macey

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.

The full article is available here.

Germany Poised for Big Step Towards Corporate Restructuring Best Practice

By Sacha Luerken (Kirkland & Ellis)

Sacha Luerken

Germany’s insolvency law has only in very few cases – around 1% of filings – been used for a Chapter 11-style going concern restructuring of a debtor company. Initiatives to introduce processes like the scheme of arrangement, an English procedure that was also commonly used to restructure non-English companies and is capable of Chapter 15 recognition in the U.S., were not successful, even though recoveries for unsecured creditors in Germany are remarkably low compared to other jurisdictions.

A paradigm shift occurred when the EU in June 2019 passed its directive 2019/1023 on preventive restructuring frameworks, which requires all EU member states to introduce a restructuring process for companies in financial difficulties, but before an actual insolvency. On September 18, 2020, a draft law was presented to introduce a scheme-like procedure in Germany, which provides for a restructuring of selected liabilities with 75% majority by amount in class, a cross-class cram-down subject to tests similar as in a U.S. Chapter 11 proceeding, a court-approved stay on enforcement and collateral realization, and even a rejection of onerous contracts by the court.

The draft law has been welcomed as a big step towards a restructuring culture in Germany by many advisors and practitioners, and as a potential blueprint for the implementation of the EU directive in other European jurisdictions.

The full article is available here.

Reprinted with permission from the October 06, 2020 edition of the Law.com International 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.

Special Considerations for Protecting Interests under Water Agreements in Bankruptcy

By Rahul D. Vashi, Anna G. Rotman, Chris Heasley, Shubi Arora, Kenneth A. Young, Fraser F. Wayne, and John C. Elkins (Kirkland & Ellis)

Rahul D. Vashi
Anna G. Rotman
Chris Heasley
Shubi Arora
Kenneth A. Young
Fraser F. Wayne
John C. Elkins

Midstream service providers in the oil and gas space typically expend substantial upfront capital investment to build pipeline systems to gather and transport hydrocarbons and produced water for oil and gas producers, and rely on the fee structures in their service contracts to recoup their investments. One common method used by midstream companies to protect their investments is to create (or attempt to create) in their service contracts a dedication of production from the oil and gas producer structured as a covenant that runs with the land.

Beginning with Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC (In re Sabine Oil & Gas Corp.), 567 B.R. 869 (S.D.N.Y. 2017), bankruptcy courts have delivered divided opinions on whether midstream gathering and transportation contracts can be rejected, resulting in substantial uncertainty about whether midstream service providers can rely on their contractual terms. The major decisions regarding the treatment of midstream contracts in bankruptcy have focused on contracts for the gathering and transportation of hydrocarbons, and whether the contracts should not be rejectable because the oil and gas producer properly granted to the midstream company a covenant running with the land in its oil and gas properties.

Providers of produced water gathering and transportation services have typically relied on the same contractual protections as those that provide hydrocarbon gathering and transportation services. However, to date, midstream water contracts purporting to contain covenants running with the land have not been tested, and there is reason to believe that such agreements may be treated differently than their oil and gas counterparts. This article discusses certain issues and considerations that are specific to midstream water agreements and may affect whether such agreements are determined to be rejectable under the Bankruptcy Code.

The full article is available here.

When Arbitration Meets Bankruptcy: Considering Arbitration Options in the Wake of a Growing Rise in Corporate Insolvencies

By Shana A. Elberg, Christine A. Okike, & Jennifer Permesly (Skadden)

Shana A. Elberg
Christine A. Okike
Jennifer Permesly

The economic hardships brought about by the COVID-19 pandemic have impacted companies globally, leading many to consider both in-court and out-of-court restructurings. This trend will likely continue as the long-term effects of COVID-19 play out, and companies with arbitration clauses in their commercial agreements may wish to consider the impact of insolvency on their options for pursuing pending or future arbitrations. Under bankruptcy law, the initiation of insolvency proceedings results in an automatic stay of all civil proceedings brought against the debtor, including claims brought in arbitration. An arbitration counterparty may ask a bankruptcy court to lift the stay, which the court is permitted to do under the Bankruptcy Code “for cause.” The decision to lift the stay is ultimately a matter of the bankruptcy court’s discretion, though federal circuit courts have held that a stay of an arbitration involving a noncore matter generally must be lifted. The balance is particularly weighted in favor of arbitration in the international context.   Although the stay of arbitration is intended to apply extraterritorially, it is not always clear that arbitration tribunals seated outside the US, or counterparties located outside the US and not subject to the bankruptcy court’s jurisdiction, will consider themselves bound by the stay.  Companies considering their options for pursuing cross-border arbitrations against an insolvent debtor must therefore consider the relevant laws in at least three regimes: the seat of the arbitration, the place in which the debtor has declared insolvency and any countries in which enforcement of the award may ultimately be sought.

The full article is available here.

Oversecured Creditor’s Right to Contractual Default-Rate Interest Allowed Under State Law

By Stacey L. Corr-Irvine and Mark G. Douglas (Jones Day)

Stacey L. Corr-Irvine
Mark G. Douglas

It is generally well understood that an “oversecured” creditor is entitled to interest and, to the extent provided for under a loan agreement, related fees and charges as part of its secured claim in a bankruptcy case. Although section 506(b) of the Bankruptcy Code provides that fees, costs or charges allowed as part of a secured claim must be “reasonable,” the provision does not expressly impose any restrictions on the amount or nature of interest allowable as part of a secured claim. A Bankruptcy Appellate Panel for the Eighth Circuit recently considered whether a secured creditor is entitled to contractual default-rate interest under section 506(b).

In In re Family Pharmacy, Inc., 614 B.R. 58 (B.A.P. 8th Cir. 2020), the panel reversed a bankruptcy court’s order disallowing a secured creditor’s claim for interest at the default rate under the parties’ contract using a penalty-type analysis generally applied to liquidated damages provisions. According to the panel, such an analysis cannot be applied to default interest provisions. The panel also held that the bankruptcy court erred when it held that the default interest rate was unenforceable based on “equitable considerations.”

The full article is available here.

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