By Stewart B. Herman (Katten) and Timothy J. Lynes (Katten)
In King v. Bombardier Aerospace Corporation et al., the trustee sought under 11 U.S.C. §§ 547(b) and 550(a) to have the lessor disgorge rent that the debtor lessee had paid to the lessor under an English-law aircraft lease during the prepetition preference period using funds advanced to the debtor by its shareholder. Pursuant to §547(b), the trustee argued that the debtor had made the payment for an antecedent debt; the loan balance on what was alleged to be disguised secured financing rather than a true lease. The lessor asserted (i) the trustee had not sufficiently shown the nature and amount of the antecedent debt as required under § 547(b)(2), (ii) under § 547(c)(4) the lessor had provided the debtor subsequent new value after the debtor made the payment, (iii) under § 547(c)(2) that the debtor had made the payment in the ordinary course of business, and (iv) that under the earmarking doctrine the payment should not be clawed back because the payment had been funded by a loan from a third party (the debtor’s shareholder). The court found (i) the trustee had not satisfactorily shown the nature and amount of the antecedent debt, (ii) the lessor had sufficiently shown it added subsequent new value to the debtors, (iii) the lessor had not sufficiently shown the payment was in the ordinary course of business, under either the subjective test or the objective test, and (iv) the lessor had not sufficiently shown facts to support an earmarking defense. The article concludes by offering suggestions for structuring leases to survive preference claims. The full article is available here.
Over the past several years, certain circuits criticized the Equitable Mootness doctrine for its lack of statutory basis and effect of avoiding review of chapter 11 plans on the merits. However, the Third Circuit recently held in In re Nuverra Environmental Solutions, Inc. v. Hargreaves, Case No. 18-3084, 834 Fed. Appx. 729 (3d Cir. Jan. 6, 2021), that the Equitable Mootness doctrine is still alive and well.
The Third Circuit rejected the appeal of Hargreaves, a creditor who timely objected to the chapter 11 plan and timely appealed the bankruptcy court’s entry of the plan’s confirmation order, because the plan was already substantially consummated and could not be unwound. Further, the Third Circuit held that it could not grant Hargreaves “individualized relief” because such relief would violate Bankruptcy Code § 1123(a)(4)’s restriction on preferential treatment of class members and § 1129(b)(1)’s prohibition on unfair discrimination between classes.
In a concurring opinion, Judge Krause rejected the application of Equitable Mootness, finding the majority did not sufficiently analyze whether disparate treatment of creditors within a class is permissible on appeal when parties choose not to object to, or appeal confirmation of, the plan. Judge Krause also noted that denial of the appeal on Equitable Mootness grounds precluded consideration of substantive arguments and development of the Third Circuit’s bankruptcy jurisprudence.
While Judge Krause’s concurring opinion highlights difficulties plan objectors face when appealing plan confirmation, the majority opinion signals that Equitable Mootness is still a healthy doctrine in the Third Circuit.
By Daniel J. Merrett (Jones Day) and Mark G. Douglas (Jones Day)
The ability of a bankruptcy trustee or chapter 11 debtor-in-possession (“DIP”) to avoid fraudulent transfers is an important tool promoting the bankruptcy policies of equality of distribution among creditors and maximizing the property included in the estate. One limitation on this avoidance power is the statutory “look-back” period during which an allegedly fraudulent transfer can be avoided—two years for fraudulent transfer avoidance actions under section 548 of the Bankruptcy Code and, as generally understood, three to six years if the trustee or DIP seeks to avoid a fraudulent transfer under section 544(b) and state law by stepping into the shoes of a “triggering” creditor plaintiff.
The longer look-back periods governing avoidance actions under various state laws significantly expand the universe of transactions that may be subject to fraudulent transfer avoidance. Indeed, under a ruling recently handed down by the U.S. Bankruptcy Court for the Western District of North Carolina, the look-back period in avoidance actions under section 544(b) may be much longer—10 years—in bankruptcy cases where the Internal Revenue Service (“IRS”) or another governmental entity is the triggering creditor. In Mitchell v. Zagaroli (In re Zagaroli), 2020 WL 6495156 (Bankr. W.D.N.C. Nov. 3, 2020), the court, adopting the majority approach, held that a chapter 7 trustee could effectively circumvent North Carolina’s four-year statute of limitations for fraudulent transfer actions by stepping into the shoes of the IRS, which is bound not by North Carolina law but by the 10-year statute of limitations for collecting taxes specified in the Internal Revenue Code.
Zagaroli does not break new ground on the power of a bankruptcy trustee or DIP to bring avoidance actions under section 544(b) of the Bankruptcy Code. Nevertheless, the court’s endorsement of the majority approach on the availability of a longer look-back period in cases in which the IRS is a creditor is notable. Widespread adoption of this approach could significantly augment estate avoidance action recoveries.
In a recent decision, In re Energy Future Holdings Corp., 2021 U.S. App. LEXIS 7400 (3d Cir. 2021) (“EFH II”), the Third Circuit held that a stalking horse may assert an administrative expense claim under section 503(b)(1)(A) of the Bankruptcy Code for certain transactional expenses, even when it is not entitled to a termination fee.
In EFH II, the debtors terminated a merger agreement with a stalking horse and the stalking horse applied for payment of a termination fee. After the application was denied, the stalking horse filed an administrative expense application for costs incurred in attempting to complete the merger. In response, various bondholders jointly filed a motion to dismiss and a motion for summary judgment. After the Delaware Bankruptcy Court granted the bondholders’ motions, the Third Circuit ruled that the administrative claim should not have been denied without further factual inquiry because the stalking horse plausibly alleged that it benefited the estate by providing information, accepting risks, and paving the way for a later successful deal.
In so holding, the Third Circuit applied a broad standard for pleading a plausible administrative claim under section 503(b)(1)(A). Going forward, it may be harder to obtain denial of an administrative expense application in the Third Circuit without a discovery process and evidentiary hearing. While this decision establishes an alternative means for stalking horses to recover certain transactional expenses, its actual impact remains to be seen, as parties can draft provisions in transactional documents to address the scope of recoverable administrative claims.
By Jared A. Ellias (Bion M. Gregory Chair in Business Law and Professor of Law, UC Hastings College of Law) and George Triantis (Professor of Law and Business, Stanford Law School)
It is widely recognized that bankruptcy law can stymie regulatory enforcement and present challenges for governments when regulated businesses file for Chapter 11. It is less-widely understood that bankruptcy law can present governments with opportunities to advance policy goals if they are willing to adopt tactics traditionally associated with activist investors, a strategy we call “government bankruptcy activism.” The bankruptcy filings by Chrysler and General Motors in 2009 are a famous example: the government of the United States used the bankruptcy process to help both auto manufacturers resolve their financial distress while promoting the policy objectives of protecting union workers and addressing climate change. A decade later, the government of California applied its bargaining power and used an innovative state law in the Pacific Gas & Electric Company’s Chapter 11 case to protect climate policies and the victims of wildfires. These examples illustrate that, by tapping into the bankruptcy system, governments gain access to the exceptional powers that a debtor enjoys under bankruptcy law, which can complement the traditional tools of appropriations and regulation to facilitate and accelerate policy outcomes. This strategy is especially useful in times of urgency and policy paralysis, when government bankruptcy activism can provide a pathway past veto players in the political system. However, making policy through the bankruptcy system presents potential downsides as well, as it may also allow governments to evade democratic accountability and obscure the financial losses that stakeholders are forced to absorb to help fund those policy outcomes.
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)
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.
By Anthony J. Casey (Professor, The University of Chicago Law School) and Joshua Macey (Assistant Professor, The University of Chicago Law School)
The United States Bankruptcy Code gives debtors wide discretion to reorganize in the venue of their choice. These lenient venue selection rules long have allowed bankruptcy courts in the District of Delaware and the Southern District of New York to dominate the market for large Chapter 11 cases, though recently the Southern District of Texas has also begun to attract a large number of cases.
This state of affairs has produced a vigorous debate. Critics of liberal venue rules charge that bankruptcy districts are engaged in a “race to the bottom” as judges compete for blockbuster cases. Others counter that competition for cases improves efficiency and predictability as judges develop expertise in overseeing large Chapter 11 cases.
This Article cautions that developments in foreign jurisdictions may limit the effectiveness of these venue reform proposals. In recent years, foreign jurisdictions have emerged as convenient forums for distressed debtors. For instance, in many cases, the English scheme of arrangement now represents a viable alternative to the American bankruptcy system, and over the past decade, a number of companies have chosen to use an English scheme of arrangement to restructure their debt instead of chapter 11, with the first United States-headquartered business doing so in 2019. Other jurisdictions have also sought to entice foreign debtors, with insolvency specialists speculating that Singapore, in particular, could become a restructuring hub.
Because American bankruptcy courts freely recognize foreign insolvency proceedings, firms that are directed to file in less favored districts may instead choose to reorganize in a foreign jurisdiction. In this environment, attempts to limit venue selection within the United States will have the opposite of their intended effect, replacing domestic venue shopping with even worse global forum shopping. By ignoring the availability of global forums, current venue reform proposals could, perversely, drive opportunistic debtors and creditors to restructure in foreign jurisdictions.
To address this, we argue that, rather than limit domestic venue choice, lawmakers should: (1) support the development of ex ante commitment to mechanisms for choosing venue and forum; and (2) whenever possible, resolve inconsistencies in substantive law across venues and forums. These are general principles of reform, and the implementation will depend on context. For example, commitment mechanisms look different for venue than they do for forum. But, if designed properly, these measures can reduce the costs of venue and forum shopping without giving up the benefits that come from allowing some choice of venue and forum.
It is worth noting that the merits of our proposal are independent of one’s view on the current state of venue shopping. If venue shopping is a real problem, the principles we introduce address that problem. If venue shopping is not a problem, the principles do no harm and even expand the choice set for debtors. Similarly, while the principles address the problem of global forum shopping, the benefits with regard to venue shopping exist with or without global forums. The same cannot be said of the status quo or the reforms currently being considered.
By Edward J. Janger (Professor, Brooklyn Law School) and Adam J. Levitin (Professor, Georgetown University Law Center)
In Distorted Choice in Corporate Bankruptcy, David Skeel offers a nuanced description of restructuring support agreements (RSAs) and how they can help a debtor to achieve the necessary consensus around a proposed Chapter 11 plan of reorganization. We take issue, however, with Skeel’s permissive view toward RSAs that permits provisions that would short circuit the “process” protections contained in Chapter 11. Such provisions include pre-disclosure lock-ups, milestones, and coercive deathtraps.
Chapter 11 contemplates bargaining in the shadow of certain basic statutory “distributional” entitlements: equal treatment, best interests, full cash payment of administrative expenses, and a guaranteed minimum-cramdown distribution. As such, RSAs can either reinforce the link between entitlement and distribution, or they can sever it.
In our view, Skeel insufficiently appreciates the purpose of process—how procedural protections such as classification, disclosure, and solicitation surrounding the vote forge the crucial link between bankruptcy bargaining and core principles of corporate governance and pre-bankruptcy entitlement. We offer, instead, an approach which sorts between process-enhancing RSAs and those that facilitate end-runs.
By Amir Licht (Professor, Interdisciplinary Center Herzliya, Israel)
In several common law jurisdictions, creditors of corporate debtors enjoy legal protections through vicinity-of-insolvency fiduciary duties, beyond what their contracts with those companies afford them. These duties form a notoriously murky area, where legal space warps. The contours of this area are fuzzy. Courts openly acknowledge that it is difficult to identify clear guideposts for its threshold—as to when exactly these duties are enlivened. In a forthcoming article, I purport to make two main contributions. First, the article expands the theoretical basis for a special legal regime in virtually insolvent firms by pointing out escalation of commitment as a potent and relevant factor that has been largely overlooked by insolvency scholars. Second, this article addresses the substantive content of the duty to protect creditors where such duties are recognized.
The standard account that is usually invoked to explain and justify special fiduciary duties to consider creditors’ interest points to the danger of opportunistic high-risk behavior by managers on behalf of shareholders. I argue that this account may be sound but is nonetheless lacking. In addition to such risk-shifting opportunism, lawmakers should also be mindful of managers’ tendency to unjustifiably continue failing projects, known as escalation of commitment. Escalation of commitment refers to a phenomenon, in which people tend to remain married to their original choices and to commit resources to them even when it is no longer rational to do so. Escalation of commitment is ubiquitous. It has been observed in organizations large and small, in business corporations and in the public sector. Escalation of commitment is not only an irrational and emotional personal behavior. More often than not, it takes place in a broader social context of one’s ingroup—in particular, the board of directors, the organization, and one’s community and culture.
Escalation of commitment poses an equal, if not greater, challenge than risk shifting does to optimal regulation of companies in looming or virtual insolvency. Being largely detached from rational calculations, escalation of commitment presents a more compelling justification for legal regulation, and a more interventionist one at that. In this view, managers—especially owner-managers—of virtually insolvent firms may not enjoy the usual level of deference that the law affords to their business judgment in regular times, as their discretion at that point is prone to be clouded by a misplaced motivation to stay the course, weather the storm, and similarly-spirited no-quitting notions.
Factors that could facilitate de-escalation include better information on costs and benefits of the project, regular evaluation and monitoring of projects, clear criteria for success and minimum target performance levels, and clear feedback about underperforming projects. Such measures will have limited efficacy, however, if the information they generate is interpreted and acted on by decision-makers who have initiated the failing project and even by different persons who are nonetheless related to those decision-makers. Change in management is thus essential.
While Delaware law rejects the idea of a pre-insolvency creditor-focused fiduciary duty, several jurisdictions do recognize duties to protect creditors, either as a duty to consider creditors’ interests or as the rule against wrongful (or insolvent, or reckless) trading. I argue that these duties should be enlivened at the very edge of the zone of insolvency, close to the latter. At that point, the mission of directors should transform from entrepreneurial to custodial. That is, they should implement strategies that aim to preserve the firm—in working condition, to the extent possible, with a view to resuming regular business—but avoid seeking new projects with a view to maximizing profits. This could mean that the shield of the business judgment rule may not be available to the same extent as in regular circumstances. The Covid-19 pandemic that swept the globe in 2020 provides a fresh context for this approach and underscores the need to implement such a regime sensibly, with high deference to business decisions even if outside the scope of the business judgment rule. The article concludes with a comparative analysis of creditor-oriented duties in several common law jurisdictions and examines how they could implement a custodial approach.
By Mitchell Mengden (Law Clerk, Delaware Court of Chancery)
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.