J. Crew, Nine West, and the Complexities of Financial Distress
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Distressed Debt Markets | 0

By Kenneth Ayotte (University of California – Berkeley School of Law) and Christina Scullly (University of California – Berkeley School of Law)

Kenneth Ayotte
Christina Scully

The Nobel laureate Herbert Simon describes a complex system as one “made up of a large number of parts that interact in a nonsimple way.” The modern large Chapter 11 fits this definition quite well. Debt contracts with overlapping provisions lie within capital structures with multiple classes of claims, layered across numerous legal entities. Distressed restructuring transactions give rise to complex litigation over entitlements to the firm’s value. Bankruptcy case governance strategies are driven by intercreditor and restructuring support agreements that are constantly evolving.

Traditional law and economics theory of bankruptcy has little to say about this complexity, except to assume that rational, forward-looking “sophisticated parties” have anticipated it and managed it optimally. Taken to its logical conclusions, this perspective leaves no useful role for bankruptcy law. After all, if some feature of the Bankruptcy Code were useful, sophisticated parties would find a way to put it in their contracts. Mandatory features, even bedrock ones like the automatic stay, become no more than harmful interferences with contractual freedom.

Simplified models that assume omnisciently rational actors are useful tools in corporate finance: they isolate the forces that drive capital structure decisions and generate testable empirical predictions. But as normative models of bankruptcy law design, they are fundamentally flawed. We provide two case studies, one involving a complex contract (J. Crew), and another involving a complex capital structure (Nine West). Taken together, they suggest that it is time for law and economics scholars to take the uncomfortable but necessary step to acknowledge bounded rationality. Bankruptcy law must function not just for the optimal contracts a theorist derives, but also for the “good enough” contracts parties actually write, and the unpredictable interactions these imperfect contracts can generate.

Our first case study recounts the narrative behind the J. Crew restructuring, the most well-known of many “liability management transactions” that have become part of the distressed borrower’s playbook. The J. Crew case illustrates how a complex loan agreement with numerous interacting terms gives rise to loopholes that sophisticated parties can exploit. We describe the two-step transaction by which J. Crew combined multiple provisions in a term loan agreement to transfer the lenders’ collateral to an unrestricted subsidiary to refinance other debt. Though one particular “trap door” provision received the most public attention, our study reveals that other contractual weaknesses, such as the administrative agent’s low-powered incentives as a lender representative, also enabled the collateral transfer.

The growing importance of liability management strategies suggests that the true effect of greater sophistication is not optimal debt contracts, but instead, a magnification of their inevitable flaws. To understand these trends, we first need a model of contracting where such weaknesses can exist. Acknowledging bounded rationality in contracting is a necessary first step toward an agenda that understands the imperfect ways complex contracts evolve. This agenda can help scholars gain an understanding what drives contractual change, why loopholes form and close, and the costs and benefits of contractual complexity.

A second case study, Nine West, illustrates a “butterfly effect” of complex capital structures: small changes can have large and unanticipated effects when a bankruptcy occurs. Sycamore Capital Partners acquired Nine West and related fashion brands in a leveraged buyout in 2014. It reorganized its corporate structure in the process, leaving most of the debt with Nine West and spinning out other brands to itself, free of debt. An eleventh-hour decision to add more debt to the deal, and to make this debt senior through subsidiary guarantees, gave rise to a dizzyingly complex array of entitlement disputes between parent and subsidiary creditors about the uncertain ownership of assets and responsibility for debts across the entities in the Nine West corporate group. These disputes contributed to the exorbitant professional fees incurred in the bankruptcy case that consumed over 20% of the company’s enterprise value. 

Insights from the study of complex systems can more realistically inform our models of bankruptcy law design. For example, an important feature of complex systems design is robustness: the system must be able to function effectively under suboptimal conditions. Features like the automatic stay and judicial oversight play a valuable role in preventing imperfections and gaps from propagating. Because interactions across contracts are most likely to lead to unanticipated effects, a perspective based in bounded rationality is also consistent with bankruptcy’s special role as a tool for addressing multiple creditor problems. Overall, we believe there is significant insight to be gained from the recognition that even sophisticated parties are imperfect.

The full article is available here.

Bankruptcy for Banks: A Tribute (and Little Plea) to Jay Westbrook
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Financial Firms and Safe Harbors, Legislation | 0

By David A. Skeel, Jr. (University of Pennsylvania Law School)

Over the past several years, Congress has considered various versions of a legislative reform that would amend the Bankruptcy Code to facilitate the prompt reorganization of systemically important financial institutions (“SIFIs”). The reform would adapt the “Single Point of Entry” strategy devised for use under Title II of the Dodd Frank Act to bankruptcy. In each context, the assets, short term liabilities, and secured debt of the troubled SIFI would be transferred to a newly created bridge institution, leaving behind its stock and long-term debt. The newly recapitalized bridge institution would be fully solvent, and could contribute liquidity to the troubled subsidiaries as necessary. Although the bankruptcy for banks legislation appears to have strong support in Congress, its reception among bankruptcy scholars has been mixed.

In this short essay, I take the opportunity of a celebration of the work and influence of Jay Westbrook to explore his and his fellow critics’ opposition to bankruptcy for banks. I begin the essay by surveying Jay’s wide-ranging contributions to bankruptcy scholarship. Jay’s functional analysis has had a profound effect on scholars’ understanding of key issues in domestic bankruptcy law, and Jay has been the leading scholarly figure on cross-border insolvency. After surveying Jay’s influence, I turn to the topic at hand: bankruptcy for banks. Jay has been a strong critic of the proposed reforms, arguing among other things that financial institutions need to be resolved by regulators and an administrative process, not bankruptcy. After addressing these and other objections, I ask Jay if he might reconsider his opposition if the legislation were amended to respond to several of his primary concerns.

The essay is available here.

The Effect of Creditor Rights on Capital Structure, Investment, Profitability, and Risk: Evidence from a Natural Experiment
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates | 0

By Aras Canipek (University of Konstanz), Axel Kind (University of Konstanz; University of Basel; University of St. Gallen), and Sabine Wende (University of Cologne)

Supply-side scholars have argued that laws which mandate managers to leave upon bankruptcy filing and which grant secured creditors strong power to quickly seize their collateralized assets lead to higher recovery rates, lower interest costs, and relaxed financial constraints, and that these consequences ultimately foster economic growth. In contrast, a more recent demand-side view raises the concern that borrowers can feel threatened by such liquidation-oriented regimes. Threatened borrowers may take (economically undesirable) actions to reduce the likelihood of having to bear high distress costs.

We find evidence in favor of the demand-side view by using Germany’s bankruptcy reform (ESUG) of 2012 and studying the causal effects of an exogenous downward shock to creditor rights on firms’ financial and investment policy. ESUG limited the rights of secured creditors by strongly facilitating firm continuation and allowing the manager to stay in unrestricted corporate control. In the study, we show that high-tangible-asset companies – which the reform predominantly affected – turned away from being overly risk-averse at the cost of profitability, relative to low-tangibility control firms. Specifically, weaker creditor rights motivated affected firms to increase financial leverage and to prefer the more flexible unsecured debt. Moreover, affected firms reduced unprofitable but risk-lowering expansions and sold off less profitable but easily-marketable assets that are useful in downturns by providing the liquidity that can prevent bankruptcy. Our results suggest that weaker creditor rights encourage firms to eliminate protection mechanisms formerly constructed to contract around liquidation-oriented bankruptcy provisions. This view is supported by the increased profitability and higher risk of treated firms after the reform.

The stronger pre-ESUG creditor rights not only produced ex post deadweight losses in terms of inefficient liquidation, but also discouraged firms to make profitable investment decisions. This reveals ex ante inefficiencies of creditor rights, an aspect largely ignored in the extant literature.

The article can be found here.