S.D.N.Y. Judge Holds Bankruptcy Code Prohibits Board-Appointed Officers from Receiving Payments Under a KERP
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Chapter 11, Insider Status, Reorganization | 0

By Sarah M. Bartlett (Harvard Law School)

Sarah M. Bartlett

On July 9, 2021, Southern District of New York Judge J. Paul Oetken held that §503(c) of the Bankruptcy Code prohibits board-appointed officers from receiving payments under a key employee retention plan (KERP) “absent a particularly strong showing that they do not perform a significant role in management,” as such officers are “insiders” within the definition of §101(31)(B)(ii). In re LSC Communications, Inc., 631 B.R. 818 (S.D.N.Y. 2021). This was the case even though the Bankruptcy Court found that the employees in question were officers “in title only.” Id. at 820. Judge Oetken’s ruling affects six employees who received KERP payments under the reorganization plan of LSC Communications, Inc. (“LSC”), which filed for Chapter 11 relief in April 2020.

In its initial order, the Bankruptcy Court approved payments under the KERP for all 190 covered employees. U.S. Trustee William K. Harrington appealed the decision to the District Court, claiming that, as LSC was incorporated in Delaware, the court should apply Delaware state law, which provides that any person appointed by a corporation’s board of directors is an officer. In response, LSC countered that the employees could not be considered insiders because they lacked any significant decision-making authority.

Judge Oetken wrote that case law regarding who constitutes an “officer” is “less than clear,” noting that the Bankruptcy Code does not define the term or provide any insight regarding its meaning. Id. at 824. Although Judge Oetken rejected the Trustee’s argument that state law exclusively applies when determining whether an employee is an officer under the Bankruptcy Code, he concluded that the Bankruptcy Court erred by looking beyond the fact that the six employees were appointed by LSC’s board.  Even if a court chooses to undertake a more expansive analysis, he wrote, the fact that the six employees were appointed by the board and would be deemed officers under Delaware corporate law should “weigh heavily in concluding that the employees are officers for Bankruptcy Code purposes.” Id. at 826. In supporting his position, Judge Oetken claimed that giving more weight to objective criterion like appointment by the board provides greater clarity to the parties than the kind of “functional, non-exhaustive test” used by the Bankruptcy Court, although he noted that this kind of test may still be appropriate in some cases. Id. at 825.

This case, and its somewhat unusual holding, seems to present a scenario that has become exceedingly rare. In September, the Government Accountability Office (GAO) published a report finding that debtors regularly avoid restrictions in the Bankruptcy Code by paying bonuses before or after filing for bankruptcy or by designating bonuses during bankruptcy as “incentive” payments. The report stated that fewer than 1% of debtors requested court approval to pay employee bonuses during 2020 and, when debtors did seek court approval, the courts approved “nearly all” of those requests. Maria Chutchian wrote in a recent Reuters article that creditors rarely challenge such bonus payments in court, noting debtors will often arrange private deals with creditors before filing for bankruptcy. In the same article, she discusses the Mallinckrodt restructuring, in which the pharmaceutical company’s creditors chose to challenge bonus payments to executives facing accusations of misconduct related to the opioid epidemic. The judge allowed the payments, stating that “mere allegations” of misconduct did not suffice to render them inappropriate.

Finally, Jared Elias concluded in an article published in 2019 that, although fewer companies have used court-approved bonus plans in the years since the Bankruptcy Code’s bonus provisions were reformed in 2005, the overall level of executive compensation has remained the same. This lends support to the GAO’s analysis and the anecdotes collected by Reuters that KERPs are rarely used because parties have ample opportunity to achieve the same end while avoiding the scrutiny of §503(c). He argues that bankruptcy and district court judges are poorly equipped to police payments made before or after a debtor files for bankruptcy, and that the U.S. Trustee’s office and creditors struggle to do so due to information asymmetries and limited resources.

Given the above, it appears that Judge Oetken’s decision this past summer may ultimately prove to be an anomaly. In most cases, these bonus payments simply will not become a part of the bankruptcy plan. Debtors can avoid scrutiny by making payments before or after filing for bankruptcy. If they decide they must make the payments during bankruptcy, they can reduce the scrutiny they will incur by recharacterizing them as  incentive payments, thereby avoiding the heightened restrictions that apply to KERPs. And, even if they decide to include the payments in their restructuring plan, it seems unlikely that creditors will challenge the payments—particularly if counsel has chosen to arrange a deal behind the scenes to avoid a dispute in court.

Chapter 11’s Descent into Lawlessness
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Jurisprudence, Workouts and Pre-Packs | 0

By Lynn M. LoPucki (Security Pacific Bank Distinguished Professor of Law, UCLA School of Law)

Lynn M. LoPucki

The bankruptcy courts that compete for big cases frequently ignore the Bankruptcy Code and Rules. This Article documents that lawlessness through a detailed examination of the court file in Belk, Inc.—a one-day Chapter 11—and a series of empirical studies.

Chapter 11’s lawlessness reached a new extreme in Belk. Belk filed in Houston on the evening of February 23, 2021. The court confirmed the plan at ten o’clock the next morning, and the parties consummated the plan that same afternoon. Almost none of Chapter 11’s procedural requirements were met. The court did not give creditors notice of the disclosure statement or plan confirmation hearings until after those hearings were held. Belk filed no list of creditors’ names and addresses, no schedules, no statement of financial affairs, and no monthly operating reports.  No creditors’ committee was appointed, no meeting of creditors was held, and none of the professionals filed fee applications. The ad hoc groups that negotiated the plan failed to file Rule 2019 disclosures. Because no schedules were filed, no proofs of claim were deemed filed. Only eighteen of Belk’s ninety-thousand creditors filed proofs of claim, and Belk apparently just made distributions to whomever Belk considered worthy. 

The procedural failures in Belk are just the tip of the iceberg.  The competing courts are ignoring impermissible retention bonuses, refusing to appoint mandatory examiners, failing to monitor venue or transfer cases, granting every request to reject collective bargaining agreements, and providing debtors with critical-vendor slush funds. The article is available here. 

Voting Rights Assignment Unenforceable, but Subordinated Creditor Lacked Standing to Participate in Chapter 11 Plan Confirmation Process
by | posted in: Chapter 11, Cramdown and Priority, Priority | 0

By Dan B. Prieto (Jones Day) and Mark G. Douglas (Jones Day)

Dan B. Prieto
Mark G. Douglas

In In re Fencepost Productions Inc., 629 B.R. 289 (Bankr. D. Kan. 2021), the U.S. Bankruptcy Court for the District of Kansas recently addressed the enforceability of a provision in a pre-bankruptcy subordination agreement under which a subordinated creditor assigned to a senior creditor its right to vote on any chapter 11 plan proposed for the borrower. The bankruptcy court ruled that such a provision is not enforceable because it conflicts with the Bankruptcy Code. In a twist, however, the court concluded that the subordinated creditor lacked “prudential standing” to participate in the confirmation process because it was extremely out-of-the-money and therefore had no stake in the outcome of the case, but was attempting to assert the rights of third parties.

Courts disagree over whether an assignment of plan voting rights in an intercreditor or subordination agreement is enforceable. Regardless of the particular approach adopted by a court on this issue, the growing consensus is that agreements that seek to limit or waive junior creditors’ voting rights must contain express language to that effect. The ruling in Fencepost adds yet another chapter to the ongoing debate on this issue.

 The Fencepost court’s conclusion that the subordinated creditor lacked prudential standing would appear to be driven in part by the facts of the case, which involved a subordinated, clearly out-of-the-money creditor intent upon impeding an otherwise consensual reorganization.

The Bankruptcy Code, however, expressly provides to the contrary by, among other things, giving every “party in interest” (including creditors and interest holders, without making an exception in cases where there is no value available for distribution to them), the right to appear and be heard “on any issue” in a chapter 11 case, the right to vote on a chapter 11 plan, and the right to object to confirmation of a plan. These provisions arguably indicate that Congress intended to modify or abrogate prudential standing requirements when it enacted the Bankruptcy Code. Moreover, the “rights” any out-of-the-money creditor or shareholder would be seeking to enforce by participating in the confirmation process are arguably their own, rather than the rights of third parties.

A logical extension of the rationale articulated in Fencepost is that clearly out-of-the-money creditors or shareholders of an insolvent corporation would never have prudential standing to participate in the chapter 11 plan confirmation process. That approach would be contrary to court rulings and general practice in many chapter 11 cases.

The full article can be accessed here.

COVID-19: Rethinking Chapter 11 Bankruptcy Valuation Issues in the Crisis
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates, Valuation | 0

By Andrew N. Goldman, George W. Shuster Jr., Benjamin W. Loveland, Lauren R. Lifland (Wilmerhale LLP)

Andrew N. Goldman
George W. Shuster Jr.
Benjamin W. Loveland
Lauren R. Lifland

 

 

 

 

 

 

 

Valuation is a critical and indispensable element of the Chapter 11 bankruptcy process. It drives many aspects of a Chapter 11 case, from petition to plan confirmation, in all circumstances. It may be obvious that the COVID-19 crisis has added a layer of complexity—and volatility—to bankruptcy valuation issues with respect to valuing assets, liabilities, and claims, both in and outside the Chapter 11 context.  But the crisis may also change the way that courts look at valuation determinations in Chapter 11—both value itself, and the way that value is measured, may be transformed by the COVID-19 crisis.  While the full extent of the pandemic’s effect on valuation issues in bankruptcy has yet to be seen, one certainty is that debtors and creditors with a nuanced and flexible approach to these issues will fare better than those who rigidly hold on to pre-crisis precedent.

The full article is available here.

Same Class, Different Recoveries — No Bar to Plan Confirmation
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Workouts and Pre-Packs | 0

By Francis J. Lawall and John Henry Schanne II (Pepper Hamilton LLP)

In Ad Hoc Committee of Non-Consenting Creditors v. Peabody Energy Corp., (In re Peabody Energy Corp.), 933 F.3d 918 (8th Cir. 2019), the Eighth Circuit held that a debtors’ Chapter 11 plan complied with Bankruptcy Code Section 1123(a)(4) (which mandates that a plan provide the same treatment to all members of a particular class), despite providing more favorable treatment to creditors that agreed to backstop a rights offering by paying the participating creditors significant premiums and allowing them to purchase preferred stock at a deep discount.

The Eighth Circuit’s decision in Peabody joins decisions from the Second, Fifth and Ninth circuits in ruling that a plan may treat one set of claim holders within a single class more favorably than another so long as the treatment is not for the claim but for distinct, legitimate rights or contributions from the favored group separate from the claim. As bankruptcy cases continue to grow in size and complexity, creative approaches such as that employed in Peabody are certain to be utilized in efforts to salvage businesses in troubled industries.

The article may be found at Law.com: the original publication.

Equitable Mootness Doctrine Persists in Bankruptcy Appeals
by | posted in: Bankruptcy Administration and Jurisdiction | 0

By Shana A. Elberg, Amy Van Gelder, and Jason M. Liberi (Skadden, Arps, Slate, Meagher & Flom LLP)

In recent years, some courts have become critical of the doctrine of equitable mootness, a judicially created abstention doctrine — unique to the corporate bankruptcy world — that allows appellate courts to dismiss appeals from a bankruptcy court’s confirmation order if the relief sought on appeal threatens to unwind a complex debtor reorganization previously approved by the bankruptcy court. The doctrine promotes finality of confirmation orders, encourages the global consensual resolutions often crucial to complex reorganizations, and protects third parties that have justifiably relied upon the bankruptcy court’s confirmation order or transactions effectuated pursuant to that order.

Despite significant concerns expressed by courts regarding the impact of the doctrine on parties’ fundamental appellate rights, equitable mootness persists in some form within every circuit that has jurisdiction over bankruptcy appeals. Thus, plan proponents and objectors alike must be aware of its implications on contested plan confirmation proceedings and prepared to act quickly to advance their interests following plan confirmation.

This article provides a brief overview of the doctrine of equitable mootness, its application by appellate courts, and key considerations for bankruptcy and non-bankruptcy practitioners faced with contested plan confirmations and subsequent appeals.

The article is available here.

Recent Developments in Bankruptcy Law October 2017
by | posted in: Bankruptcy Administration and Jurisdiction, Cramdown and Priority, Workouts and Pre-Packs | 0

By Richard Levin (Jenner & Block LLP)

The bankruptcy courts and their appellate courts continue to explore issues of interest to practitioners and academics. This quarterly summary of recent developments in bankruptcy law covers cases reported during the third quarter of 2017.

The Second Circuit adopted the use of a market rate to determine cram-down interest rates in a chapter 11 case. It also disallowed a secured lender’s make-whole, although without deciding whether a make-whole should be generally disallowed as unmatured post-petition interest. (In re MPM Silicones (Momentive)) In contrast, the Houston bankruptcy court allowed a make-whole in a solvent case, but also without reaching the post-petition interest issue. (In re Ultra Petroleum)

The Delaware bankruptcy court clarified its jurisdiction to approve a third-party release in a settlement implemented through a confirmed chapter 11 plan, holding that plan confirmation is a core proceeding, so Article III limits do not apply. (In re Millennium Lab Holdings II, LLC) The Delaware bankruptcy court also reconsidered, and disallowed, a merger agreement termination fee after termination of the agreement. (In re Energy Future Holdings, Inc.)

Bankruptcy courts increasingly approve of the idea that under section 544(b), the trustee may use the longer reachback periods of the Internal Revenue Code and the Federal Debt Collection Procedures Act (In re CVAH, In re Alpha Protective Services). And the Ninth Circuit has ruled that for the trustee to pursue an avoidance claim against the United States, section 544(b) does not require a separate sovereign immunity waiver. (In re DBSI, Inc.) 

Finally, the courts have been sympathetic to attorneys in allowing their fees. (In re Stanton; In re Hungry Horse, LLC; In re CWS Enterps., Inc.) Less so for investment bankers. (Roth Capital Partners)

The full memo, discussing these and other cases, is available here, and the full (900-page) compilation of all prior editions is available here.

Finding Acceptance: Using Strategic Impairment to Satisfy 1129(a)(10)
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Cramdown and Priority | 0

by David L. Curry, Jr. and Ryan A. O’Connor (Okin Adams LLP; Houston, Texas)

Section 1129(a)(10) of the Bankruptcy Code – requiring acceptance of a proposed plan from at least one impaired voting class – can often pose a unique challenge for single asset real estate debtors. Finding Acceptance: Using Strategic Impairment to Satisfy 1129(a)(10) (the “Article”), explores the potential use of “strategic” or “artificial” impairment as a means of achieving plan confirmation in contested cases where consensual restructuring of the secured creditor’s claim is not obtainable.  Whether such artificial impairment is permissible remains an open question, but the Article notes a growing majority of courts finding that impairment need not be economically driven. Yet, while artificial impairment may not be prohibited by § 1129(a)(10), courts have found that plans relying upon such may be subject to heightened scrutiny under § 1129(a)(3)’s good faith requirements. Thus, the Article goes on to contrast two recent circuit court opinions – Western Real Estate Equities, L.L.C. v. Vill. At Camp Bowie I, L.P. (In re Vill. at Camp Bowie I, L.P.), 710 F.3d 239, 244 (5th Cir. 2013) and Vill. Green I, GP v. Fannie Mae (In re Vill. Green I, GP), 811 F.3d 816 (6th Cir. 2016) – and their opposing outcomes in an effort to understand what factors a court may consider when determining whether a plan has been proposed in good-faith.  Ultimately, the Article concludes that while strategic impairment of insiders or other closely related parties may give rise to an inference of bad faith, the impairment of unrelated, minor creditors should be permissible.

The full article is available to download here.

David L. Curry, Jr. is a partner, and Ryan A. O’Connor is an associate, in the Houston office of Okin Adams LLP. The views expressed in this article are those of the authors, and not Okin Adams.

 

Bankruptcy’s Quiet Revolution
by | posted in: Cramdown and Priority | 0

Douglas G. Baird, University of Chicago School of Law

 

Over the last few years, reorganization practice has undergone a massive change. A new device—the restructuring support agreement—has transformed Chapter 11 negotiations. This puts reorganization law at a crossroads. Chapter 11’s commitment to a nonmarket restructuring with a rigid priority system requires bankruptcy judges to police bargaining in bankruptcy, but the Bankruptcy Code gives relatively little explicit guidance about how they should do this policing.

In the past, the debtor initiated multiple rounds of negotiations in which everyone participated. Each party would push back against the claims of the other, and a consensus eventually emerged that left things roughly in equipoise. This has now changed. Instead of bargaining in which everyone participates, there is now a sequence of two-party bargains, beginning with the key players.

Changing the structure of negotiations in this fashion would not matter much if there were not much to bargain over. If bankruptcy’s substantive rules allowed for little variation in what each party received or if the debtor had an incentive to limit what each creditor group received, changing the rules would not change outcomes. But neither is the case, at least not any more.

Priority rights in bankruptcy are sufficiently uncertain that there are a broad range of confirmable plans in any case, each with radically different distributional consequences for the various creditor groups. And modern debtors are interested in a speedy and successful exit from Chapter 11. They are relatively indifferent to how rights in the firm are divided among competing creditors.

These changes have become manifest only in the last few years, and there is little wisdom about how the bankruptcy judge should respond. This essay suggests that long-established principles inform how bankruptcy judges should go about this task. In assessing whether a plan is “fair and equitable” and whether it has been filed in “good faith,” judges should focus not on how the plan apportions rights in the reorganized firm, but whether the process that has led to the plan ensures that everyone’s cards are on the table.

In particular, judges should ensure that restructuring support agreements do not interfere with the flow of information to the judge. Negotiations that lead to a confirmable plan should be problematic to the extent, but only to the extent, that they keep the judge in the dark and limit her ability to ensure that the plan complies with the terms of the Bankruptcy Code.

Click here to view the full article.

Earnings Management and Firm Value in Chapter 11
by | posted in: Valuation | 0

Timothy C.G. Fisher, University of Sydney

Ilanit Gavious, Ben-Gurion University of the Negev

Jocelyn Martel, ESSEC Business School & THEMA

 

Earnings management occurs when managers deliberately manipulate the company’s earnings either to mislead stakeholders about the underlying economic performance of the company or to influence contractual outcomes. We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11.

Using the UCLA-LoPucki Bankruptcy Research Database, we merge a sample of 261 U.S. public firms that filed for Chapter 11 between 1995 and 2009 with firm-level financial information. We construct three measures of earnings management, two of which are accounting (accrual) manipulation measures (discretionary accruals and abnormal working capital accruals) and one a real activities manipulation measure (abnormal operating cash flows).

We find that upward earnings management (more positive or less negative abnormal accruals/operating cash flows) prior to filing significantly reduces the likelihood of confirmation, while downward earnings management significantly increases the likelihood of confirmation. We also find that the likelihood of emerging from Chapter 11 is significantly lower with upward earnings management. The impacts on confirmation and emergence are primarily due to the influence of earnings management values that are one- and two-standard deviations above or below the mean. Thus, our findings are consistent with creditors rewarding unduly conservative earnings reports while punishing overly optimistic earnings reports. We also find that auditor choice (Big 4 vs. non-Big 4) directly affects the probability of confirmation and of emergence from bankruptcy.

Overall, we find that upward management of earnings destroys economic value by making the survival of the firm less likely, an effect that has not previously been uncovered in the literature.

To access the full article, please click here.