Holdout Panic
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates, Insider Status | 0

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.

A Functional Analysis of SIFI Insolvency
by | posted in: Financial Firms and Safe Harbors | 0

By Stephen J. Lubben (Seton Hall University School of Law)

Since the disgrace of Lehman, the question of how to handle failing SIFIs has been quite vexed.   On the one hand, governmental rescue of shareholders and other investors is beyond annoying, and there is some intuitive sense that if management does a poor job, they and their investor backers should face the consequences, just like any other firm.   That bank managers would have the temerity to pay themselves large bonuses shortly after a taxpayer rescue only emphasizes the point.

On the other hand, there is a widespread understanding that a large bank, or a sufficiently interconnected one, is not quite like Kmart, Enron, or even American Airlines, in that when the bank fails, it tends to take a large chunk of the economy along with it.   Pre-failure regulation can mitigate some of the effects, but by the time we get to insolvency—or “financial distress”—the regulatory string has pretty much played out.   And in the end, we have trouble deciding if we really mean to treat large financial institutions like normal failed firms.

In A Functional Analysis of SIFI Insolvency, I argue that we need to consider what it is that we are trying to achieve in a bank insolvency case, and how that compares with bankruptcy law in general.  Bank insolvency, I submit, is all about special priorities: both ordinal and temporal.  The Bankruptcy Code, on the other hand, takes an “equality is equity” approach to priorities as a baseline, mostly using state law to draw the claim-asset border.

Financial insolvency law expressly rejects this model; it instead is all about protecting some favored group from the effects of insolvency.   There is no equality here, and it was never intended that there would be equality.   And thus it is time to stop pretending SIFI insolvency is “normal” corporate insolvency but bigger.

The full article is available here.

Roundup: Recent Op-Eds on Bankruptcy for Banks
by | posted in: Bankruptcy Roundtable Updates, Financial Firms and Safe Harbors | 0

The House of Representatives’ passage first of the Financial Institution Bankruptcy Act (FIBA) and then of the Financial CHOICE Act last Thursday has made bankruptcy for banks and the fate of Dodd-Frank’s Orderly Liquidation Authority (OLA) a live issue again. Both FIBA and the CHOICE Act would add a “subchapter V” to chapter 11 to resolve financial conglomerates in bankruptcy. Unlike FIBA, however, the CHOICE Act would also repeal the OLA, leaving bankruptcy as the only option for handling the failure of a financial conglomerate.

Several academics, former regulators, and practitioners, including several contributors to the Bankruptcy Roundtable, have recently published op-eds weighing arguments for and against replacing the OLA with bankruptcy. Support for adding tools to the Bankruptcy Code is widespread. Commentators differ, however, on whether bankruptcy, by itself, can address the systemic risk concerns that prompted the creation of the OLA and on whether it would be useful to have a bankruptcy procedure more robust than subchapter V.

Stephen Lubben contends that without a mechanism for providing liquidity to financial institutions—the usual providers of funding for companies in chapter 11—the Bankruptcy Code cannot effectively handle a widespread financial crisis. Mark Roe emphasizes that economic stability requires having the OLA and related structures to allow subchapter V to succeed (through regulatory coordination with international authorities and supervision over financial institutions to ensure that they have the capital structures to facilitate a subchapter V resolution). The OLA is also needed in case a subchapter V reorganization fails, as subchapter V is not a general bankruptcy authorization but, instead, a mechanism to use the 48-hour “single-point-of-entry” restructuring strategy in bankruptcy. This point renews some of the arguments Roe and David Skeel expressed earlier on ways subchapter V should be strengthened, such as by the addition of a regulatory trigger and a means to deal with an inability to complete the resolution within 48 hours.

Finally, Sheila Bair and Paul Volcker argue that having the OLA as a backstop for a failed bankruptcy makes government bailouts less likely, as the OLA provides regulators with the tools to wind down a failed financial institution in an orderly fashion. In contrast, Stephen Hessler argues that the Bankruptcy Code, amended along the lines of subchapter V, would promote both market discipline and financial stability. A bankruptcy judge applying well established precedents and rules in a subchapter V case would combat moral hazard more effectively than the OLA, which grants regulators significant discretion to treat similarly situated creditors differently.

(By Rebecca Green, Harvard Law School, J.D. 2017.)

Recent Roundtable coverage of this subject includes posts on a letter submitted to Congress by academics and the Trump administration’s direction to the Treasury to issue a report on the OLA.

Sovereign Bankruptcy Hydraulics
by | posted in: International and Comparative | 0

By Stephen Lubben (Seton Hall University School of Law)

The frequent suggestion that the world needs a sovereign bankruptcy mechanism is puzzling.   What precisely would be gained?

The core of any insolvency system consists of a stay against creditor action, an ability to recover preferential payments, and an ability to revamp the debtor’s operations by rejecting burdensome contracts and selling assets. These features, however, are largely irrelevant to sovereign debtors.

In the event of insolvency – or, more simply an inability to pay – sovereign debtors have four tools at their disposal. First, the sovereign might hide behind its immunity, by refusing to be sued. Or the sovereign might change its own law applicable to the debt. That might violate norms, but the sovereign who does this probably also controls the remedy for violations of such norms. Third, the sovereign might manipulate the currency in which its debts are paid. There are economic consequences to doing this, but they might be preferable to a formal default.

These first three tools comprise the modern concept of “sovereign immunity.” But a discussion of sovereign debtors must include a fourth, related issue: the ability to shield assets from collection. That is, even if the debtor can be sued somewhere, in some court, a judgment might be worthless.

If a government issuer can employ some or all of these mechanisms, it has little need of a bankruptcy mechanism because it can refuse to pay its debts, or it can negotiate with creditors to restructure the debt on its own. Kings and queens of old had no need for a bankruptcy mechanism because they could use all four of these tools. They would pay when they felt that paying was worth it, such as when they needed more funds from lenders.

Of course, there are differing forms of “sovereign immunity.” Few sovereigns retain full, old-fashioned sovereign immunity. Today, many emerging market borrowers and all American municipalities lack access to the first three tools. Their ability to avoid paying turns on the fourth tool, which they can deploy with varying ability.

In short, sovereignty and sovereign immunity occur along a continuum, and the need for a bankruptcy system to address financial distress varies inversely with a sovereign’s place on the continuum.

My short paper, Sovereign Bankruptcy Hydraulics, forthcoming in NYU’s Annual Survey of American Law, examines this basic dynamic and its implications for the insolvency of sovereigns and semi-sovereigns.

Too Big and Unable to Fail
by | posted in: Financial Firms and Safe Harbors | 0

By Stephen J. Lubben (Seton Hall University School of Law) and Arthur E. Wilmarth, Jr. (George Washington University Law School)

Financial regulation after the Dodd-Frank Act has produced a host of new regulatory tools for resolving failures of systemically important financial institutions (SIFIs). The explicit goal of this new “resolution” regime is to enable SIFIs to go bankrupt without a government bailout, just like other businesses. In our paper, forthcoming in the Florida Law Review, however, we express significant doubts about the new regime’s ability to work as advertised.

The “single point of entry” (SPOE) strategy, which focuses all resolution efforts on a SIFI’s parent holding company, addresses a very stylized, even hypothetical sort of failure. We believe that it is unlikely to work during a global crisis that involves multiple failing SIFIs operating thousands of subsidiaries across dozens of national boundaries.

The Federal Reserve’s “total loss absorbing capacity” (TLAC) proposal is closely tied to SPOE. It would require SIFI holding companies to issue large amounts of debt securities that can be “bailed in” (converted into equity) in a resolution proceeding to make the holding company solvent again. In our view, TLAC debt will also create a new, more opaque way to impose the costs of SIFIs’ financial distress on ordinary citizens, because retail investors in brokerage accounts, mutual funds, and pension funds are likely to be the largest TLAC debtholders.

We propose several strategies for forcing SIFIs and their Wall Street creditors to internalize at least some of the costs of the enormous risks they create. Among other things, mutual funds and pension funds that invest in TLAC debt should disclose the bail-in risks to investors and should include in their offering materials “black box” warnings similar to those already used in selling junk bonds to investors. In addition, each SIFI should describe its resolution plan on a web page that also contains a straightforward discussion of the risks TLAC debtholders are taking on—risks that creditors and counterparties of operating subsidiaries are unwilling to assume. Only with such disclosures can the hazards of TLAC debt be appropriately priced by the market.

The full paper can be found here.

 

Failure of the Clearinghouse: Dodd-Frank’s Fatal Flaw?
by | posted in: Financial Firms and Safe Harbors | 0

Stephen J. Lubben

Harvey Washington Wiley Chair in Corporate Governance & Business Ethics, Seton Hall University School of Law.

Clearinghouses reduce risk by acting as a central hub for trades. Each party to a trade faces only the risk of the clearinghouse’s non-performance, rather than the doubtlessly greater risk that the counterparty to the trade will fail to perform.

But the concentration of derivatives trades into a very small number of clearinghouses or central counterparties (CCPs) makes the clearinghouse’s own failure a matter of systemic concern. As such, the recovery and resolution of CCPs becomes vital in the post-crisis financial system.

Given that important context, I argue in my paper—recently published in the Virginia Law & Business Review—that the lack of any obvious resolution mechanism for clearinghouses represents a major flaw in the Dodd-Frank regulatory fabric.

I explain why Dodd-Frank’s new orderly liquidation authority was probably not intended to apply to clearinghouses and would provide little help in the case of a distressed CCP in any event. The Bankruptcy Code is equally unhelpful, in that clearinghouses are forced into Chapter 7 liquidation proceedings, and the “safe harbors” for derivative contracts would make such a filing an exercise in futility.

I also argue that the CCP’s own, internal resolution mechanisms will be unworkable in times of systemic crisis. Most clearinghouse rules state that upon exhaustion of their default fund and any assessment rights they have against members, all contracts will be closed and member positions netted. Given the concentration of certain trades in one or two clearinghouses, the sudden termination of more than half of the index CDS trades—to take but one example—could not help but have systemic effects.

In the paper, I propose that the government should nationalize the clearinghouses upon failure, and that the intention to do so should be made clear ex ante. That is, the government should expressly state clearinghouses that ultimately fail will be nationalized, with specific consequences to investors, and an expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable. This should provide stakeholders in the clearinghouses with stronger incentives to oversee the clearinghouse’s management, and avoid such a fate.

In essence, what I propose is a system of precommitment or “structured bailouts.” Bailouts of clearinghouses seem inevitable. We must specify what would happen today, both to discourage an avoidable situation, and to facilitate an organized response in the event of an essential bailout.

Lehman’s Derivative Portfolio
by | posted in: Financial Firms and Safe Harbors | 0

By Stephen Lubben, Seton Hall University School of Law

Derivatives themselves were likely at most a secondary cause of the Lehman’s collapse, and played a more central role in other firms caught up in the financial crisis, like AIG. But the late Harvey Miller suggested that derivatives were responsible for a massive loss in value suffered by Lehman post-bankruptcy. Bryan P. Marsal, the Lehman estate administrator, likewise asserted that as much as $75 billion in value was destroyed, largely as a result of the sudden termination of Lehman’s derivatives book.

The singular losses caused by Lehman’s derivative portfolio to Lehman’s bankruptcy estate come from these safe harbors and the system of closeout netting the safe harbors support. While the safe harbors have been thoroughly studied and debated in the abstract, a close look at Lehman’s experience provides important insights for the future.

In particular, the largest part of Lehman’s derivative portfolio shows how financial institutions will suffer when resolution is attempted in the traditional bankruptcy system, despite the Dodd-Frank Act’s professed preference for “normal” bankruptcy process over specialized insolvency regimes like the new “Orderly Liquidation Authority.”

And the abrupt closeout of Lehman’s cleared derivatives portfolio by CME, which Lehman’s examiner noted as the source of several obvious losses to the bankruptcy estate, also provides important insights, especially given Dodd-Frank’s strong preference for central clearing going forward.

My paper Lehman’s Derivative Portfolio, written as a chapter for a forthcoming book, looks at both issues, and suggests that the continuation of the safe harbors “as is” renders chapter 11 nonviable for larger financial institutions, and recent contractual attempts to work around the safe harbors are insufficient to solve the problem, while the increased role of clearinghouses in financial institution failures will force regulators to confront difficult choices. In short, the regulators will have to balance two competing systemic risks: the risk of an unruly resolution of the financial institution, balanced against increased risk to the clearinghouse.

The Roundtable has previously posted multiple items on the derivatives safe harbors: on selling Lehman’s derivatives portfolio, systemic risk issues, the safe harbors’ history, two posts on the ISDA derivatives stay protocols (here and here), and on congressional testimony.

Corporate Bankruptcy Tourists
by | posted in: International and Comparative | 0

By Oscar Couwenberg & Stephen J. Lubben

Insolvency procedures are not designed for corporate group, but for individual debtor corporations. This becomes an especially important issue when corporations have international operations.

When such a corporate group becomes financially distressed, then different national insolvency procedures will claim jurisdiction over assets and debts of the corporation, the consequence of which is an uncoordinated wealth-destroying piecemeal sale of assets. The obvious solution is to look for a single forum that can address an entire firm’s financial distress.

In this paper we argue that chapter 11 of the United States Bankruptcy Code, and to a lesser extent also the UK scheme of arrangement under the Companies Act 2006, can be considered such bankruptcy havens for corporate bankruptcy tourists.

We construct a database of foreign debtors initiating a chapter 11 case over the period 2005 to 2012. In total our dataset includes 316 corporate debtors, organized in 49 corporate groups.

What we find is that corporations with mobile assets, with subsidiaries in many jurisdictions, or both, are the most frequent tourists in chapter 11. We further discuss why chapter 11 and its competitor in the UK render a trans-national insolvency system superfluous. We expect these two jurisdictions to see increasing amounts of “tourist” activity as Europe moves from its traditional reliance on bank financing to more frequent use of North American style high yield bond markets.

The full version of this article is available here.

The Costs of Corporate Bankruptcy: How Little We Know
by | posted in: Bankruptcy Administration and Jurisdiction | 0

Author: Stephen J. Lubben, Seton Hall University School of Law

lubben-176x220_1 For almost as long as there have been bankruptcy laws, there have been complaints that the primary beneficiaries of these laws are insiders who administer the bankruptcy system. In recent decades, this line of criticism has carried with it an implicit criticism of bankruptcy courts, which are urged to more aggressively police the costs of bankruptcy. Indeed, at least one recent critic has unkindly suggested that the failure of the courts to control bankruptcy costs is the result of a corrupt bargain between bankruptcy courts and practitioners.

Rarely addressed is why bankruptcy courts regulate professional costs at all. In most areas of American law, a professional is accountable solely to its client. Complaints about excessive cost might result in a separate malpractice action, but a client who thinks they have been overcharged for the defense of their speeding ticket will find little relief in traffic court. Why is bankruptcy different?

This paper begins to look at this question with brief overview of the concept of bankruptcy costs, traditionally divided between direct and indirect costs. I next turn to a consideration of the process for overseeing bankruptcy costs. I briefly trace the history of court control of compensation in corporate bankruptcy, and then detail the current legal structure. The final part of the chapter then surveys the existing understanding of chapter 11 cost, and concludes with a some thoughts on the important questions that remain unanswered.

In short, we know a bit about direct costs, but very little about any other sort of costs. Moreover, what we know is almost entirely lacking in context. This makes it quite hard to understand if the existing system of cost regulation is either useful or justified.

This article is available here.

 

Essential Corporate Bankruptcy Law
by | posted in: Bankruptcy Administration and Jurisdiction | 0

Authors:  Oscar Couwenberg & Stephen J. Lubben

In every economy, the question of what to do with financially distressed businesses is a matter of concern.   The United States has a long history of corporate restructuring law, starting with the reorganization of railroads in the nineteenth century and continuing through chapter 11 in its current form.   This naturally leads to a tendency to adopt chapter 11, or something like it.

But why?  In particular, chapter 11 is a rather ornate system of corporate reorganization, and it has been adorned with elements that reflect little more than particular creditors’ ability to lobby Congress.

We reexamine chapter 11 to understand its core.  In short, what, if any, are the essential elements of corporate bankruptcy law?

We point to two facets of chapter 11:  asset stabilization and asset separation.  These two aspects of chapter 11 could not be established other than by statute, and jurisdictions looking to reform their corporate bankruptcy processes should focus there.

Asset stabilization is the ability to temporarily protect assets as a coherent whole.  It includes obvious things like the stay on individual creditor collection, provision of post-bankruptcy liquidity and delays on termination of contracts with the debtor.

Asset separation captures the ability to separate assets from their concomitant liabilities.  This might take the form of a discharge, but is not necessary.  Essential is that the system provides clean title to a new owner of the assets, which may or may not be the post-bankruptcy firm.

As this is the core of any sensible corporate insolvency system, features beyond that are a matter of policy, and politics.

The full article can be found here.