|The South Bay Law Firm Law Blog highlights developing trends in bankruptcy law and practice. Our aim is to provide general commentary on this evolving practice specialty.|
JonesDay’s comprehensive and always-readable summary of notable bankruptcies, decisions, legislation, and economic events was released just over a week ago. A copy is available here.
As 2012 gets off to an uncertain start, some more recent headlines are accessible immediately below.
Can a senior secured lender require, through an inter-creditor agreement, that a junior lender relinquish the junior’s rights under the Bankruptcy Code vis á vis a common debtor?
Though the practice is a common one, the answer to this question is not clear-cut. Bankruptcy Courts addressing this issue have come down on both sides, some holding “yea,” and others “nay.” Late last year, the Massachusetts Bankruptcy Court sided with the “nays” in In re SW Boston Hotel Venture, LLC, 460 B.R. 38 (Bankr. D. Mass. 2011).
The decision (available here) acknowledges and cites case law on either side of the issue. It further highlights the reality that lenders employing the protective practice of an inter-creditor agreement as a “hedge” against the debtor’s potential future bankruptcy may not be as well-protected as they might otherwise believe.
In light of this uncertainty, do lenders have other means of protection? One suggested (but, as yet, untested) method is to take the senior lender’s bankruptcy-related protections out of the agreement, and provide instead that in the event of the debtor’s filing, the junior’s claim will be automatically assigned to the senior creditor, re-vesting in the junior creditor once the senior’s claim has been paid in full.
One of the most effective vehicles for the rescue and revitalization of troubled business and real estate to emerge in recent years of Chapter 11 practice has been the “363 sale.”
Named for the Bankruptcy Code section where it is found, the “363 sale” essentially provides for the sale to a proposed purchaser, free and clear of any liens, claims, and other interests, of distressed assets and land.
The section has been used widely in bankruptcy courts in several jurisdictions to authorize property sales for “fair market value” . . . even when that value is below the “face value” of the liens encumbering the property.
In the Ninth Circuit, however, such sales are not permitted – unless (pursuant to Section 363(f)(5)) the lien holder “could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”
A recent decision issued early this year by the Ninth Circuit Bankruptcy Panel and available here) provides a glimpse of how California bankruptcy court are employing this statutory exception to approve “363 sales.”
East Airport Development (EAD) was a residential development project in San Luis Obispo which, due to the downturn of the housing market, never came completely to fruition.
Originally financed with a $9.7 million construction and development loan in 2006, EAD’s obligation was refinanced at $10.6 million in mid-2009. By February 2010, the project found itself in Chapter 11 in order to stave off foreclosure.
A mere two weeks after its Chapter 11 filing, EAD’s management requested court authorization to sell 2 of the 26 lots in the project free and clear of the bank’s lien, then to use the excess proceeds of the sale as cash collateral.
In support of this request, EAD claimed the parties had previously negotiated a pre-petition release price agreement. EAD argued the release price agreement was a “binding agreement that may be enforced by non-bankruptcy law, which would compel [the bank] to accept a money satisfaction,” and also that the bank had consented to the sale of the lots. A spreadsheet setting forth the release prices was appended to the motion. The motion stated EAD’s intention to use the proceeds of sale to pay the bank the release prices and use any surplus funds to pay other costs of the case (including, inter alia, completion of a sewer system).
The bank objected strenuously to the sale. It argued there was no such agreement – and EAD’s attachment of spreadsheets and e-mails from bank personnel referencing such release prices ought to be excluded on various evidentiary grounds.
The bankruptcy court approved the sale and cash collateral use over these objections. The bank appealed.
On review, the Ninth Circuit Bankruptcy Appellant Panel found, first, that the bankruptcy court was within the purview of its discretion to find that, in fact, a release price agreement did exist – and second, that such agreement was fully enforceable in California:
The Ninth Circuit Bankruptcy Appellate Panel‘s East Airport decision provides an example of how bankruptcy courts in the Ninth Circuit are creatively finding ways around legal hurdles to getting “363 sales” approved in a very difficult California real estate market. It likewise demonstrates the level of care which lenders’ counsel must exercise in negotiating the work-out of troubled real estate projects.
Title II of the Dodd-Frank Act provides “the necessary authority to liquidate failing financial companies that pose a systemic risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.”
Under this authority, the government would have had the requisite authority to structure a resolution of Lehman Brothers Holdings Inc. – which, as readers are aware, was one of the marquis bankruptcy filings of the 2008 – 2009 financial crisis.
Readers are also aware that Dodd-Frank is an significant piece of legislation, designed to implement extensive reforms to the banking industry. But would it have done any better job of resolving Lehman’s difficulties than did Lehman’s Chapter 11?
Predictably, the FDIC is convinced that a government rescue would have been more beneficial – and in “The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” (forthcoming in Vol. 5 of the FDIC Quarterly), FDIC staff explain why this is so.
The 19-page paper boils down to the following comparison between Chapter 11 and a hypothetical resolution under Dodd-Frank:
By contrast, under Dodd-Frank:
Convinced? You decide.
When a municipality faces municipal distress, who ultimately picks up the tab? More importantly, who should pick up the tab?
That’s the issue taken up by Clayton P. Gillette, NYU’s Max E. Greenberg Professor of Contract Law, in a recent paper titled “POLITICAL WILL AND FISCAL FEDERALISM IN MUNICIPAL BANKRUPTCY.” Though the academic prose doesn’t read quite like the Economist, Professor Gillette’s discussion is a timely and important one for observers of US municipalities and their current financial troubles.
In essence, Professor Gillette argues that Chapter 9 of the Bankruptcy Code (municipal bankruptcy) is often perceived as a “dumping ground” for governmental entities who could raise taxes, but simply don’t have the political gumption to do so. Historically, municipal debtors have attempted to utilize Chapter 9 as a means of shifting the burden of imprudent debt onto creditors. But Gillette argues that in an age of government bailout and centralized governmental assistance for failing municipalities, Chapter 9 also effectively acts as a “bargaining chip” for municipal debtors dealing with federal and state agencies who would prefer to address municipal financial distress outside of bankruptcy – albeit at a moderate cost to local officials.
In support of this argument, Gillette explains that the structure of Chapter 9 offers municipalities a shot at having it both ways: They can run up a tab, then determine whom (other than themselves or their taxpayers – i.e., private creditors or states and federal agencies) they’d prefer to pick it up.
What’s the answer to this perceived recipe for irresponsibility? For Professor Gillette, it involves giving bankruptcy courts the power to impose affordable tax increases:
Whatever readers may think of the constitutionality of his idea, Professor Gillette’s article is an intriguing contribution to evolving thought on municipal distress.
During recent years, the global economy has seen significant growth in transactions which purport to be governed by classic Islamic – or Shari’a – law. Primarily, the legal and business community’s focus has been on Shari’a finance. But what happens under Shari’a law when a transaction or venture turns sour?
That is the question posed recently by Abed Awad and Robert E. Michael of Pace Univeristy in White Plains. In IFLAS AND CHAPTER 11: CLASSICAL ISLAMIC LAW AND MODERN BANKRUPTCY, Awad and Michael (both adjunct professors at Pace, and both practicing attorneys in the New Jersey-New York metropolitan area) explore this issue in some much-needed detail.
Specifically, their article:
In light of continuing global financial turmoil and further political turmoil in the Middle East, the article – which first appeared in last fall’s issue (Vol. 44) of SMU’s International Lawyer – is worth reading.
Jones Day’s Charles Oellerman and Mark Douglas have just issued The Year in Bankruptcy: 2010. It is a (relatively) concise, thorough (81 pages), and useful compendium of bankruptcy statistics, trend analyses, case law highlights, and legislative updates for the year.
What to expect for 2011? According to the authors:
Ever since the first corporate reorganizations in the US, business owners have been looking for ways to retain ownership of their restructured companies while reducing debt. And ever since owners have been trying to retain ownership, courts have been resisting them.
Today, it is commonly understood that the equity holders of a reorganizing business cannot retain their ownership unless other, senior creditors are paid in full. This principle, known as the “absolute priority rule,” has been developed and refined through various decisions which date back to the 1860’s – before the concept of “corporate reorganization” was formally recognized as such.
Despite the pedigree of the “absolute priority rule,” equity owners nevertheless have continued undaunted in creative efforts to retain some piece of the (reorganized) pie even though creditors senior to them receive less than full payment. And courts, though stopping short of prohibiting it outright, nevertheless keep raising the bar for such ownership.
Yesterday, the Second Circuit Court of Appeals raised the bar another notch with its decision in In re DBSD Incorporated.
The basic economic scenario in DBSD is a relatively common one for business reorganizations: DBSD was an over-leveraged “development stage” start-up company with reorganizable technology and spectrum licensing assets, but no operations – and therefore, no revenue. It was essentially wholly owned by ICO Global, which sought to de-leverage DBSD through Chapter 11 – but who also sought to retain an equity interest in DBSD.
To accomplish these goals, ICO Global negotiated a Chapter 11 Plan which (i) paid its first lien-holders in full; (ii) paid its second lien-holders in stock in the reorganized entity worth an estimated 51% – 73% of their original debt; and (iii) paid general unsecured creditors in stock worth an estimated 4% – 46%. The Plan further provided that ICO Global would receive equity (i.e., shares and warrants) in the newly organized entity.
One of the larger unsecured creditors objected, claiming that DBSD’s Plan violated the “absolute priority rule.” Both the Bankruptcy Court and the District Court found that that the holders of the second lien debt, who were senior to the unsecured creditors and whom the bankruptcy court found to be undersecured, were entitled to the full residual value of the debtor and were therefore free to “gift” some of that value to the existing shareholder if they chose to.
The Second Circuit disagreed. In a lengthy decision (available here), the Court of Appeals held, essentially, that merely calling a Plan distribution a “gift” doesn’t make it one. As a result, the Plan’s distribution of stock and warrants to ICO Global under the Plan was impermissible.
Nevertheless, the Second Circuit didn’t slam the door altogether on the “gifting” of stock from senior creditors to equity. Equity holders looking to de-leverage with the assistance of senior creditors may still consider the following approaches:
– A separate agreement for distributions outside the Plan. Though the DBSD decision notes that the “absolute priority rule” preceded the present Bankruptcy Code, and further devotes some discussion to the general policy reasons behind it, the Second Circuit stopped short of precluding such gifts altogether:
This analysis suggests it may be possible to negotiate outside a Chapter 11 plan for the same economic result as that originally proposed (but rejected) in DBSD.
– A “consensual” foreclosure by a senior secured creditor. Along the way to its conclusion, the Second Circuit distinguished DBSD from another “gifting” case – In re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993).
In SPM, a secured creditor and the general unsecured creditors agreed to seek liquidation of the debtor and to share the proceeds from the liquidation. 984 F.2d at 1307-08. The bankruptcy court granted relief from the automatic stay and converted the case from Chapter 11 to a Chapter 7 liquidation. Id. at 1309. The bankruptcy court refused, however, to allow the unsecured creditors to receive their share under the agreement with the secured creditor, ordering instead that the unsecured creditors’ share go to a priority creditor in between those two classes. Id. at 1310. The district court affirmed, but the First Circuit reversed, holding that nothing in the Code barred the secured creditors from sharing their proceeds in a Chapter 7 liquidation with unsecured creditors, even at the expense of a creditor who would otherwise take priority over those unsecured creditors.
The Second Circuit held that DBSD‘s result should be different from SPM‘s because (i) SPM involved a Chapter 7 (where the “absolute priority rule” doesn’t apply); and (ii) the creditor had obtained relief from stay to proceed directly against its collateral – and therefore, the collateral was no longer part of the bankruptcy estate.
This distinction suggests that, under appropriate circumstances, a stipulated modification of the automatic stay and “consensual foreclosure” by a friendly secured creditor might likewise facilitate the transfer of property to equity holders outside the strictures of a Chapter 11 Plan.
DBSD offers interesting reading – both for its coverage of reorganization history, and for its implicit suggestions about the future of “creative reorganizations.”
Readers of this blog will know that a number of jurisdictions around the world have remodeled their insolvency schemes based on concepts developed originally in the US under Chapter 11 of the Bankruptcy Code. Relatively recent examples of this trend include the People’s Republic of China as well as Mexico.
But not all jurisdictions have rushed to follow the US. For one, Hong Kong – one of the world’s leading financial centers – has struck out on a different path.
With origins steeped in colonial history and a long-standing tradition of UK law, Hong Kong still follows the legal contours of most commonwealth jurisdictions, including those applicable to the resolution of insolvencies. In Hong Kong, a “winding-up” is the traditional means of achieving a moratorium on creditor activity; however, “winding up” has been limited to liquidation.
Corporate reorganization (or “corporate rescue,” as it’s sometimes called) relies on the implementation of a “scheme of arrangement.” In Hong Kong, however, schemes are deemed of little practical value where their comparative complexity and expense buy no moratorium from creditors.
Previously, corporate reorganization in Hong Kong relied upon an ad hoc solution – utilization of the “winding up” procedure to implement what was known colloquially a “provisional liquidation.” The essence of the “provisional liquidation” concept is that a voluntary winding up is commenced – and the debtor can avail itself of a moratorium against creditor action – while a court administrator is appointed to oversee the debtor until the company and its creditors can reach acceptable reorganization terms (at which time, the winding up is dismissed and the debtor reorganized consensually). Though initially accepted, such solutions were ultimately sharply limited by the Hong Kong courts.
In 2009, Hong Kong’s Financial Services and Treasury Bureau (FSTB) published a consultation paper reviewing corporate rescue procedure with the aim of reforming key reorganization issues. The FSTB paper – and the different concepts it proposes for Hong Kong reorganization vis á vis “US”-style Chapter 11’s – are the subject of recent analysis by Dr John K.S. Ho, Assistant Professor, School of Law, City University of Hong Kong and Dr Raymond S.Y. Chan, Associate Professor, School of Business, Hong Kong Baptist University.
Specifically, Dr’s Ho and Chan ask “Is Debtor-in-Possession Viable in Hong Kong?” In providing an answer, they discuss reform efforts in Hong Kong, noting that a “provisional supervision” has been and remains the preferred approach to Chapter 11 rather than a US-style “Debtor-in-Possession” (DIP) approach, where management remains in control of its own destiny.
So why doesn’t a US-oriented corporate rescue scheme work in Hong Kong? According to Ho and Chan, “[i]n order to understand the corporate rescue law of a jurisdiction, one must also recognize the economic nature and historical development of that society.” Some of the differences in economic development which shape differences in US and Hong Kong insolvency laws include:
Varying Appetites for Risk. “In the US, it is widely believed that there is a different attitude towards risk and risk-takers . . . . Debt forgiveness, both personal and business debt, ultimately was seen as critical to a vibrant American economy. These historical and economic factors explain in large part why the US business bankruptcy system is more forgiving towards the debtor than other jurisdictions are. However, the same analogy may not apply to the concept of corporate rescue in Hong Kong because the stakeholders which reform proposal in Hong Kong is most concerned with are different from Chapter 11 in the US.”
Different Stakeholders. How are Hong Kong stakeholders different? And why should corporate rescue look different in Hong Kong than in the US?
[I]n Hong Kong, the objectives for . . . corporate rescue are radically different . . . . [E]mployees should generally be no worse off than in the case of insolvent liquidation and . . . consideration should be given to allow greater involvement of creditors in the rescue process in exchange for their being bound by the moratorium once the process commences and the rescue plan is agreed . . . . [P]revious attempt[s] to introduce a corporate rescue law failed in Hong Kong because of the disappointing treatment of workers’ wages, complete exclusion of shareholders from the provisional supervision process, and the difficulty in classification of creditors. Therefore, if a law is to be successfully promulgated this time, greater consideration would need to be given to these stakeholders.
Though they explain how the proposed treatment of Hong Kong stakeholders in a corporate reorganization might differ from those in a US Chapter 11, Ho and Chan don’t really explain the why of those differences. What they do offer is an explanation for the absence of any interference with secured creditors’ rights, noting that this “is understandable given the fact that many major secured creditors [in Hong Kong] are financial institutions such as major banks and their influence both politically and economically cannot be ignored given that the growth of Hong Kong as a financial services hub has been supported largely by the banking sector.”
These differences are “in line with the legal creditor rights ratings of the two jurisdictions as reported in a financial economics study in which a creditor rights index is developed for 129 countries and jurisdictions. This index ranges from 0 to 4 (with higher scores representing better creditor rights) and measures four powers of secured lenders in bankruptcy. Hong Kong (and also the UK) has a perfect score of 4, but the US has a score of 1.”
Different Corporate Ownership and Control Structures. A more interesting difference arises from the authors’ argument that, unlike in the US, share ownership and corporate control in Hong Kong are closely related:
According to research conducted at the turn of the millennium, . . . separation of ownership and control, [has] largely become the phenomenon in the US. This trend was accompanied by a shift in bankruptcy law towards a more flexible, manager-oriented regime, assuming that managers of corporations that have filed Chapter 11 will subsequently make business decisions in the best interests of the corporations as a whole. On the bankruptcy side these developments culminated in 1978 with the enactment of the Bankruptcy Code and its DIP norm. However, in Hong Kong, [this] type of [dispersed corporate ownership] is not as prevalent. According to research on ownership structures and control in East Asian corporations, about three-quarters of the largest 20 companies in Hong Kong are under family control, while fewer than 60 per cent of the smallest 50 companies are in the same category. As for corporate assets held by the largest 15 families as a percentage of GDP, Hong Kong displays one of the largest concentrations of control, at 76 per cent. For comparison, the wealth of the 15 richest American families stands at about 3 per cent of GDP.
Because of this reality, the Ho and Chan argue that the DIP concept so common in US reorganizations simply isn’t practical in Hong Kong:
Given such context, a corporate rescue process based on the DIP concept of the US will not be practical for Hong Kong because wide dispersion of share-ownership and manager-displacing corporate reorganization simply do not exist in reality. This is consistent with the government’s proposal in rejecting the DIP given concerns that if the existing management was allowed to remain in control, a company could easily avoid or delay its obligations to creditors as the managers of a family business either are family members or are nominated by the family. They are expected to place the family’s interests in the corporation as the first priority even at the expense of creditors’ interests.
Though these differences may be true in the case of publicly held and traded US corporations, they are not so clear in the case of closely-held US companies – which many readers will acknowledge comprise the bulk of US business.
Why No Post-Petition Financing? As for post-petition financing – a mainstay of US reorganizations – Ho and Chan point out that though the US has developed a vibrant distressed debt market, “the debt market is not as developed and is materially underused in Hong Kong. The major reason for illiquidity and lack of use is best expressed as Hong Kong’s cultural background. Hong Kong lacks no resources for deal structuring but has no tradition of traded debt, and corporate governance practice has historically been insufficient to support issue of debts by large companies.”
Economic Efficiency. Finally, the authors cite well-recognized and frequently noted flaws in the Chapter 11 process: Its perceived inefficiency arising from its “one-size-fits-all” approach, as well as the arguably high rates of recidivism amongst those debtors who do successfully confirm a Chapter 11 Plan.
Whatever one’s take on Ho and Chan’s assessment of US-style reorganizations, their work affords an interesting glimpse into alternative methods of corporate rescue currently under consideration in one of the world’s most sophisticated financial jurisdictions.