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    Archive for May, 2010

    Making Sense of “Cram-Down”

    Sunday, May 23rd, 2010

    Practitioners and business people who have toiled in and around US-based restructuring work are well-acquainted with one of the great strengths (and primary threats) of Chapter 11:  The ability of a debtor to restructure its secured obligations over the objection of a lender through the use of the “cram-down” procedures of Section 1129(b).

    For those who may be less familiar, the concept of “cram-down” is not as difficult than the colorful term might suggest.  Essentially, a debtor may confirm a Chapter 11 plan and restructure its debts over the objection of secured creditors so long as the debtor’s plan offers those creditors the present value of their allowed secured claims, such that they receive an appropriate rate of interest which accurately maintains the present value of their concern.

    Fighting over “cram-down,” therefore, really boils down to fighting over which interest rate ought to apply to the lender’s restructured loan.

    In an era where real estate and other collateralized capital assets are under significant duress (and “risk-free” rates of interest are near all-time lows), the issue of “cram-down” is once again a matter of immediate relevance – and its resolution can often spell the difference between restructuring or foreclosure.

    Because the notion of “cram-down” has been part of US insolvency jurisprudence for decades, US Courts have accumulated considerable collective sophistication in addressing the financially-oriented evidence and arguments that surround “cram-down fights.”

    But sophistication does not mean consistency.

    Last week, Ray Clark of Orange County-headquartered VALCOR Consulting, LLC released a succinct overview of some of the more notable case law surrounding “cram down” developed in the years since the US Supreme Court decided Till v. SCS Credit Corp., 541 U.S. 465, 124 S.Ct. 1951 (2004).

    Category:Federal courthouses of the United States
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    Tracing several key cases issued by Circuit Courts of Appeal since Till, Ray – who has previously appeared on this blog as a guest – offers a very concise, readable summation of what it takes to win (or defeat) a “cram down” effort in Chapter 11.

    One of Ray’s strengths is his ability to make the often unfamiliar and complex financial underpinnings of restructuring work accessible to the average, intelligent business person.  His summary is available here – and is well worth a read.

    Questions?

    Contact rclark@valcoronline.com or mgood@southbaylawfirm.com.

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    Bankruptcy and Derivatives: What’s All the Fuss, Anyway?

    Monday, May 17th, 2010

    The esoteric world of credit default swaps and other derivative securities often appears far removed from the everyday practice of Chapter 11.  But the impact of this little-known (and often less-understood) corner of the securities market upon the bankruptcy world has recently garnered considerable academic interest – and is now attracting some legislators’ attention as well.

    Credit Default Swap (CDS) payment streams betw...
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    Several posts on this blog (beginning here) have summarized the intersection between credit default swaps and bankruptcy.  Some academics have explored the potential indirect effect of these securities upon out-of-court netogiations – focusing primariliy on the potential problems of “holdout” creditors and the “empty creditor hypothesis.”  Others (here and here) have offered their preliminary thoughts on the continued usefulness of the Bankruptcy Code’s “securities safe harbors,” originally included to shield financial markets from the effects of large bankruptcy filings – but now perceived as distorting creditor priorities and possibly exacerbating the financial risk created by such events.

    Some portions of this debate (such as the true impact of CDS’s on corporate insolvency) continue to play out in the realities of Chapter 11 economics.  Other portions (such as the continued viability of the Bankruptcy Code’s “safe harbor” rules) are beginning to work themselves – albeit slowly – into legislative proposals.

    Within the last 30 days, Florida’s Sen. Bill Nelson has offered a brief, 2-page amendment to the proposed financial reform legislation now working its way through the US Senate.  In essence, the amendment would strip the “safe harbors” out of the Bankruptcy Code, ostensibly “leveling the playing field” for all creditors.

    U.S. Senator Bill Nelson, of Florida.
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    For its simplicity, the amendment – which has no co-sponsors – has provoked still further discussion amongst academics.  Seton Hall’s Steve Lubben commends it as a good “first step” toward amending the Bankruptcy Code, but believes further compromise is necessary (his proposed compromises are outlined here).  Harvard’s Mark Roe says, in an updated research paper, that the amendment deserves “central consideration” in connection with financial reform legislation.

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    Fraudulent Transfers and LBOs – It’s All In the Numbers . . . Or Is It?

    Monday, May 10th, 2010

    Leveraged buy-outs (LBO’s) are a time-honored means of financing the acquisition of companies.  They tend to occur in waves, finding greatest popularity when credit is easy and money is cheap.

    Because of their dependence on favorable credit conditions, LBO’s are also rather risky.  When credit markets tighten and asset values drop – as they did most recently during the “Great Recession” of 2008 – the risk is borne primarily by unsecured creditors of the acquisition target. 

    LBO’s, popular during the “roaring 80’s” and again during the “go-go” years of the George W. Bush Administration, are once again crashing and burning in significant numbers.  Recent victims include household names like Chrysler, Hawaiian Telcom, Linens ‘N Things, Simmons, LyondellBasell, Capmark Financial Group Inc., and Tribune Co.  Others, including Clear Channel Communications, Harrah’s Entertainment, and TXU, have defaulted on their LBO debt.  Indeed, nearly half of non-financial American companies that defaulted on Moody’s-rated debt instruments in 2009 were reportedly leveraged acquisitions of private-equity funds.

    Companies with overburdened balance sheets are forced to “de-leverage” and restructure their debt, typically at the expense of these creditors.  Because the essence of an LBO is the use of secured debt to finance an acquisition, the historical response to “de-leveraging” has been for unsecured creditors to attempt to unwind the security interests encumbering the company’s assets.  These efforts are typically undertaken through fraudulent transfer claims – which are reportedly on the rise in the wake of last year’s financial turmoil.

    {{en|1=Diagram of leveraged buyout transaction...
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    The original idea behind fraudulent transfer claims – which trace their roots back nearly half a millenium in Anglo-American commercial law – was that debtors shoudln’t be able to place valuable assets beyond the reach of their creditors.  The idea is a simple one, but proving a debtor’s subjective intent is often far more difficult than it looks.

    In light of this difficulty, courts have developed certain “objective tests” to determine whether a transaction is “construtively fraudulent.”  Though a number of modern variations exist, their primary theme is that transfers made (or liabilities incurred) by a debtor in a financially precarious position may be “avoided” (i.e., unwound).

    A debtor is generally considered to be in a financially precarious position if it receives less than “reasonably-equivalent value” in exchange for property or debt while the debtor (1) is insolvent at the time of the exchange; (2) is rendered insolvent by the exchange; (3) is left, following the exchange, with “unreasonably small capital” for the business in which it is engaged or is about to engage; or (4) intends to or believes it will incur, debts it would be unable to pay as they matured.

    Where an LBO is found to have been a fraudulent transfer, the court’s order that the transfer is avoided may include: (1) stripping the lender of its liens; (2) recovery of loan payments and fees; (3) subordination or disallowance of lender’s claims in bankruptcy; and (4) recovery of fees paid to professionals in connection with a leveraged buyout.

    As attractive as all this might sound for unsecured creditors, unwinding an LBO as “constructively fraudulent” is unfortunately only slightly less difficult than establishing subjective fraudulent intent.  As a result, such creditors have little recourse but to settle fraudulent transfer claims very cheaply.  LBO participants, on the other hand, are incentivized to take on risky acquisitions at the creditors’ [potential] expense.

    That, at least, is the argument put forth by John Ginsberg in his recently-uploaded draft article entitled “Remedying Law’s Failures to Remedy Fraudulent Transfers in Leveraged Buyouts” (downloadable at SSRN).

    Ginsberg, an in-house lawyer at an unnamed federal agency, focuses on the “unreasonably small capital” test (the test most commonly used in attacking an LBO) and argues that the standard for meeting that test – whether insolvency is “reasonably foreseeable” – requires far greater certainty in order for creditors to realize the protections intended for them by fraudulent transfer law.

    In essence, Mr. Ginsberg argues that rather than asking whether insolvency is “reasonably foreseeable,” courts ought to clarify “reasonable foreseeability” in probabalistic terms.  It should be easier to attack (or to defend) a fraudulent transfer if it can be shown, for example, that the “probability” of insolvency at the time of an LBO was 50% – or 60%, or 75%.  Further, courts ought to articulate what, for them, constitutes an acceptable margin of error (say, 40% risk of insolvency with a margin of error of +/- 15%).

    Finally, Mr. Ginsberg argues that a “probabalistic” approach eliminates the potential confusion arising when a subsequent “insolvency triggering event” is blamed for sinking a perhaps-somewhat-risky-but-otherwise-perfectly-viable LBO: If the probability of insolvency is established ahead of such a “trigger event,” it is far easier to determine whether or not that event is, in fact, a significant factor in the company’s failure.

    Mr. Ginsberg’s article (a working copy of which is available on SSRN) is an interesting read – not least because it offers a succinct and accessible snapshot of recent decisions addressing fraudulent transfers and LBOs.

    Mr. Ginsberg’s proposed approach is also not the only one available to those seeking a more “objective” treatment of LBO financing.  A number of authors have suggested that the “foreseeability of insolvency” may be best determined by reference to prevailing industry liquidity and solvency ratios.  These are easily accessible through research databases, and provide some objective benchmarks as to what the participants in an LBO transaction might reasonably have anticipated at the time of the transfer.

    That said, even these more “objective” approaches are not without their problems.

    For example, if courts in a particular jurisdiction have enunciated a 50% or greater probability as the threshold for “reasonably foreseeable” insolvency, won’t the parties engaging in an LBO simply adjust their forward-looking assumptions to be certain that the “probability” is something less than 50%?  And what level of probability rises to the level of “reasonably foreseeable” in the first place?  Ginsberg’s article acknowledges this last uncertainty, and leaves the matter open for discussion.

    Ratio-based tests also have their own problems.  Which solvency ratios are most meaningful to a particular industry?  And which ones is a court most likely to apply to a particular transaction?  Though ratios are comparatively easy to compute, their application has been a subject for juducial hand-wringing and scholarly suggestions for the better part of 8 decades.

    Something to think about.

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    “Small Business” Chapter 11’s – Are They Really Worth It?

    Monday, May 3rd, 2010

    A recent post by University of Illinois’ Professor Bob Lawless over at the always-stimulating “Credit Slips” blog focuses on an often-ignored, but important, corner of the Chapter 11 world: “Small Business” Chapter 11’s.  Perhaps more accurately, the post focuses on Chapter 11’s that could be – but aren’t – formally designated as “Small Business” Chapter 11’s.

    Prof. Lawless – whose research interests include empirical methodologies in legal studies – recently reviewed bankruptcy data from 2007, observing that of 2,299 chapter 11s filed in 2007 where the debtor (i) was not an individual; (ii) claimed predominately business debts; and (iii) scheduled total liabilities between $50,000 and $1,000,000, only 36.8% were designated “small business” bankruptcies.  Anecdotally, Prof. Lawless refers to one of the cases he surveyed:  a manufacturer that scheduled about $800,000 in debt and yet did not self-designate as a small-business debtor.

    So why don’t more “small businesses” that commence Chapter 11 proceedings (many don’t, but this is a different issue) claim “small business” status?

    The answers from practitioners – some of whom responded on the post, and others who voiced their views on a national list-serve also maintained by Prof. Lawless. – appear to coalesce around the following:

    – Congress’ 2005 amendments impose additional filing requirements.  Section 1116 requires the provision of “the most recent” balance sheet, profit-and-loss statement, and statement of cash flows, as well as the most recent Federal income tax return.  One busy LA practitioner noted that he avoids the “Small Business” designation for this reason.

    – The “small business” deadlines are too compressed.  For example, the Code’s exclusivity provisions generally “caps” the time period in which a “Small Business” debtor may file a Chapter 11 Plan and Disclosure Statement at 300 days.  This period can, of course, be extended within the original 300-day period if the debtor can demonstrate that plan confirmation within a “reasonable period” is “more likely than not.”  But as a practical matter, the debtor has about 10 months to get a Chapter 11 Plan and Disclosure Statement filed.

    – The combination of increased reporting and compressed deadlines puts any “small business” case on a hair-trigger under the expanded dismissal provisions of Section 1112.

    – Some practitioners simply overlook the designation – which appears as a “check-the-box” on the face page of the petition’s official form.

    – The concept of separate “small business” treatment emerges out of “local practices” implemented by bankruptcy judges for the purpose of streamlining their own dockets, but which were never really a good idea from a practical perspective.

    With the possible exception of attorney oversight, these all appear emininently practical reasons for staying away from “Small Business” Chapter 11’s.

    But are they always?

    It may be that “small business” cases are perceived as problematic because, in fact, they cut against the grain of the traditional law firm business model.  For example:

    Additional filing requirements.  There may be circumstances where the client’s non-compliance with income tax filing requirements preclude any “small business” self-designation.  But most businesses – even troubled ones – can generate a very rudimentary set of financial statements.  Even for clients who generally operate without them, it should be possible to generate such statements (albeit very cursory ones) at the initial client interview or very shortly thereafter.  It’s worth noting that in California’s Central District, the additional “up-front” filing requirements are offset, at least to some degree, by the dramatically reduced monthly reporting requirements with the US Trustee’s Office.  In one “small business” Chapter 11 case handled last year by South Bay Law Firm, the extremely relaxed monthly operating reporting requirements were one – though certainly not the only – reason a “small business” filing was recommended for the client.

    Compressed deadlines.  Part of South Bay Law Firm’s pre-petition planning involves a review of the client’s “exit strategy.”  The fundamental question is: What is the client’s perceived business objective for the contemplated Chapter 11?  If there isn’t one, the client has more fundamental issues to consider – and the conversation typically turns to a discussion of whether or not Chapter 11 makes business sense.  If there is a business purpose for the contemplated Chapter 11, the business purpose and the “exit strategy” are typically reduced to an informal “Plan Term Sheet” which will, itself, become the nucleus of a combined Chapter 11 Plan-Disclosure Statement.  At South Bay Law Firm, our experience is that the combined document is generally a bit easier and less time-consuming to draft than 2 separate documents.  And with the “end game” relatively well-defined at or near the outset of the case, getting to a successful exit just got a lot easier.  This is a factor critical to the speed that is so important to an economically successful Chapter 11.

    More reasons for dismissal.  It is certainly true that Section 1112 imposes draconian consequences for failure to make required filings.  But more often, the real challenge isn’t Section 1112 – or the US Trustee’s Office.  Instead, it’s helping the “small business” Chapter 11 debtor focus on the administrative requirements of a Chapter 11 – and in California’s Central District, there are many.  To that end, the extra discipline required up-front for a “small business” Chapter 11 is, in fact, an important test of the debtor’s ability and willingness to get through the process with success.  If the debtor can’t even comply with a few additional filing requirements, it’s preferable to know right away that this debtor will have difficulty dealing with the myriad other contingencies that are certain to emerge in even a small Chapter 11 case.

    It’s all an impractical (though perhaps well-intended) judicial idea.  For the reasons described above, the additional filing requirements and compressed deadlines of a “Small Business” Chapter 11 may, in fact, bt very practical – at least in the larger scope of Chapter 11 economics.  But even if the practicalities are questionable (practicality is, after all, in the eye of the practitioner), their result – docket efficiency and speed of administration – are both great sources of judicial pleasure.  The judicial clerkship experience resident at South Bay Law Firm attests that there really is no better way to make friends with everyone behind the bench than making their job easier – even if the job is just a tad bit harder on counsel’s end.  We’ll gladly invest a little extra effort if it will mean the benefit of the doubt on a “jump ball” in front of the person wearing the black robe.

    All of this may be very interesting, but how does it implicate the law firm business model?

    Only this way: In an industry predominated by an “hourly fee” pricing model and on bringing as much business in the door as possible, the pressure on increased speed and discipline in a “small business” Chapter 11, requires more focus (and time) up-front, drives down administrative costs, demands an internal adherence to business process, and “weeds out” many candidates unsuitable for Chapter 11 – “small business” or otherwise.  This, in turn, has the effect of making “small business” Chapter 11’s generally quicker and cheaper – and therefore potentially less profitable, at least from an “hourly fees” point of view.  It also tends, at least initially, to restrict or limit overall client “volume.”

    However, it also has the effect of creating a relatively well-defined “product” which is potentially salable to a larger segment of troubled small businesses.  And a larger overall market segment means a larger absolute number of “small business” debtors who are possessed of the discipline and determination to reorganize their businesses successfully.

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