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    Archive for January, 2011

    . . . But Will It Work?

    Monday, January 31st, 2011

    The 2008 financial crisis sparked a vigorous debate over how the financial problems of troubled financial institutions ought to resolved.  Ultimately, Congress’ answer to this (and a host of other regulatory matters involving financial institutions) was the Dodd-Frank Act.

    But is Dodd-Frank the best answer to resolving the distress of financial insitutions?  In a paper forthcoming in the Seattle Law Review, Seton Hall Professor Stephen J. Lubben discusses The Risks of Fractured Resolution – Financial Institutions and Bankruptcy.  According to Professor Lubben:

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    Under Dodd-Frank, “[a]ll large bank holding companies, which now include former investment banks such as Goldman Sachs, and many other important institutions, with more than 85% of their activities in ‘finance,’ will be subject to a new resolution regime controlled by the FDIC and initiated by the Treasury Secretary and the Federal Reserve.  But by developing a new system for addressing financial distress, instead of integrating the new system into the existing structure of the Bankruptcy Code, the financial reform act simply recreates the prior problem in a new place.  The future Lehmans and AIGs will be covered by the new procedure, but other firms that have 84% of their activities in finance will not.  In short, the disconnect between bankruptcy and banking has moved to a different group of firms.  And we may have done nothing but protect ourselves against an exact repeat of the financial crisis.

           . . . .

    I use this paper to argue that there are significant gaps in the federal system for resolving financial distress in a financial firm, even after passage of the Dodd-Frank bill.  These gaps represent potential sources of systemic risk – that is, risk to the financial system as a whole.   They must be fixed.  But I should make clear at the outset that I do not argue that these gaps must be filled with the Bankruptcy Code.  Rather, the point is that the various systems for resolving financial distress among financial firms – including the FDIC bank resolution process, the new resolution authority, state insurance resolution proceedings, and the SIPC process for broker-dealers, as well as chapter 11 of the Code – must be integrated so that the result of financial distress is clear and predictable.  Integrating all under the Bankruptcy Code is an option, but not the only way to achieve such clarity.”

    Lubben’s work provides an insightful perspective on Dodd-Frank’s effectiveness, at least as it regards the resolution of financial institution insolvency.

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    It’s Different In Hong Kong

    Monday, January 24th, 2011

    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.

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    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.

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    Now Coming to a Bankruptcy Court Near You: The Section 363 Discharge(?!)

    Tuesday, January 18th, 2011

    Norton’s recently-published 2010 Annual Survey of Bankruptcy Law offers an intriguing article focusing on an often-overlooked difference between “Section 363 sales” and Chapter 11 Plans – and suggesting that, for certain liabilities, Section 363 may actually afford broader relief than a Chapter 11 discharge.

    In Classic Chapter 11 Reorganizations Versus Section 363 Sales And The Effects On Environmental Cleanup Obligations: The Choice After Apex Oil Co. And General Motors, authors Joel Gross and Christopher Anderson contend:

    “[U]nless the law [surrounding Section 363 sales] changes, any debtor seeking to provide maximum protection to its surviving business from broad cleanup liabilities for divested properties would be best advised to utilize a Section 363 sale.  The protection from successor liability that can be achieved through such a sale will very likely exceed the more narrow discharge from monetary claims that can be obtained if the property is transferred under a plan of reorganization.”

    In support of their argument, Gross and Anderson compare the results of two recent decisions – In re Apex Oil and the 2009 In re General Motors Corp. decision.

    In Apex Oil, the 7th Circuit held that, despite its prior discharge in Chapter 11, the reorganized debtor remained liable for environmental liabilities incurred years earlier on the grounds that such liabilities were not “claims” subject to discharge under Chapter 11’s provisions.  A prior post regarding Apex is available here.

    In General Motors – by contrast – the the US Government supported, and the Bankruptcy Court accepted, the transfer of GM’s business assets to a newly-formed entity (“New GM”) under a sale “free and clear of all . . . interests,” including successor liability claims.  In reaching this decision, the Bankruptcy Court relied on the reasoning set forth in In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir.2003) – i.e., that Section 363 provides a basis for selling assets free and clear of successor liability claims.

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    Not every circuit permits an extension of Section 363’s “free and clear” language to successor liability claims.  See Michael H. Reed, Successor Liability and Bankruptcy Sales Revisited—A New Paradigm, 61 Bus. Law. 179, 208–211 (2005) (surveying the lower courts’ application of TWA).  Though at least one District Court and the Ninth Circuit Bankruptcy Appellate Panel have followed the TWA decision, the Ninth Circuit has not explicitly ruled.

    Consequently, “[i]n light of the split in circuit authority, it remains to be seen whether the view that successor liability claims can ultimately be cut off via a Section 363 sale will prevail.  For the time being, however, the majority of appellate courts (including the Second and Third Circuits where so many major Chapter 11 cases are fled) have held that they can, and there seems to be a similar trend in the lower courts.”

    That said, the use of Section 363 to avoid environmental liabilities isn’t without its problems: “One potentially important limitation, which appears not to have been addressed by any court to date, is Section 363(e)’s requirement that all sales approved under Section 363 provide adequate protection for the interest of any entity in the property sold.”

    Other issues present themselves as well.  For example:

    - Is it possible to provide for liens against the sale proceeds for successor interests?  Gross and Anderson don’t think so – as they see it, doing so would provide otherwise-unsecured creditors with preferential treatment.

    - How much are contingent successor claims truly worth?  Even if it were possible to provide “adequate protection” for successor claims, doing so raises the question of what such claims are truly worth.

    - Finally, the ability to shield assets from successor liability claims frequently implicates the Court’s equitable power under Section 105, and the extent of its scope.

    Problematic or not, these considerations likely won’t stop debtors from taking a shot at a sale: “[G]iven the certainty following Apex Oil that at least some injunctive claims will survive a traditional chapter 11 reorganization, it can be expected that debtors with significant environmental exposure will prefer to follow the roadmap laid out in GM.”

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    Federal Bankruptcy Rules Revisions – Analysis and Comment

    Sunday, January 2nd, 2011

     

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    The Insolvency Law Committee for the California State Bar’s Business Law Section has produced a very helpful analysis of recent changes to the Federal Bankruptcy Rules – which (as most readers are aware) became effective as of December 1, 2010.

    A copy is available here.

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