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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.
As the economy lurches forward into an uncertain back half of 2010, the DIP lending market remains in flux. In a short piece appearing in the Journal of Corporate Renewal last Wednesday, Imran Choudhury and Frank Merola – both of Jeffries & Co., Inc. – offer a concise overview of the factors affecting credit availability and expense over the last two years.
After a sharp contraction in 2008, Choudry and Merola show how DIP funding has increased – both in terms of deal size and in terms of new money . . .
and likewise, how spreads have eased during the same period . . . .
Their walk-away, in light of this data:
Many readers of this blog will be well aware that “venue shopping” – usually to a known, “debtor-friendly” jurisdiction such as Delaware or the Southern District of New York – is a common feature of Chapter 11 practice. For those who may not be, the primary idea is that the debtor’s management, looking to increase the likelihood of a successful reorganization, often identifies a “debtor-friendly” jurisdiction and seeks to fit within the venue provisions for commencing a reorganization case there.
But though the federal venue provisions (at least as interpreted by these courts) generally make it easy to obtain access to file a Chapter 11 case, not every such case filed in New York or Delaware stays there without a fight from one or more creditors who disagree with the debtor’s choice of forum.
Last week, another example of creditors disagreeing with the debtor’s choice of forum – in the strongest possible terms – presented itself in the recently-filed Chapter 11 bankruptcies of Rock & Republic Enterprises, Inc. and Triple R, Inc.
The purveyors of high-end jeans sought Chapter 11 protection on April 1 in Manhattan. Though the bulk of their management and facilities – and their creditors – are located in the Los Angeles metropolitan area, the companies opted for an East Coast venue, each citing a single office – and a showroom – as the basis for their request to reorganize in New York’s Southern District.
The companies’ primary secured creditor, RKF, LLC, wasn’t pleased. It immediately filed an “Emergency Motion to Transfer Venue” to the Central District of California, alleging:
– The companies’ status as California corporations;
- The companies’ management offices, books and records, and address for service of process are in the Los Angeles area;
- All but 2 of 10 of the companies’ leased premises are in the Los Angeles area;
- 16 of the companies’ top 25 creditors are based in Los Angeles (only 2 are in New York); and
- 9 of 14 litigation matters involving the companies are being heard in California.
On Friday, RKF was joined by Zabin Industries, Inc. Zabin is one of the companies’ self-described “larger unsecured creditors” and is also based in Southern California.
No word yet on a date for the hearing on RKF’s “Emergency Motion” – as of this writing, presiding Judge Arthur Gonzales hadn’t set one. Meanwhile, the Judge has set an accelerated hearing date on the companies’ request to reject an exclusive distribution agreement with Richard I Koral, Inc. (dba “Jessica’s”), the companies’ present off-price distributor.
A great deal of scholarly ink has been spilled over last year’s well-publicized sales of Chrysler and GM, each authorized outside a Chapter 11 plan. Some of that ink is available for review . . . here.
It’s worth noting that both Chrysler and GM have enjoyed a considerable presence in Canada. Indeed, the Canadian government participated in the automakers’ Chapter 11 cases. Yet their bankruptcy sales were not recognized under Canadian cross-border insolvency law, nor were Canadian insolvency proceedings ever initiated.
Seton Hall’s Stephen Lubben and York University’s Stephanie Ben-Ishai collaborated last month to offer an answer to that question. The essence of their article, “SALES OR PLANS: A COMPARATIVE ACCOUNT OF THE ‘NEW’ CORPORATE REORGANIZATION” comes down to two points of difference between the Canadian reorganization process and US Chapter 11 – speed and certainty – and is captured in the following excerpt:
The article offers a very interesting perspective on the strategic use of specific insolvency features of different jurisdictions to effect cross-border bankruptcy sales, and is well worth the read.
With both the global and regional Southern California economies showing early signs of life – but still lacking the broad-based demand for goods and services required for robust growth – opportunities abound for strong industry players to make strategic acquisitions of troubled competitors or their distressed assets.
Ray Clark, CFA, ASA and Senior Managing Director of VALCOR Consulting, LLC, is no stranger to middle-market deals. His advisory firm provides middle market restructuring, transactional and valuation services throughout the Southwestern United States from offices in Orange County, San Francisco, and Phoenix.
As most readers are likely aware, distressed mergers and acquisitions can be handled through a variety of deal structures. Last week, Ray dropped by South Bay Law Firm to offer his thoughts on a process commonly known in bankruptcy parlance as a “Section 363 sale.”
In particular, Ray covers the “pros and cons” of this approach.
The floor is yours, Ray.
Meanwhile, happy hunting.
The market collapse of 2008 and resulting financial crisis have led to significant reflection on a number of systemic features of our financial markets and on the stability of institutions that play significant roles in their function.
That reflection has produced a fresh round of legal scholarship on what role – if any – the federal Bankruptcy Code should play in addressing the financial difficulties of these institutions. In a recent paper, Columbia’s Harvey R. Miller Professor of Law Edward R. Morrison asks, “Is the Bankruptcy Code an Adequate Mechanism for Resolving the Distress of Systemically Important Institutions?”
The issue, at least as put by Professor Morrison in the opening paragraphs of his paper, is framed as follows:
Morrison’s paper sets out to assess this debate, and concludes by advocating [again, in his words] “an approach modeled on the current regime governing commercial banks. That regime includes both close monitoring when a bank is healthy and aggressive intervention when it is distressed. The two tasks – monitoring and intervention – are closely tied, ensuring that intervention occurs only when there is a well-established need for it.” As a result of the close relationship between the power to intervene and the duty to monitor, however, any proposed legislation “is unwise if it gives the government power to seize an institution regardless of whether it was previously subject to monitoring and other regulations.”
Elsewhere in the Empire State, at the University of Rochester, Distinguished Professor Thomas H. Jackson proposes “Chapter 11F: A Proposal for the Use of Bankruptcy to Resolve (Restructure, Sell, or Liquidate) Financial Institutions.” According to Jackson:
Jackson’s response to this growing chorus of objections is to propose amending existing Chapter 11 legislation. Again, in his words:
With views as divergent as these, one might be tempted to look for a fundamental assessment of the differences between the banking regulatory system and the Chapter 11 process. And that assessment is, in fact, available from the Congressional Research Service – which last April provided its own comparison of “Insolvency of Systemically Significant Financial Companies: Bankruptcy v. Conservatorship / Receivership.” As summarized by its author, Legislative Attorney David H. Carpenter:
Fascinating reading . . . and an awful lot of it.
The purchase of debt on the cheap and subsequent use of activist litigation to seize control of a troubled company, or obtain other economic concessions from the debtor, is a common tactic in Chapter 11 practice. But it is not without risk – especially when the purchased debt comes with possible strings attached.
From New York’s Southern District last week, a cautionary tale of what can happen when an agressive distressed debt investor presses its luck despite ambiguous lending documents:
ION Media Networks’ Pre-Petition Credit Arrangements and Pre-Arranged Chapter 11.
ION Media Networks Ltd. and its affiliates (“ION”) entered into a series of security agreements with its first- and second-priority lenders during the “go-go” days of 2005. The documents included an intercreditor agreement setting forth the respective parties’ rights to ION’s assets.
By early 2009, ION was involved in restructuring discussions with the first-priority lien holders. Those discussions resulted in a Restructuring Support Agreement (“RSA”) by which ION conveyed 100% of ION’s reorganized stock to the first-priority lien holders upon confirmation of a Chapter 11 plan. In furtherance of the RSA, the ION companies filed jointly administered Chapter 11 cases in May 2009.
Enter Stage Right: Cyrus.
In the meantime, Cyrus Select Opportunities Master Fund Ltd. (“Cyrus”) purchased some of ION’s second-lien debt for pennies on the dollar. Using its newly acquired stake, Cyrus systematically attempted to interpose itself into ION’s pre-arranged reorganzation: It objected to DIP financing proposed by the first-priority lien holders, requested reconsideration of the DIP financing order so it could offer alternative financing on better terms, objected to ION’s disclosure statement, commenced its own adversary proceeding for a declaratory judgment, prosecuted a motion to withdraw the reference with respect to two adversary proceedings concerning ION’s FCC broadcast licenses, objected to confirmation, proposed amendments to the Plan to enable it more effectively to appeal adverse rulings of the Bankruptcy Court, and even filed supplemental papers in opposition to confirmation on the morning of the confirmation hearing.
Cyrus’ basic objective in this campaign was quite straightforward. It sought to challenge the rights of ION’s first lien holders (and DIP lenders) to recover any of the enterprise value attributable to ION’s FCC broadcast licenses. Its ultimate objective was to leverage itself into economic concessions from ION and the first lien holders – and a hefty profit on its debt acquisition.
Cyrus picked its fight (i) while its position was “out of the money”; and (ii) in the face of an Intercreditor Agreement prohibiting Cyrus from “tak[ing] any action or vot[ing] [on a Chapter 11 plan] in any way . . . so as to contest (1) the validity or enforcement of any of the [first lien holders’] Security Documents … (2) the validity, priority, or enforceability of the [first lien holders’] Liens, mortgages, assignments, and security interests granted pursuant to the Security Documents … or (3) the relative rights and duties of the holders of the [first lien holders’] Secured Obligations . . .”).
Cyrus apparently decided to go forward because, in its view, ION’s valuable FCC broadcast licenses were not encumbered by the first-priority liens that were the subject of the Intercreditor Agreement. As a result, Cyrus claimed a right to pro rata distribution, along with the first-priority lien holders (who were themselves undersecured), in the proceeds of the purportedly unencumbered FCC licenses. Therefore, its objections, based on Cyrus’ position as an unsecured creditor, were appropriate. By the time the cases moved to confirmation, the ION debtors had commenced their own adversary proceeding to determine whether or not Cyrus’ objections were so justified.
Second-Guessing Cyrus’ Strategy.
Cyrus’ game of legal “chicken” was, in the words of New York Bankruptcy Judge James Peck, a “high risk strategy” designed to “gain negotiating leverage or obtain judicial rulings that will enable it to earn outsize returns on its bargain basement debt purchases at the expense of the [first lien holders].”
Unfortunately for Cyrus, its “high risk strategy” was not a winning one.
In a 30-page decision overruling Cyrus’ objections to ION’s Chapter 11 plan, Judge Peck appeared to have little quarrel with Cyrus’ economic objectives or with its activitst approach. But he was sharply critical of Cyrus’ apparent willingness to jump into the ION case without first obtaining a determination of its rights (or lack thereof) under the Intercreditor Agreement:
In contrast to Cyrus’ reading of the Intercreditor Agreement, Judge Peck read it to “expressly prohibit Cyrus from arguing that the FCC Licenses are unencumbered and that the [first lien holders’] claims . . . are therefore unsecured . . . . At bottom, the language of the Intercreditor Agreement demonstrates that [Cyrus’ predecessors] agreed to be ‘silent’ as to any dispute regarding the validity of liens granted by the Debtors in favor of the [first lien holders] and conclusively accepted their relative priorities regardless of whether a lien ever was properly granted in the FCC Licenses.”
Judge Peck further found that because Cyrus’ second-priority predecessor had agreed to an indisputable first-priority interest in favor of the first lien holders regarding any “Collateral,” this agreement also included any purported “Collateral” – and, therefore, prohibited Cyrus’ dispute of liens in the FCC broadcast licenses . . . even if such licenses couldn’t be directly encumbered:
Judge Peck acknowledged case law from outside New York’s Southern District that disfavors pre-petition intercreditor agreements which prohibit junior creditor voting on a Chapter 11 plan or a junior creditor’s appearance in the case as an unsecured creditor. But these features were not the ones at issue here: Cyrus was permitted to vote, and it could (presumably) make a general appearance as an unsecured creditor. However, it could not, in this capacity, object to the ION Chapter 11 plan.
Finally, Judge Peck noted that his own prior DIP Order acknowledged the first lien holders’ senior liens on “substantially all the [ION] Debtors’ assets.” As a result, Cyrus was independently prohibited from re-litigating this issue before him – and couldn’t have done so in any event because it had no standing to raise a proper objection.
Food for Thought.
The ION decision raises a number of questions – about the activist litigation tactics often used to extract the perceived value inherent in distressed debt acquisitions, and about the debt itself.
Was Cyrus overly aggressive in enforcing its purchased position? Judge Peck suggests, in a footnote, that Cyrus would have been free to raise objections to a settlement between the ION debtors and unsecured creditors by which the unsecured creditors were provided consideration sufficient to meet the “best interests of creditors” test required for confirmation. But wouldn’t any objection ultimately have raised the same issues as those put forward by Cyrus independently – i.e., the claimed lack of any direct encumbrance on ION’s FCC licenses, and the extra value available to unsecured creditors?
Or perhaps Cyrus wasn’t agressive enough? For all the paper it filed in the ION cases, shouldn’t Cyrus have concurrently given appropriate notice under its second-priority debt Indenture and commenced an adversary proceeding to determine its rights under the Intercreditor Agreement?
Finally, what of Cyrus’ purchased position? Was the Intercreditor Agreement truly “unambiguous” regarding Cyrus’ rights? Didn’t the “Collateral” described and the difficulty of directly encumbering FCC licenses create sufficient ambiguity to trigger an objection of the sort Cyrus offered? Are “purported liens” the same as “purported collateral“? And is a distinction between the two merely “technical”?
For distressed debt investors (and for lenders negotiating pre-petition intercreditor agreements), ION Media offers provoking food for thought.
But while you’re thinking . . . be sure to check your loan documents.