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      Bankruptcy News and Analysis - Week Ending January 30, 2015
    Insolvency News and Analysis - Week Ending January 16, 2015
    Insolvency News and Analysis - Week Ending January 9, 2015
    Happy Holidays from South Bay Law Firm!
       

    Posts Tagged ‘Chapter 11’

    Insolvency News and Analysis – Week Ending January 16, 2015

    Sunday, January 18th, 2015
    A bond from the Dutch East India Company, dati...

    A bond from the Dutch East India Company, dating from 7 November 1623, for the amount of 2,400 florins. (Photo credit: Wikipedia)

    Legislation and Reform

    ABI Wants Chapter 11 Easier for Small Companies: Bankruptcy

    Automatic Stay

    Prepetition Stay Waivers: Which Way Is The Wind Blowing?

    Postpetition Ratification of Prepetition Stay Waivers – A Possible End Around of the General Prohibition Against Prepetition Waivers of Bankruptcy Rights?

    Secured Claims

    Charging Liens and Trump Cards: Specific Isolated Funds Not Required

    UCC Collateral Description: More May Not Be Better

    Unsecured Claims

    Chesapeake Bond Redemption Case: Ambiguity, Plain Meaning and Value

    Reorganization and Exit Strategy

    Cashing Out: The Rise of M&A in Bankruptcy

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    Insolvency News and Analysis – Week Ending January 9, 2015

    Saturday, January 10th, 2015

    BK Options

    Trends

    Bankruptcy Count Lowest Ever. Uptick Anticipated – Health Care Filings Lead Count

    Bankruptcies Down 12% in 2014, Forecast Predicts the Same Decline for 2015

    Legislation and Reform

    Redemption Option Value: Broad Implications for Secured Lenders

    ABI Chapter 11 Reform Commission Series: Oversight of the Case (Part I)

    Corporate Governance

    APPOINTMENT OF INDEPENDENT DIRECTORS ON THE EVE OF BANKRUPTCY: WHY THE GROWING TREND?

    Secured Claims

    Review Twice, File Once, Review Again; UCC-3 Termination Intent Irrelevant

    Even The “Cleverly Insidious” Lender Cannot Prevent Its Borrower From Filing Bankruptcy

    Common Provisions in a Chapter 11 Plan Prevent Lender from Collecting From the Owner of the Debtor

    Leases and Executory Contracts

    Capital Leases in Bankruptcies – A Lesson from Xchange Technology Group

    It’s Not Purdy, But It’s Not A Per Se Security Agreement

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    Insolvency News and Analysis – Week of December 19, 2014

    Sunday, December 21st, 2014
    English: The United States Supreme Court, the ...

    The Nine

    Legislation

    Four Things You Need to Know About Chapter 11 Reform

    Corporate Governance

    Slouching Towards Bankruptcy: Corporate Fiduciaries Escape Liability in Ultimate Escapes

    Secured Credit

    When is a Typo in a Loan Document More Than Just a Typo?

    Avoidance and Recovery

    Good Faith Transferee in a Fraudulent Transfer Action can only Retain Transfers Equal to the Value It Provided to the Debtor

    Confirmation

    SCOTUS To Decide Whether Order Denying Plan Confirmation Is “Final,” Appealable

    Cross-Border

    U.S. Court Asserts its Authority in a Cross-Border Bankruptcy Case

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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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    DIP Lending in Transition

    Monday, August 9th, 2010

    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:

    “The overall state of the DIP financing market has changed over the last couple of years as the broader credit markets have changed. Lower yields due to improvements in the overall credit markets have resulted in lower rates in the DIP loan market as well.

    While it is difficult to say precisely what DIP yields will be over the next year or so, it seems very likely that the worst part of the credit cycle is over and DIP yields are not going to reach the same levels as they did in late 2008 and early 2009. Even though yields on DIP loans are not at their peak levels, the loans will still likely be used for . . . strategic reasons—protecting existing debt positions or controlling restructuring processes or acquiring assets through credit bids.”

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    Rock & Republic . . . and Venue

    Monday, April 12th, 2010

    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.

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    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:

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     – 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.

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    Sales or Plans: A Comparative Account of the “New” Corporate Reorganization

    Monday, April 5th, 2010

    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.

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    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.

    Why not?

    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:

    [B]oth the United States and Canada have well-established case law that supports the “pre-plan” sale of a debtor’s assets.  The key difference between the jurisdictions thus turns not on the basic procedures, but rather the broader context of those procedures . . . .   [I]n the United States it is generally possible to sell a debtor’s assets distinct from any obligations or liabilities associated with those assets.  Indeed, the only obligations that survive such a sale are those that the buyer willing[ly] accepts and those that must survive to comport with the U.S. Constitution’s requirements of due process.

    [I]n Canada the debtor has less ability to “cleanse” assets through the sale process.  Particularly with regard to employee claims, a pre-plan sale under the CCAA is not apt to be quite as “free and clear” as its American counterpart.

    The jurisdictions also differ on the point at which the reorganization procedures – and the sale process – can be invoked.  Canada, like most other jurisdictions, has an insolvency prerequisite for commencing [a reorganization] proceeding, whereas Chapter 11 does not.  And the Canadian sale process is tied to the oversight of cases by the [court-appointed] monitor: without the monitor’s consent, it is unlikely that a Canadian court would approve a pre-plan asset sale.  In the United States, on the other hand, there is no such position.  Accordingly, a [US] debtor can seek almost immediate approval of a sale upon filing.  Finally, there remains some doubt and conflicting case law in Canada about the use of the CCAA in circumstances that amount to liquidation, particularly following an asset sale.  In the US, it is quite clear that Chapter 11 can be used for liquidation.

    [T]hese latter factors are the more likely explanations for the failure to use the CCAA in [GM’s and Chrysler’s] cases . . . .  [I]t is the questions of speed and certainty that mark[] the biggest difference between the two jurisdictions . . . .  In the case of GM and Chrysler, where the governments valued speed above all else, these issues came to the fore.

    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.

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    Buying Assets in Bankruptcy – To Be or Not to Be . . . a Stalking Horse?!

    Monday, March 1st, 2010

    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.

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    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.

    Today’s economic environment has created an opportunity to acquire assets of financially distressed entities at deeply discounted prices, and one of the most effective ways to make those acquisitions is through a purchase in the context of a bankruptcy under Section 363 of the Bankruptcy Code (the “Code”).  When purchasing the assets of a failed company under Section 363, there are distinct advantages to being first in line.  Depending on the circumstances, however, it may be best to wait and let the process unfold – and then, only after surveying the entire landscape, submit a bid.

    The 363 Sale Process

    A so-called “363 Sale” is a sale of assets of a bankrupt debtor, wherein certain discrete assets such as equipment or real estate – or substantially all the debtor’s business assets – are sold pursuant to Section 363 of the Bankruptcy Code (11 USC §363).  Upon bankruptcy court approval, the assets will be conveyed to the purchaser free and clear of any liens or encumbrances. Those liens or encumbrances will then attach to the net proceeds of the sale and be paid as ordered by the Bankruptcy Court.

    A Section 363 sale looks much like a traditional controlled auction.  Basic Section 363 sale mechanics include an initial bidder, often referred to as the “stalking horse,” who reaches an agreement to purchase assets – typically from the Chapter 11 debtor, or “debtor-in-possession” (DIP).  The buyer and the DIP negotiate an asset purchase agreement (APA), which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to “higher and better” or “over” bids.  The Bankruptcy Court will approve the bidding procedures, including the incentives, i.e., a “bust-up” fee, for the stalking horse bidder, and will pronounce clear rules for the remainder of the sale process.  Notice of the sale will be given, qualified bids will arrive and there will be an auction.  The sale to the highest bidder will commonly close within four to six weeks after the notice and the stalking horse will either acquire the assets or take home its bust-up fee and expense reimbursement as a consolation. 

    Advantages for the Stalking Horse Bidder

    Bidding Protections - During negotiations with the debtor for the purchase of assets, the stalking horse will also typically negotiate certain protections for itself during the bidding process.  These bidding protections, which include a bust-up fee and expense reimbursement, will be set forth in the 363 sale motion and are generally approved by the bankruptcy Court.  As a result, stalking horse bidders seek to insulate themselves against the risk of being out-bid.  To do so, proposed stalking-horse bidders commonly require that any outside bidder will typically have to submit not only a bid that is higher than that of the stalking horse, but will also need to include an amount to cover the stalking horse’s transactional fees and expenses.

    Bidding Procedures – The stalking horse will also negotiate certain bidding procedures with the debtor, which will be set forth in the 363 sale motion that will be evaluated, and most likely approved, by the Court.  The sale procedures generally include the time frame during which other potential bidders must complete their due diligence and the date by which competing bids must be submitted.

    Other delineated procedures typically included in the motion include the amount of any deposit accompanying a bid and the incremental amount by which a competing bid must exceed the stalking horse bid.  In addition, if the sale procedures provide for an abbreviated time frame in which to complete an investigation of the assets, a competing bidder will be at a distinct disadvantage and may be unable, as a result, to even submit a bid.

    Deal Structure – As the first in line, the stalking horse bidder will also negotiate all of the important elements of the transaction, including which assets to acquire, what contracts – if any – to assume, the purchase price and other terms and conditions.  In doing so, it establishes the ground rules by which the sale process will unfold and the framework for the transaction, which will be difficult, if not impossible, for another outside bidder to change. 

    “First Mover” Advantage – The stalking horse bidder will typically be viewed by the Court as the favored asset purchaser in that it will have negotiated all of the relevant terms and procedures, and established its financial ability and intent to acquire the assets.  As a result, short of an overbid by an outside party, which typically involves an additional amount to cover the stalking horse’s bust-up fee and expenses, the stalking horse bidder will prevail.

    Cooperation of Stakeholders – As the lead bidder, the stalking horse also has an opportunity to negotiate with other key stakeholders in the process and establish a close relationship with those parties that may prove advantageous when all offers are evaluated.

    Bust-up Fee and Expense Coverage – Lastly, if an outside party happens to submit the high bid, the stalking horse will typically receive its bust-up fee and expense reimbursement. This generally includes items such as due diligence fees, legal and accounting fees, and similar expenses, but is limited by negotiation. 

    Disadvantages to the Stalking Horse Bidder

    Risk of Being Outbid – As noted, the stalking horse will expend a great deal of time, energy, and resources analyzing and negotiating for the purchase of the assets.  All a competing bidder must do is show up to the sale and submit an over-bid.  If the competing over-bidder prevails, the stalking horse runs the risk of walking away with only its bust-up fee and expense reimbursement.

    Risk of Bidding Too High – After negotiating the APA, the stalking horse then participates in the 363 sale process.  If no other bidders materialize, it may be because the stalking horse effectively over-paid for the assets. 

    Inability to Alter Terms – If some new information comes to light that would otherwise suggest a reduction in the price or alteration of the terms, the stalking horse may have difficulty altering either of these and may be locked in to the negotiated structure.

    Questions?

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

    Meanwhile, happy hunting.

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    Does “Too Big to Fail” Mean “Too Big for Bankruptcy”?

    Sunday, January 31st, 2010

    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:

    The President and members of Congress are considering proposals that would give the government broad authority to rescue financial institutions whose failure would threaten market stability. These systemically important institutions include bank and insurance holding companies, investment banks, and other “large, highly leveraged, and interconnected” entities that are not currently subject to federal resolution authority.  Interest in these proposals stems from the credit crisis, particularly the bankruptcy of Lehman Brothers.

    That bankruptcy, according to some observers, caused massive destabilization in credit markets for two reasons.  First, market participants were surprised that the government would permit a massive market player to undergo a costly Chapter 11 proceeding. Very different policy had been applied to other systemically important institutions such as Bear Stearns, Fannie Mae, and Freddie Mac.  Second, the bankruptcy filing triggered fire sales of Lehman assets. Fire sales were harmful to other, non-distressed institutions that held similar assets, which suddenly plummeted in value. They were also harmful to any institution holding Lehman’s commercial paper, which functioned as a store of value for entities such as the Primary Reserve Fund. Fire sales destroyed Lehman’s ability to honor these claims.

    Lehman’s experience and the various bailouts of AIG, Bear Stearns, and other distressed institutions have produced two kinds of policy proposals. One calls for wholesale reform, including creation of a systemic risk regulator with authority to seize and stabilize systemically important institutions.  Another is more modest and calls for targeted amendments to the Bankruptcy Code and greater government monitoring of market risks.  This approach would retain bankruptcy as the principal mechanism for resolving distress at non-bank institutions, systemically important or not.

    Put differently, current debates hinge on one question: Is the Bankruptcy Code an adequate mechanism for resolving the distress of systemically important institutions? One view says “no,” and advances wholesale reform. Another view says “yes, with some adjustments.”

    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:

    Bankruptcy reorganization is, for the most part, an American success story. It taps into a huge body of law, provides certainty, and has shown an ability to respond to changing circumstances. It follows (for the most part) nonbankruptcy priority rules – the absolute priority rule – with useful predictability, sorts out financial failure (too much debt but a viable business) from underlying failure, and shifts ownership to a new group of residual claimants, through the certainty that can be provided by decades of rules and case law.

    Notwithstanding its success, bankruptcy reorganization has a patchwork of exceptions, some perhaps more sensible than others.  Among them are depository banks (handled by the FDIC), insurance companies (handled by state insurance regulators), and stockbrokers and commodity brokers (relegated to Chapter 7 and to federal regulatory agencies).  In recent months, there has been a growing chorus to remove bankruptcy law, and specifically its reorganization process, from “systemically important financial in-stitutions (SIFIs),” with a proposed regulatory process substituted instead, run by a designated federal agency, such as the Federal Reserve Board or the Securities and Exchange Commission.

    Putting aside political considerations, behind this idea lie several perceived objections to the use of the bankruptcy process.  First, it is argued, bankruptcy, because it is focused on the parties before the court, is not able to deal with the impacts of a bankruptcy on other institutions – an issue thought to be of dominant importance with respect to SIFIs, where the concern is that the fall of one will bring down others or lead to enormous problems in the nation’s financial system.  Second, bankruptcy – indeed, any judicial process – is thought to be too slow to deal effectively with failures that require virtually instant attention so as to minimize their consequences.  Third – and probably related to the first and second objections – even the best-intentioned bankruptcy process is assumed to lack sufficient expertise to deal with the complexities of a SIFI and its intersection with the broader financial market.

    Jackson’s response to this growing chorus of objections is to propose amending existing Chapter 11 legislation.  Again, in his words:

    The premise of [Jackson’s] “Chapter 11F” proposal, which [he] flesh[es] out [in his paper], is that, assuming the validity of each of these objections, they, neither individually nor collectively, make a case for creating yet another (and very large) exception to the nation’s bankruptcy laws and setting up a regulatory system, run by a designated federal agency, that operates outside of the predictability-enhancing constraints of a judicial process. Rather, bankruptcy’s process can be modified for SIFIs – [Jackson’s] Chapter 11F – to introduce, and protect, systemic concerns, to provide expertise, and to provide speed where it might, in fact, be essential. Along the way, there is probably a parallel need to modify certain other existing bankruptcy exclusions, such as for insurance companies, commodity brokers, stockbrokers, and even depository banks, so that complex, multi-faceted financial institutions can be fully resolved within bankruptcy.

    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:

    One clear lesson of the 2008 recession, which brought Goliaths such as Bear Sterns, CitiGroup, AIG, and Washington Mutual to their knees, is that no financial institution, regardless of its size, complexity, or diversification, is invincible. Congress, as a result, is left with the question of how best to handle the failure of systemically significant financial companies (SSFCs). In the United States, the insolvencies of depository institutions (i.e., banks and thrifts with deposits insured by the Federal Deposit Insurance Corporation (FDIC)) are not handled according to the procedures of the U.S. Bankruptcy Code. Instead, they and their subsidiaries are subject to a separate regime prescribed in federal law, called a conservatorship or receivership. Under this regime, the conservator or receiver, which generally is the FDIC, is provided substantial authority to deal with virtually every aspect of the insolvency. However, the failure of most other financial institutions within bank, thrift, and financial holding company umbrellas (including the holding companies themselves) generally are dealt with under the Bankruptcy Code.

    In March of 2009, Treasury Secretary Timothy Geithner proposed legislation that would impose a conservatorship/receivership regime, much like that for depository institutions, on insolvent financial institutions that are deemed systemically significant. In order to make a policy assessment concerning the appropriateness of this proposal, it is important to understand both the similarities and differences between insured depositories and other financial institutions large enough or interconnected enough to pose systemic risk to the U.S. economy upon failure, as well as the differences between the U.S. Bankruptcy Code and the FDIC’s conservatorship/receivership authority.

    [Carpenter’s] report first discusses the purposes behind the creation of a separate insolvency regime for depository institutions. The report then compares and contrasts the characteristics of depository institutions with SSFCs. Next, the report provides a brief analysis of some important differences between the FDIC’s conservatorship / receivership authority and that of the Bankruptcy Code. The specific differences discussed are: (1) overall objectives of each regime; (2) insolvency initiation authority and timing; (3) oversight structure and appeal; (4) management, shareholder, and creditor rights; (5) FDIC “superpowers,” including contract repudiation versus Bankruptcy’s automatic stay; and (6) speed of resolution. This report makes no value judgment as to whether an insolvency regime for SSFCs that is modeled after the FDIC’s conservatorship/receivership authority is more appropriate than using (or adapting) the Bankruptcy Code. Rather, it simply points out the similarities and differences between SSFCs and depository institutions, and compares the conservatorship/receivership insolvency regime with the Bankruptcy Code to help the reader develop his/her own opinion.

    Fascinating reading . . . and an awful lot of it.

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    Chicken.

    Monday, November 30th, 2009

    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:

    Cyrus has chosen . . . to object to confirmation and thereby assume the consequence of being found liable for a breach of the Intercreditor Agreement.  Cyrus’ reasoning is based on the asserted correctness of its own legal position regarding the definition of collateral and the proper interpretation of the Intercreditor Agreement.  To avoid potential liability for breach of the agreement, Cyrus must prevail in showing that objections to confirmation are not prohibited because those objections are grounded in the proposition that the FCC Licenses are not collateral and so are not covered by the agreement.  But that argument is hopelessly circular. Cyrus is free to object only if it can convince this Court or an appellate court that it has correctly analyzed a disputed legal issue. It is objecting as if it has the right to do so without regard to the incremental administrative expenses that are being incurred in the process.

    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:

    The objective was to prevent or render moot the very sort of technical argument that is being made here by Cyrus regarding the validity of liens on the FCC [l]icenses. By virtue of the Intercreditor Agreement, the parties have allocated among themselves the economic value of the FCC [l]icenses as “Collateral” (regardless of the actual validity of liens in these licenses).  The claims of the First Lien Lenders are, therefore, entitled to higher priority . . . .  Affirming the legal efficacy of unambiguous intercreditor agreements leads to more predictable and efficient commercial outcomes and minimizes the potential for wasteful and vexatious litigation . . . .  Moreover, plainly worded contracts establishing priorities and limiting obstructionist, destabilizing and wasteful behavior should be enforced and creditor expectations should be appropriately fulfilled.

    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.

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