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    Posts Tagged ‘Debtor-Creditor Negotiations’

    The Chrysler Sale – Back to the Future?

    Monday, September 28th, 2009

    The bankruptcy blogosphere is replete with commentary on Chrysler LLC’s sale, through Section 363 of the Bankruptcy Code, to a newly-formed entity.  The sale, of substantially all of Chrysler’s assets for $2 billion, gave secured creditors an estimated $0.29 on the dollar.  Other, unsecured creditors received more.  Though challenged, the sale ultimately received the 2d Circuit’s approval in a decision issued August 5.

    Was the Chrysler sale proper?  Or did it constitute an inappropriate “end run” around the reorganization provisions that ordinarily apply in a confirmed Chapter 11 plan?

    Harvard Law’s Mark Roe and Penn Law’s David Skeel tackle this question in a paper released earlier this month entitled “Assessing the Chrysler Bankruptcy.”  Roe and Skeel argue, in essence, that there was no way to tell whether or not the sale was proper because the sale lacked valuation, an arm’s length settlement, or a genuine market test (i.e., an auction) – all traditional measures of whether or not secured creditors received appropriate value for their collateral.  They then suggest that the Chrysler transaction may portend a return of sorts to the equitable receiverships used to reorganize the nation’s railroads at the end of the ninenteenth century.

    Roe and Skeel follow two fundamental strands of thought.

    First, they review the basic facts of the Chrysler sale against the context of other so-called “363 sales” and ask where Chrysler fits within this context.

    Their answer is that it really doesn’t fit.

    Most complex bankruptcy sales (i.e., sales that effectively determine priorities and terms that the Code is structured to determine under Section 1129) are insulated from running afoul of the Code’s reorganization provisions through judicial innovations such as expert valuations or priority determinations, creditor consents, or competitive auctions.  According to Roe and Skeel, the Chrysler sale had none of these.  Instead,

    “[Chrysler's] sale determined the core of the reorganization, but without adequately valuing the firm via [Section] 1129(b), without adequately structuring a . . . bargain [with creditors or classes of creditors], and without adequately market testing the sale itself.  Although the bankruptcy court emphasized an emergency quality to the need to act quickly . . . there was no immediate emergency.  Chrysler’s business posture in early June did not give the court an unlimited amount of time to reorganize, but it gave the court weeks to sort out priorities, even if in a makeshift way.”

    How was the Chrysler sale deficient in these respects?

    Though it involved a valuation presented by Chrysler, “the court did not give the objecting creditors time to present an alternative valuation from their experts . . . .  Here, the judge saw evidence from only one side’s experts.”

    For those who may protest that the Chrysler sale did, indeed, enjoy the consent of Chrysler’s secured lenders, Roe and Skeel argue that the largest of these lenders were beholden to the U.S. Treasury and to the Federal Reserve – not only as regulators, but as key patrons via the federal government’s rescue program.  They were, therefore, willing to “go along with the program” – and the Bankruptcy Court was inclined to use their consent to overrule other objections from lenders not so well situtated.  On this basis, Roe and Skeel contend that the secured lenders’ “consent” – such as it may have been – wasn’t independent “consent” at all.

    Roe and Skeel also point out that the “market test” proposed as a means of validating the sale was, in fact, not a test of Chrysler’s assets, but of the proposed sale: “There was a market test of the Chrysler [sale], but unfortunately, it was a test that no one could believe adequately revealed Chrysler’s underlying value, as what was put to market was the . . . [sale] itself.”

    The authors then go on to argue that the sale was mere pretense – and that, in fact, “there was no real sale [of Chrysler], . . . at its core Chrysler was a reorganization”:

    “Consider a spectrum.  At one end, the old firm is sold for cash through a straight-forward, arms-length sale to an unaffiliated buyer.  It’s a prime candidate to be a legitimate [Section] 363 sale.  At the other end, the firm is transferred to insider creditors who obtain control; no substantial third-party comes in; and the new owners are drawn from the old creditors.  That’s not a [Section] 363 sale; it’s a reorganization that needs to comply with [Section] 1129.

    . . . .

    [To determine where a proposed sale falls along this spectrum,] [a] rough rule of thumb for the court to start with is this stark, two-prong test: If the post-transaction capital structure contains a majority of creditors and owners who had constituted more than half of the old company’s balance sheet, while the transfer leaves significant creditor layers behind, and if a majority of the equity in the purportedly acquiring firm was in the old capital structure, then the transaction must be presumed to be a reorganization, not a bona fide sale.  In Chrysler, nearly 80% of the creditors in the new capital structure were from the old one and more than half of the new equity was not held by an arms-length purchaser, but by the old creditors.  Chrysler was reorganized, not sold.”

    Was the Chrysler transaction – however it may be called – simply a necessary expedient, borne of the unique economic circumtsances and policy concerns confronting the federal government during the summer of 2009?

    Roe and Skeel argue that, in fact, the government could have acted differently: It could have picked up some of Chrysler’s unsecured obligations (i.e., its retiree obligations) separately.  It could have offered the significant subsidies contemplated by the deal to qualified bidders rather than to Chrysler.  It could even have paid off all of Chrysler’s creditors in full.  But it did none of this.

    Second, Roe and Skeel consider that “[t]he deal structure Chrysler used does not need the government’s involvement or a national industry in economic crisis.”  Indeed, it has already been offered as precedent for proposed sales in the Delphi and Phoenix Coyotes NHL team bankruptcies – and, of course, in the subsequent GM case.

    One very recent case in which South Bay Law Firm represented a significant trade creditor involved a similar acquisition structure, with an insider- and management-affiliated acquirer purchasing secured debt at a significant discount, advancing modest cash through a DIP facility to a struggling retailer, and proposing to transition significant trade debt to the purchasing entity as partial consideration for the purchase.

    The deal got done.

    What’s to become of this new acquisition dynamic?  Employing a uniquely historical perspective, Roe and Skeel travel back in time to observe:

    “The Chrysler deal was structured as a pseudo sale, mostly to insiders . . . in a way eerily resembling the ugliest equity receiverships at the end of the 19th century.  The 19th century receivership process was a creature of necessity, and it facilitated reorganization of the nation’s railroads and other large corporations at a time when the nation lacked a statutory framework to do so.  But early equity receiverships created opportunities for abuse.  In the receiverships of the late 19th and early 20th century, insiders would set up a dummy corporation to buy the failed company’s assets.  Some old creditors – the insiders – would come over to the new entity.  Other, outsider creditors would be left behind, to claim against something less valuable, often an empty shell.  Often those frozen-out creditors were the company’s trade creditors.”

    They trace the treatment of equity receiverships, noting their curtailment in the US Supreme Court’s Boyd decision, the legislative reforms embodied in the Chandler Act of 1938, and the 1939 Case v. Los Angeles Lumber Products decision which articulated the subsequently-enacted “absolute priority rule” (but preserved the “new value exception”).  Against this historical background, “Chrysler, in effect, overturned Boyd.”

    But with a twist.

    “One feature of Chrysler that differed from Boyd may portend future problems.  Major creditors in Chrysler were were not pure financiers, but were deeply involved in the automaker’s production.”  In cases where the value of the assets is enhanced by the continued involvement of key non-financial creditors, “players with similar [legal] priorities will not . . . be treated similarly.”

    Translation: When non-financial creditors are driving enterprise value, a Chrysler-style sale suggests that some will make out, and some creditors – even, on occasion, some secured lenders – will get the shaft.

    If accurate, Roe’s and Skeel’s Chrysler analysis raises some significant considerations about access to and pricing of business credit.  It raises new concerns for trade creditors.  It likewise presents the possibility that the Chapter 11 process – which has, in recent years, tilted heavily in favor of secured lenders – may not be quite as predictable or uniformly favorable as in the past.

    Meanwhile . . . it’s back to the future.

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    The Law of Unintended Consequences

    Monday, September 14th, 2009

    Unintended consequences.

    Unfortunately, life is full of them . . . and so is the 2005 Bankruptcy Code.  Today’s post will discuss just one: The expanded protection afforded trade creditors under Section 503(b)(9).

    What does this section do?  And just how much protection does it provide?  As amended, Section 503(b)(9) was intended by Congress to protect vendors who supplied goods to a debtor within 20 days of a debtor’s bankruptcy filing by extending “administrative” (i.e., 100% payment) status to their claims.  Along with amendments to Section 546(c), the idea was to protect vendors who extended credit to a debtor immediately before the debtor filed a case.  But in fact, Section 503(b)(9)’s application may now be leaving many such vendors at greater risk.

    How so?  A recent Daily Deal piece by Natixis’ Christophe Razaire briefly outlines three general problem areas. 

    Goods?  Or services?  Section 503(b)(9) protects suppliers of goods well enough, and understandably so: Along with Section 546(c), it is designed to preserve and augment the protections extended to the same vendors under the Uniform Commercial Code.  But what about suppliers of services?  Unfortunately, as a number of creative service providers have discovered, the Code offers no such similar protection.  Moreover, where a company relies primarily on services for its activity, it appears doubtful that the Code’s amendment does anything to alleviate the risk of a debtor’s default and eventual bankruptcy.

    Payment?  Or post-petition payables?  Though Section 503(b)(9) provides administrative priority for “20-day” vendor claims and Section 546(c) likewise permits vendors to assert reclamation demands for goods supplied immediately prior to the debtor’s filing, in practice, vendors rarely see any early compensation in the case. 

    Instead, a bankruptcy court is far more likely to simply afford such claims their entitled administrative status, then require the vendors holding them to wait until the conclusion of the case for payment.  Economically, this means that vendors who should be enjoying administrative protection and receiving cash are, in fact, merely exchanging one “IOU” for another – and, in the meantime, suffering as much liquidity distress as any other general unsecured creditor.

    Needless to say, this liquidity distress has to be dealt with in some fashion.  And it is often addressed through a refusal to further supply the debtor-in-possession except on “COD” or similarly restrictive terms.  Alternatively, other customers of a cash-strapped vendor may feel the squeeze through tightened terms as the vendor struggles to compensate for large – but unsatisfied – administrative obligations owed by the debtor.

    Administrative protection?  Or administrative insolvency?  Perhaps the most unintended consequence of Section 503(b)(9)’s amendment is that business reorganizations involving large numbers of “20-day” claims may, in fact, be threatened by its application.

    “20-day vendors” can, if they so choose, accept payments on their administrative claims at a discount – and, in fact, it is not uncommon for debtors to attempt to cut such deals.  But where there are numerous “20-day” claimants, the debtor often faces very slow, arduous negotiations.  Many vendors are reluctant to negotiate with the debtor for fear of “selling out” too low; others may try their hand at brinksmanship, betting that the debtor’s need to satisfy such claims prior to emerging from bankruptcy will reward their willingness to “hold out.”

    Often, the “reward” for such bargaining is something less than creditors may have hoped for.  The debtor concludes it cannot negotiate and must instead incur the [additional] administrative expense of contesting such claims directly in an effort to reduce their aggregate amount.  If these claims disputes do not go the debtor’s way, or if the debtor is already struggling to emerge with sufficient cash, the debtor may be forced to liquidate – thereby leaving all creditors, from secured debt to general unsecured claims, with far less than might otherwise be the case.

    How big can these problems get?  A recent “Dealscape” blog post by Ben Fidler illustrates how the section is playing out in the troubled retail and auto parts sectors, where vendors of goods often play a significant role in a company’s operations.  Fidler points to larger Chapter 11 filings, such as Empire Beef Co., Blackhawk Automotive Plastics, Inc., and Plastech Engineered Products, Inc., which have been left administratively insolvent or have been threatened with such insolvency, as a result of section 503(b)(9)’s amendments.

    Though not every case is as large as the ones cited by Fidler – and not every case results in administrative insolvency – similar dynamics with similar results can just as easily arise in smaller Chapter 11’s.

    In sum, this anecdotal data suggests that Congress’ well-intended efforts to afford some creditors with more options in a debtor’s reorganization may, in fact, have left all creditors with far less options.

    Surely, this cannot have been Congress’ intended consequence.

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    Credit Default Swaps: The New “Bankruptcy Trigger”?

    Monday, May 4th, 2009

    An earlier post on this blog covered the potential impact of credit default swaps (CDS’s) on distressed debt and suggested that

    CDS’s could impede the negotiation of workouts, pre-arranged or pre-negotiated Chapter 11 plans, as creditors with a vested interest in the debtor’s failure either refuse to negotiate or – worse yet – actively seek the company’s demise.

    A spate of recent articles in April indicates this is exactly what appears to be happening in the troubled auto industry – and elsewhere.

    In a short April 17 piece, The Atlantic’s Megan McArdle cites to mall operator General Growth Partners (GGP) and newsprint maker AbitibiBowater as examples of recent Chapter 11 filers who – but for the credit protection provided lenders and bondholders by CDS’s – might have been able to negotiate consensual restructurings without the need for a court proceeding.  Two other, more recent articles – one from the Detroit Free Press and another from The Deal – reference the same negotiation dynamic in talks surrounding proposed workouts for automakers General Motors and Chrysler.  Readers will undoubtedly be aware that Chrysler commenced Chapter 11 proceedings last Thursday in New York.  GM’s impending bankruptcy has been the subject of speculation for some time.

    When a troubled business attempts to restructure its debt, how should its management address the “CDS effect?”  Should CDS issuers be incorporated into the work-out discussion?  Where the issuer is a counter-party on a number of “at-risk” CDS’s involving multiple troubled companies, should the issuer be allowed to fail so that lenders are instead required to deal directly with their debtors?

    Ms. McArdle cites to earlier work – including a Financial Times article, and a Business Insider article tying the continued viability of some CDS protection to the AIG bailout (an earlier Business Insider piece went further, directly linking AIG-issued CDS’s to GM’s inability to reach terms with its lenders).  She then goes on to argue that a bankruptcy system too creditor-friendly (i.e., one that permits lenders to rely upon third-party protection, rather than forcing them to the table with their debtors) discourages entrepreneurship, makes reorganization more difficult, and in the end, proves a societal disadvantage.

    Now, wait a minute.

    Wasn’t the AIG bail-out (which, in turn, “propped up” the viability of the CDS’s on which many lenders rely) itself really an attempted government-sponsored reorganization of sorts?  If so, McArdle’s argument (and the articles she cites) leads to the conclusion that government intervention for the purpose of propping up the issuers of CDS’s ultimately leads to more corporate failure.

    Can it be that government efforts to shore up the economy (or at least, to shore up the issuers of CDS’s) are, in fact, making it harder for businesses across a broad range of industries to negotiate their own restructuring?

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    Credit Default Swaps and Bankruptcy

    Sunday, April 5th, 2009

    In a series of papers – the most recent a chapter in Greg N. Gregoriou’s and Paul U. Ali’s Credit Derivatives Handbook: Global Perspectives, Innovations, and Market Drivers (McGraw-Hill 2008) – Seton Hall Professor Stephen J. Lubben has argued over the past year or so that credit default swaps (CDS’s) will change the negotiation dynamic of large Chapter 11 cases.

    How so?

    An understanding of Lubben’s argument requires at least a rudimentary understanding of what CDS’s are and the purpose they serve.  As discussed by a brief article appearing in the March 5, 2009 edition of The Economist, “[a] CDS works like a fire-insurance policy: the holder pays a regular premium, but if the house burns down there is a big payoff. With CDSs, the payoff is triggered by a default – and filing for Chapter 11 [does] indeed trigger some CDSs.”

    Against this conceptual background, Lubben argues that where the holder of a CDS is better off with with a default on the debt underlying the swap than it is waiting for the debt to pay out, the dynamics of debtor-creditor negotiation before and during Chapter 11 will change.  In particular:

    – CDS’s could impede the negotiation of workouts, pre-arranged or pre-negotiated Chapter 11 plans, as creditors with a vested interest in the debtor’s failure either refuse to negotiate or – worse yet – actively seek the company’s demise.

    – CDS’s may shorten the timeframe for workout negotiations or promote the increased use of involuntary bankruptcy filings. 

    In a helpful post offered last month on the academically-oriented bankruptcy blog “Credit Slips,” John Marshall Law School Professor (and fellow “Credit Slips” blogger) Jason Kilborn points readers to the March 5 Economist article and suggests further that the CDS market may incentivize claims trading amongst speculators betting on the debtor’s failure:

    [W]hat if high-risk investors (speculators?) buy CDS['s], banking on a corporation’s default (akin to “naked short selling” of a company’s stock) [?]  This explosive situation comes to a head if the borrower company attempts a reorganization.  Now you’ve got very dedicated and often aggressive investors hoping for your failure!  [With] enough riding on the CDS paying out, one can easily imagine a CDS holder offering to buy a blocking position (34%) of the unsecured debt of a company attempting reorganization – which the CDS holder can probably do for a song in light of the pending reorganization (and the payout on the CDS will almost inevitably be more than a plan promises to unsecureds).  I’ve heard lots of grousing among judges wanting to know how certain “creditors” voting unsecured claims came to own those claims – now I understand why these judges want that info and what scary info they might find if the question is answered.  I presume the “not in good faith” votes of CDS holders voting down a reasonable reorg plan could be equitably subordinated or classified (rejected).  What a nightmare for debtor’s counsel!  All that work to then have your plan fail because investors with no real skin in your game tank your deal so they can collect the equivalent of hazard insurance on your failure.

    Precisely how – and under just what circumstances – CDS’s will affect the negotiation dynamics that for years have been a staple of reorganizations remains to be seen.  Lubben suggests that under some circumstances, the holders of CDSs may, in fact, still retain an interest in seeing the debtor succeed.  Kilborn himself points to recent developments in the case of LyondellBasell, the Dutch petrochemicals giant whose American unit, Lyondell Chemicals, commenced Chapter 11 proceedings in January: According to the March 7 Economist article, “some CDS holders want to force the debtor’s European parent to default, bringing in the complications of a cross-border reorganization.  That would so complicate the case that the chance of a total meltdown – and a payout on the CDS – would spike, so DIP lenders have ponied up just to avoid that eventuality.”

    Regardless of the ultimate outcome, this formerly esoteric and little-understood corner of the bond market appears to be having a very practical, real-world effect on larger Chapter 11 cases.

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