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    Posts Tagged ‘distressed debt’

    The Debt Effect

    Sunday, February 21st, 2010

    While some global economic indicators suggest an economic recovery is getting underway in earnest, research released earlier this month by global accountancy Grant Thornton LLP (and co-sponsored by the Association for Corporate Growth) argues that a fresh wave of business bankruptcy is nevertheless about to wash over US Bankruptcy Courts.

    Grant Thornton LLP
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    In “The Debt Effect“, a white paper addressing the present state of private equity, Grant Thornton’s Harris Smith – Los Angeles-based head of the firm’s Private Equity practice group – agrees that “[a] global recovery is under way, albeit slowly, and there are reasons to be cautiously optimistic about 2010 and beyond.”  Against that backdrop, however, he cautions the arrival of a nascent global recovery does not mean deal-making and the lending supporting it will immediately return to its prior levels – or that it will all look the same as before when it does.  More importantly, he demonstrates that additional corporate distress is likely on the way.

    Specifically, Harris notes that mergers and acquisition activity remains at levels that are a mere fraction of what the same activity was during 2006 and 2007.  Moreover, a significant portion of deals done earlier in the decade are now in jeopardy:  According to Moody’s, over 50 percent of the deals done between 2004 and 2007 by big private equity funds are now either in default or distress.  Many of these situations have been addressed – at least temporarily – through debt extensions and other types of forbearance.  But many of these temporary fixes are set to expire.  Moreover, Harris’ research projects that “[t]he number of maturating loans will steadily increase until it peaks in 2013.  The opportunities for distress buyers will continue to grow during this time because many companies will not be able to meet their debt obligations.”

    According to Grant Thornton’s Marti Kopacz, national managing principal of the firm’s Corporate Advisory and Restructuring Services, “We expect the restructuring wave to be a three- to five-year wave.  This is only the first year.”

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    The “Empty Creditor Hypothesis” – Systemic Financial Risk? Or Worrisome Empty-Headedness?

    Sunday, December 27th, 2009

    A significant amount of ink has been spilled in recent months over the state of the financial derivatives markets and their role in 2008′s financial melt-down.

    Some of that ink has spilled into the area of corporate insolvency - and in particular, into an examination of whether or not credit default swaps (CDSs) - a type of derivative instrument designed to let a creditor hedge its risk with a debtor – have any impact on the dynamics of work-out negotiations when the debtor experiences difficulty repaying the debt.

    This blog has devoted two prior posts (here and here) to the role of CDSs and bankruptcy.  One of the troubling issues raised by researchers (and noted here) in connection with the distressed debt market has been whether or not high-risk investors (i.e., speculators) might be incentivized to buy CDSs on distressed debt, banking on the debtor’s default (akin to “naked short selling” of a company’s stock) on the anticipation that the debtor would fail – thereby triggering a payout on the CDS.  This issue is known more popularly as the “empty creditor problem” – so-called because speculators holding the CDSs issued with respct to a distressed company are not legitimate creditors, but merely risk-takers maneuvering to profit from (and thereby attempting to engineer) corporate failure.

    As 2009 draws to a close, the International Swaps and Derivatives Association (ISDA) has stepped into the debate with a recently published research paper on the matter.  Entitled “The Empty Creditor Hypothesis,” the ISDA’s research paper argues – convincingly – that this sort of speculation is far less a problem than some have suggested.  This is so primarily because the pricing on CDSs begins to rise dramatically as the CDS-backed debtor begins to falter.  Therefore, the profits to be made from purchasing such CDSs are, effectively, non-existent – and there is little reason to speculate in them.

    The ISDA’s point is that there simply isn’t enough of a profit to be made in purchasing CDSs typically issued on distressed firms – and therefore, insufficient potential payoff to attract the sort of “empty creditors” that have concerned distressed debt researchers.  As a result, the “empty creditor problem” really isn’t a “problem.”

    But speculation isn’t the only point of impact that CDSs may have on a distressed debtor’s efforts to negotiate with creditors.  Where the holder of a CDS is also the original lender or the holder of CDS-backed debt, the existence of such derivative securities – which effectively “back-stop” the underlying debt similar to the way in which a fire insurance policy “back-stops” the risk of loss on a building – may incentivize the company’s creditors to be far less flexibile in their discussions with the debtor.

    The ISDA attempts to address this potential effect by pointing to a small sample of data available for the research paper, which suggests that during the period that CDS hedging has been available, workouts (i.e., restructuring events) have grown as a percentage of the number of defaults recorded during the same period.  Therefore, “the . . . statistics presented . . . would not appear to support the empty creditor hypothesis, according to which the availability of credit default swaps would make restructurings less likely.”  However, the ISDA admits that

    “[a] full analysis of the relationship between [the] likelihood of restructuring and availability of hedging with credit default swaps would require extensive data collection, . . . and is beyond the scope of this note.”

    The ISDA’s research paper has received attention – and succinct summaries – from the New York Times, London’s Financial Times, and Reuters.

    The ISDA’s suggestion that CDSs have essentially no impact on corporate restructuring smacks of whistling by the graveyard: In fact, the impact of CDSs has been noted, at least anecdotally, in several large corporate bankruptcy filings during 2008 and 2009.  Nevertheless, the precise nature and extent of the “CDS effect” remains to be seen – and is likely fodder for another research paper . . . or five.

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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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    Taking the Punchbowl Away from the Party

    Monday, October 12th, 2009

    Business bankruptcies in the US can be big business for hedge funds trading in distressed debt.  But that business may be sharply curtailed – or effectively eliminated – if proposed new disclosure rules in bankruptcy take effect.

    In a recent series of articles dealing with these proposed changes, the Hedge Fund Law Report (HFLR) has explored their anticipated impact on hedge funds’ participation in bankruptcy proceedings – and has graciously included in its analysis a couple of quotes by members of South Bay Law Firm.

    Some background may be helpful.

    Hedge Funds and Rule 2019

    Hedge funds have become major participants in recent bankruptcy proceedings, in which they often form unofficial or ad hoc committees in order to aggregate their claims and benefit from the additional leverage such aggregation provides.  For example, a committee might seek to consolidate a “blocking position” with respect to a class (or classes) of the distressed firm’s debt, then negotiate for financial or other concessions regarding the debtor’s reorganization plan.  Though their investment strategies may differ, hedge funds are typically uniform in their insistence on the privacy and confidentiality of their investments.  Further, such secrecy is viewed as necessary to protect the funds’ proprietary trading models from duplication.

    The fiercely guarded privacy of hedge funds contrasts sharply with the insistence on disclosure that pervades American Bankruptcy Courts.  The two have never co-existed comfortably.  Bankruptcy Courts and other parties seeking to look behind the veil of secrecy surrounding a participating group of funds have looked for help to Bankruptcy Rule 2019.  That Rule essentially requires disclosure of certain information from informal “committees” in a bankruptcy case.

    Rule 2019 traces its roots to the correction of abuses unearthed in the 1930s, when a series of hearings conducted for the SEC by [as-of-then-yet-to-be-appointed Supreme Court Justice] William O. Douglas uncovered the frequent practice of inside groups (so-called “protective committees”) working with bankrupt companies to take advantage of creditors.  Douglas’ investigation uncovered “[i]nside arrangements, unfair committee representation, lack of oversight, and outright fraud [that] often cheated investors in financially troubled or bankrupt companies out of their investments.”

    Hedge funds do not occupy the same role as the “protective committees” of 70 years ago.  But creditors have nevertheless relied on the Rule’s provision to claim that ad hoc committees must “open the kimono” to reveal not only their members’ purchased positions in the debtor, but the timing and pricing of those purchases.  This most hedge funds will not do – at least not without without a very stiff fight.

    Reaction to this use of Rule 2019 has been mixed.  In a pair of decisions issued in 2007, the Bankruptcy Courts for the Southern District of New York and the Southern District of Texas went in opposite directions, finding that ad hoc committees in the respective cases of Northwest Airlines Corp. and Scotia Development LLC must comply (in New York) or were exempt (in Texas) from the provisions of Rule 2019.  The measure of hedge funds’ resistance to this disclosure is gauged by the fact that in the wake of the court’s decision in Northwest Airlines, several funds withdrew from the case rather than divulge the information otherwise required of them.

    Proposed Amendments to Rule 2019

    On August 12, 2009, the Advisory Committee on the Federal Rules of Bankruptcy Procedure weighed in on this dispute by proposing a significant revision of Rule 2019.  The Rule has been essentially re-drafted.  According to the Committee Notes, subdivision (a) of the Rule defines a “disclosable economic interest” – i.e., “any economic interest that could affect the legal and strategic positions a stakeholder takes in a chapter 9 or chapter 11 case.”  The term is employed in subdivisions (c)(2), (c)(3), (d), and (e), and – according to the Rules Committee that drafted it – is intended to extend beyond claims and interests owned by a stakeholder.

    In addition to applying to indenture trustees (as the Rule presently does), subdivision (b) extends the Rule’s coverage to “committees . . . consist[ing] of more than one creditor or equity security holder,” as well as to any “group of creditors or equity security holders that act in concert to advance common interests, even if the group does not call itself a committee.”  If these extensions of Rule 2019 weren’t broad enough, subdivision (b) goes even further.  It permits the Court, on its own motion, to require “any other entity that seeks or opposes the granting of relief” to disclose the information specified in Rule 2019(c)(2).  Although the Rule doesn’t automatically require disclosure by an individual party, the court may require disclosure when it “believes that knowledge of the party’s economic stake in the debtor will assist it in evaluating that party’s arguments.”

    Subdivision (c) – and, in particular, (c)(2) – is the heart of the Rule.  It requires disclosure of the nature, amount, and timing of acquisition of any “disclosable economic interest.”  Such interests must be disclosed individually – and not merely in the aggregate.  The court may, in its discretion, also require disclosure of the amount paid for such interests.

    Subdivision (d) requires updates for any material changes made after the filing of an initial Rule 2019 statement, and subdivision (e) authorizes the court to determine where there has been a violation of this rule, any solicitation requirement, or other applicable law.  Where appropriate, the court may impose sanctions for any such violation.

    Though potentially broad-reaching, one of the obvious flashpoints for the amended Rule’s application will be on the continued participation of hedge funds in Chapter 11 cases.

    WIll the Amendments Work?

    Are the amendments necessary?  Or helpful?  And how – if at all – will they affect the participation of hedge funds or other parties in Chapter 11 cases?

    Comments gathered by HFLR suggest that certain aspects of the amendments may, in fact, assist in blunting the effect of credit default swaps – derivative securities through which the holder of distressed debt can shift the economic risk of the debtor’s obligation to a non-debtor third party, and therfore refuse to negotiate with the debtor.  But other provisions may, in fact, permit abuse similar to the type perceived by William O. Douglas’s original investigation: The debtor’s management may use the new Rule in collusion with a friendly committee (or other creditors) to harrass, embarrass, and pressure an individual creditor, who may not be in an economic position to resist this treatment.

    Some hedge funds have offered the argument that Rule 2019′s disclosure requirements run afoul of the Bankruptcy Code section 107′s protection of “trade secrets,” which may be protected from the public through the sealing of papers filed with the Court.  But is a hedge fund’s trading information in a specific case really a “trade secret?”  HFLR quotes South Bay Law Firm’s Michael Good, who notes that “Where hedge funds are concerned, the plausibility of a ‘trade secret’ argument depends upon what can or can’t be reverse engineered, something that only people with access to and familiarity with the funds’ ‘black box’ trading models and expertise in understanding them can know.”

    To date, Bankruptcy Courts have not been persuaded by the “trade secret” argument.  The Bankruptcy Court for the Southern District of New York specifically rejected it in Northwest Airlines.

    Even so, Bankruptcy Courts have questioned whether or not case-specific trading information (such as the timing and pricing of a fund’s purchase) is truly relevant to the disclosure issues that arise before them.  HFLR cites to the Delaware Bankruptcy Court’s handling of similar concerns raised by parties in the Sea Containers bankruptcy case, where the court ordered attorneys for a group of five bondholders to “revise the 2019 statement to provide the information that’s required by 2019(a)(1), (2), and (3) but not (4) [subsection (4) requires disclosure of the purchase price, which is the information considered most sensitive by hedge fund managers] because I don’t think that [the purchase price] is relevant in any way.”

    Many practitioners agree with this assessment.  South Bay Law Firm’s Good opined that the Sea Containers court’s balancing of interests “is probably right. I don’t know that it is truly problematic for parties, hedge funds or others, to disclose who they are or what are their aggregate holdings.  The problems more commonly arise with the revelation of the price at which they purchased distressed securities, and occasionally with the timing of the purchase.  Though it might be relevant in certain circumstances, trading information is often far less relevant than identifying the participants in bankruptcy, their relationships with one another, and the conflicts of interest that can surface through the disclosure of these relationships.”

    So What?

    Why all the fuss, anyway?  What’s really at stake with these amendments?

    On the one hand, Temple law professor Jonathan Lipson has argued in a recent article that the business bankruptcy process serves an important informational function for the markets and for the economy generally by “outing” poor corporate practices and systemic inefficiencies that can only be addressed and corrected after they’ve seen the light of public scrutiny.  Consequently, the proposed amendments should keep the bankruptcy process honest – and are therefore necessary.

    But other scholars have suggested elsewhere that the glare of public scrutiny will keep many well-heeled investors out of the distressed investment market altogether.  According to them, hedge funds are widely perceived as facilitating more competitive financing terms and increased liquidity in the debt markets.  They are also particularly useful in the restructuring process because they can make different types of investments (debt and equity) in a single company.  Additionally, their exemption from traditional regulation allows them to quickly adapt their investment strategies to the situation at hand.  The proposed amendments to Rule 2019 – and even the proposed application of Rule 2019 in its present form – may effectively remove this “market lubricant” and may further deprive distressed firms of the liquidity they need at a time when they need it most.

    Comment on the proposed amendments is due by February 16, 2010.

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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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