The South Bay Law Firm Law Blog highlights developing trends in bankruptcy law and practice. Our aim is to provide general commentary on this evolving practice specialty.
 





 
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      Insolvency News and Analysis - Week of December 19, 2014
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    Posts Tagged ‘“financial distress”’

    . . . But Will It Work?

    Monday, January 31st, 2011

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

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

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

           . . . .

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

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

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    What’s It Worth?

    Monday, December 7th, 2009

    Prior to the economic downturn – when sales were rising and debt was cheap – many businesses found it convenient to spur further growth by taking on “second-tier” secured financing, or engaging in aggressive leveraged buy-outs (LBO’s).  With the recession and resulting steep drop-off in firm revenues worldwide, many of the same businesses (and LBO targets) found themselves over-leveraged and struggling to service their debt.  First priority lenders have responded to this distress by negotiating exclusively with their debtors for pre-arranged “restructuring” plans that, in effect, provide for the transfer of assets and repayment of the first-priority debt – but provide little, if anything, to “second-tier” lenders and other creditors.

    recent piece from Reuters discusses what junior creditors are doing about it.

    As illustrated in recent Chapter 11 cases such as Six Flags Inc., Pliant Corp., and Trump Entertainment Resorts, Inc., junior creditors are attempting to fight back with competing restructuring plans of their own – proposed plans that provide them with better returns, or with a meaningful equity stake in the reorganized debtor. 

    A review of the dockets in each of those cases indicates that these efforts have met with varying degrees of success.  The Reuters piece suggests three variables that can impact the success of this strategy:

    Valuation.   Arguably the most critical factor in supporting a plan that competes with one pre-negotiated with the first-priority creditors is evidence demonstrating that the debtor is, in fact, worth more than the first-priority creditors claim.  That demonstration can be challenging, particularly in light of today’s uncertain economy and pricier debt.  Even so, junior creditors are likely to argue credibly that a company whose revenues were historically strong should not be under-valued purely on the basis of weaker performance in a generally weaker economy.  Still other junior creditors seeking to preserve their original position may be willing to advance additional funds, thereby opening up a possible source of financing otherwise unavailable to the debtor.

    The Court.  Concerns such as docket management and the court’s philosophical disposition to maximize enterprise value or protect the position of junior creditors – or not – are factors that have real effect on the success of junior creditors’ bid to present a competing plan.

    Cost-Benefit.  Finally, the presence – or absence – of effective negotiation between the parties can impact the perceived benefit of a competing plan.  When everyone is talking and a plan can be effectively built, a successful outcome is more likely than a full-blown “plan fight” which weighs down the estate with administrative expense and can, if sufficiently large, even jeopardize the debtor’s successful post-confirmation operations.

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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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    “Bankruptcy Boundary Games”

    Monday, August 24th, 2009

    One of the little-emphasized features of the 2005 Bankruptcy Code is a series of amendments designed to insulate the financial markets from the effects of corporate bankruptcy.  These changes build upon earlier provisions designed to accomplish the same objective, and continue a more general Congressional policy toward the separation of bankruptcy and securities law dating back to the Chandler Act of 1938.

    But are the securities markets and the Bankruptcy Courts better off for this “insulation”?  Do the Bankruptcy Code’s various “securities exemptions” truly work as advertised?

    That is the question raised by the University of Pennsylvania’s David A. Skeel, Jr.

    Skeel, Penn Law School’s S. Samuel Arsht Professor of Corporate Law, explores the intersection between bankruptcy and securities law in a recently-authored Penn Institute for Law and Economics research paper titled “Bankruptcy Boundary Games.”  The paper focuses on Bankruptcy Code provisions intended to subordinate corporate bankruptcy protections to the work-a-day operation of securities markets.  In particular, Skeel focsuses on three examples of this deference:

    - The Chapter 11 “brokerage exclusion” set forth in Bankruptcy Code Section 109(d);

    - Section 546(e)’s “avoidance safe harbor” for securities-related “settlement payments;” and

    - Special treatment of “derivative transactions” under Section 362(b)(7) and elsewhere in the Code.

    According to Skeel, “Debtors have sidestepped the brokerage exclusion from Chapter 11, the settlement safe harbor has been invoked in contexts well outside the transactions it was originally designed to protect, and the exemption from the stay for derivatives and other financial contracts performed much differently than advertised when Bear Stearns, Lehman Brothers and then AIG failed.”

    Specifically, Skeel delves into recent case law and Chapter 11 filings to argue:

    - Congress’s original contemplation that a Chapter 7 liquidation would be “cleaner” and more efficient than Chapter 11 has been superseded by the current, actual corporate structure of investment banking, which has permitted firms such as Lehman to utilize Chapter 11 and the “363 sale” process to accomplish the same result, more quickly and economically than might occur in a brokerage’s “straight 7.”  As a result, this exclusion is largely irrelevant to the realities of present financial markets and their participants.

    - Section 546(e)’s “avoidance safe harbor,” hobbled by a circular and virtually useless definition of the key term “settlement payment,” has been inconsistently applied by Bankruptcy Courts faced with challenges made on this ground to avoidance actions.  These challenges are often raised in contexts far different from what Congress appears to have originally contemplated.  In the context of LBO-related avoidance claims, courts are divided over when – or if – the “safe harbor” applies.  In Enron, the “safe harbor” defense was interposed with respect to at least three different types of transactions, and each defense appears to have been resolved on fact-specific grounds – with differing results.  Skeel suggests that this “safe harbor” may leave markets insulated, but at the cost of extreme uncertainty regarding specific transactions.

    - The exemption of derivatives from the Code’s automatic stay and other provisions were originally implemented in order to avoid a feared “domino effect” in the securities markets created by a corporate Chapter 11 filing.  Ironically, however, these exemptions appear to do as much to invite systemic problems in the markets (e.g., runs in the event of financial distress) as they do to avoid them.  Among other examples, Skeel argues that Bear Stearns’ 2008 bailout (in lieu of a Chapter 11 filing) was borne of precisely this concern.  He suggests these exemptions have, in reality, done little to curb the “spill-over” effects in the securities markets that result from corporate bankruptcies.

    In an environment where a great deal of federal securities regulation is up for fresh review, is it time for a legislative re-write of the Bankruptcy Code’s “securities exemptions?”

    Perhaps, suggests Skeel.

    But “Bankruptcy Boundary Games” also hints at a more immediate and pragmatic approach to reconiling the Code’s provisions with the realities of the market: Creative lawyering and intelligent judging.  “Overall,” he writes, “the Bankruptcy Courts have done a relatively good job of handling the fallout from the sweeping protection of securities markets.”

    A point well taken.

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