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      Insolvency News and Analysis - Week Ending September 26, 2014
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    Posts Tagged ‘“research paper”’

    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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    “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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