A Primer on Bankruptcy Law and Trends in Corporate Bankruptcy Research U.C. Berkeley School of Law
Outline 1. Historical origins of corporate reorganization 2. What are the goals of Chapter 11? 3. Major features of the bankruptcy code 4. Research trends and developments
Early corporate reorganization: railroads The major building blocks of corporate bankruptcy law today come from railroad reorganizations in the late 1800s. Characteristics of railroads: Large amounts of capital required up front Financed by bond issues, dispersed investor base Mortgage bonds secured by cars and track Though heavily indebted, RR worth more as going-concern than liquidated (who wants to pull up track from the ground?) But hard to get all parties around the table to agree to a workout: small creditors may hold out. What do we do? For a detailed discussion see David A. Skeel, Debt s Dominion
Solution: equity receiverships Investment banks who underwrote the bonds (J.P. Morgan) forms a committee Bondholders deposit their bonds with the committee who acts on their behalf Petition a court to stop all collection activities while a foreclosure sale takes place Management continues to run the railroad in the interim At the foreclosure sale : Investment bank sets up a new entity to bid, which is usually the only bidder at the sale Credit bids with the deposited securities and some new cash
Later additions to the process At the end of the process: The new entity owns the railroad, and sets up a new, lesslevered capital structure with old bondholders as new equity Cash from foreclosure sale is paid to holdout creditors, old entity extinguished Later developments: Suppliers to the railroad were given priority claims to encourage them to continue supplying during the foreclosure process Courts added upset prices : minimum floor price that holdouts must receive Most of the features of this informal process are codified today in the bankruptcy code!
Types of bankruptcy Three chapters in the U.S. bankruptcy code that are most commonly used in business context: Chapter 7: Liquidation Management is replaced by a trustee who sells the assets Chapter 13: Adjustment of debts Available only to individuals, but sole proprietorships can use it to restructure small business debts. May be cheaper than Ch 11. Chapter 11: Reorganization Most relevant chapter for corporate debtors if survival is possible. Liquidation can occur in Ch 11, or case can be converted to Ch 7 later in the process.
What are the goals of Chapter 11? Two goals (sometimes in conflict): 1. To maximize the value of the estate - May involve keeping the firm as a going-concern, or may involve liquidating it 2. To pay creditors according to their contractual priorities Basic priority ranking: secured first (up to value of collateral), then unsecured, then equity The problem: (a form of real options problem) It s hard to know what a firm is objectively worth A party s priority ranking distorts their incentive to maximize the value of the estate. Secured creditors may have a fire-sale bias, while junior creditors/equity have a continuation bias
When is Chapter 11 useful? The railroad case is instructive because it describes a situation where a Chapter 11 filing is most useful: The business may be worth more as a going-concern than liquidated Creditors are dispersed and uncoordinated: possibility of creditor runs, negotiations are challenging The firm needs: Time/ breathing space (to sort out its affairs, decide what to do with the firm and who gets what, find potential buyers) Cash (to continue operations while decisions are made) Restructuring (shedding assets and unprofitable operations) Reduction in debt burden (so that the firm can operate profitably going forward, if it chooses to reorganize)
Time and breathing space: the automatic stay The automatic stay ( 362) Targets creditor run problem Puts an effective shield around the property of the debtor s estate Requires creditors (and other parties) to stop any collection efforts Remains in effect until the conclusion of the case Creditors may ask the court for relief from the stay in some circumstances Example: secured creditor can ask for stay to be lifted if interest in property is not adequately protected ( 361)
New cash: Debtor-in-possession financing Debtor in possession financing ( 364) Targets debt overhang problem Allows new money to come into the firm at a higher priority than the firm could offer a lender outside of bankruptcy Usually, DIP loan is secured by any free assets, or by a second-lien on asset where a first-lien creditor is oversecured Overrides any contractual terms (like negative pledge clauses in bonds) that attempt to prevent firm from granting security to new lender
Restructuring: Sale of assets free and clear Selling assets free and clear of liens ( 363) Targets adverse selection (lemons) problem Outside of bankruptcy, a lien follows the asset to the buyer Subjects potential buyers to costly investigations, due diligence, etc. to know what they are getting Bankruptcy allows for buyers to purchase assets free and clear lienholder consent not always required In today s environment, common for the entire going concern to be sold via a 363 sale
Restructuring: Assumption, rejection, and assignment Leases and other executory contracts ( 365) Debtor decides whether to assume (keep), reject (abandon), or assign (transfer) its leases and executory contracts. Another real option: debtor has time to decide, and must perform while deciding If it assumes, firm must cure defaults and continue paying according to its lease contract If it rejects, lessor can seize the leased asset Also gets damages for breach, but the claim is unsecured! Debtor can assign the lease to a third-party, even if an antiassignment clause in the lease contract
Reducing debt burden: confirming a plan of reorganization Targets holdout/free rider problems Basic requirements of confirming a consensual plan of reorganization ( 1129(a)): Creditors grouped into classes, must be substantially similar Classes vote: for creditors, 2/3 in value and ½ in number for a class to approve (just 2/3 in value for equity) All impaired classes must approve Debtor has exclusive rights to propose a plan for the first 120 days of the case. Prior to 2005 act, exclusivity period could be extended at judge s discretion, now 18 month limit
Cramdown Alternatively, a party can propose a cramdown ( 1129(b)): Done when consensual plan is not attainable does not require approval by all impaired classes Judge can confirm plan only if it satisfies the absolute priority rule: For each class, either paid in full, or No lower class of claims (or interests) receives any value
Current topics in corporate bankruptcy research The rise of secured creditor control and creditor conflict Theory of the firm/theory of corporate groups The influence of activist investors
Bankruptcy narratives Early narrative: Debtor control Managers/shareholders use debtor-friendly features of bankruptcy to delay, extract concessions from creditors Too many reorganizations of companies that should have liquidated, deviations from priority, low creditor recoveries Example: Eastern Airlines (Weiss and Wruck 1998) Recent narrative: Secured creditor control Baird and Rasmussen (2002), Skeel (2003) Secured lender controls access to cash All assets subject to liens Uses covenants in pre-bankruptcy and DIP loans to steer case outcomes Concerns about fire sales and inefficient liquidations.
Ayotte and Morrison: Creditor Control and Conflict in Chapter 11 (Journal of Legal Analysis 2009) 100% 80% 60% 40% 20% Sale UCC Sale Objection 0% 0% 0-50% 50-100% > 100% Ratio of Secured-Debt-To-Assets Quicker sales are more prevalent, relative to longer reorganizations, when asset value is close to value of senior debt. Unsecured creditors object most often to sale in these circumstances. Recent working paper by Jenkins and Smith (2014) finds a similar pattern.
The changes: creditor control While the bankruptcy code has not changed substantially, creditors (particularly, secured bank creditors) have learned how to protect themselves Evidence on creditor control from large bankruptcies: CEO turnover: 70% of CEOs in place two years prior to filing are out by the filing date Deviations from absolute priority toward equity are rare (only about 6% of cases) Sales of the business (either piece-meal or going concern) much more common than traditional reorganization (about 2/3 are sales) See Ayotte and Morrison, Creditor Control and Conflict in Chapter 11. Journal of Legal Analysis 2009.
Digital Domain in Chapter 11
Theory of the firm/corporate groups Theory of the firm literature in economics (Grossman/Hart/Moore, Williamson, etc) asks: why are assets under common ownership or separate ownership Legal scholarship confronts a different question: Why are commonly owned assets held in corporate groups? Hansmann and Kraakman (2000): entity shielding and creditor monitoring costs Baird and Casey (2013), Casey (2015), Ayotte and Gaon (2011), Ayotte (2015): stronger creditor rights in bankruptcy
Ayotte (2015): The Double-Edged Sword of Withdrawal Rights Unsecured Creditors Debtor Corp (assets: A,B) Secured Creditor (asset A) Secured Creditor (asset B) If Debtor Corp files for bankruptcy, all secured and unsecured creditors are subject to an automatic stay. Cannot seize collateral without court permission Stay is mandatory: can not waive by contract
Parent/Sub structure changes the outcome Unsecured Creditors (UC) ParentCo (asset A, 100% of Sub Corp stock) SubCo (asset B) SC-A (secured by asset A) SC-B (secured by asset B) If ParentCo files for bankruptcy but SubCo does not, then SC- B is not affected by automatic stay in ParentCo bankruptcy. If SC-B contracted for the right to withdraw asset B when ParentCo defaults, it can do so.
Date 1: E borrows from secured creditor(s) P1, purchases asset A. Date 2: E borrows from secured creditor P2, purchases complementary asset B E chooses whether P2 is subject to a stay or can withdraw. Date 3a: Success or Default, E bargains with withdrawal rights creditor. Firm Continues or Liquidates. Date 3b: Info is realized, Reorganization/Liquidation decision made. Reorg is efficient in states h,m but liquidation efficient in state l. Date 1 Date 2 Date 3a Date 3b Date 4 P1 invests P2 invests Success p X 3 Recovery X 4 1-p Default State realized {h,m,l} Liquidate Continue Liquidate Reorganize π j 1-π j Failure L 3 = α 3 + β 3 L 4 = α 4 + β 4
Conclusions: Double Edged Sword 1. A mandatory stay may be optimal 1. Parties do not necessarily contract for it on their own due to externalities imposed on other creditors 2. Necessary conditions to justify a mandatory stay: 1. (Some) early lenders cannot police a debtor s subsequent contracts Trade creditors, asset-based lenders, landlords, bonds 2. The firm may have going-concern value, 3. Bargaining may break down, and 4. Asset subject to withdrawal right is specific The model further suggests that withdrawal rights are more problematic when: 1. Capital structure renders the firm illiquid 2. Subsidiary financing: new creditor lacks recourse to firm
Good papers to read: Activist investors, courts and judges Activist investors: Hedge funds: Jiang, Li and Wang (JF, 2012) Private equity: Hotchkiss, Smith and Stromberg (working paper) Claims trading: Ivashina, Iverson and Smith (JFE, forthcoming) Courts and Judges: In crowded courts: Iverson (working paper, 2015) Debtor/creditor friendliness: Chang and Schoar (working paper, 2007)
(Somewhat messy) citations, I Ayotte, K. and S. Gaon (2011). Asset Backed Securities: Costs and Benefits of Bankruptcy Remoteness. Review of Financial Studies. Ayotte, K. (2015) The Double-Edged Sword of Withdrawal Rights. Working paper, U.C. Berkeley School of Law. Ayotte, K. and E. Morrison. (2009) Creditor Control and Conflict in Chapter 11. Journal of Legal Analysis. Baird, D. and A. Casey (2013) No Exit? Withdrawal Rights and the Law of Corporate Reorganizations. Columbia Law Review. Baird, D. and R. Rasmussen (2002) The End of Bankruptcy. Stanford Law Review Casey, A. (2015) The New Corporate Web: Tailored Entity Partitions and Creditors Selective Enforcement. Yale Law Journal, forthcoming. Chang, T. and A. Schoar (2007). The Effect of Judicial Bias in Chapter 11 Reorganization.
(Somewhat messy) citations, II Hansmann, H. and R. Kraakman (2000). The Essential Role of Organization Law. Yale Law Journal. Hotchkiss, E. D. Smith and P. Stromberg, Private Equity and the Resolution of Financial Distress. Working paper. Ivashina, V., B. Iverson and D. Smith, The Ownership and Trading of Debt Claims in Chapter 11. Forthcoming, Journal of Financial Economics. Iverson, B. (2015). Get In Line: Chapter 11 Restructuring in Crowded Bankruptcy Courts. Working Paper Jenkins, M. and D. Smith. (2014) Creditor Conflict and the Efficiency of Corporate Reorganization. Working paper. Jiang, W, K. Li and W. Wang. (2012) Hedge Funds in Chapter 11. Journal of Finance. Skeel, D. (2003). Creditors Ball: The New New Corporate Governance in Chapter 11. University of Pennsylvania Law Review Weiss and Wruck, (1998). Information problems, conflicts of interest, and asset stripping: : Chapter 11's failure in the case of Eastern Airlines. Journal of Financial Economics.