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Bankruptcy Reform Two Years: Later Much Ado About Little

December 6, 2016 -Written by Elliot Ganz and Danielle D’Onfro[1].  December 8th marked the second anniversary of the publication of the report (the Report) by the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11 (the Commission)[2]. The 400-page Report was the result of a two-year project that examined all aspects of Chapter 11 and included over 200 distinct proposals.  Importantly, many of the proposals are designed to address the perception by members of the Commission that the bankruptcy code is out of balance largely because of the proliferation of secured debt and the control exercised by secured creditors. 

 The Loan Syndications and Trading Association (LSTA), observed that much of the work of the Commission was, by their own admission, based on anecdote unsupported by data or rigorous academic work.  Indeed, as we demonstrate below, the consensus of modern empirical studies is that the United States’ bankruptcy system is functioning well.  In our view, many of the proposed reforms narrowing secured creditors’ rights would do more harm than good, both to the bankruptcy process and the broader credit markets and would result in reduced availability and higher costs for corporate credit.  

To add data and balance to the bankruptcy reform debate, on October 8, 2015, the LSTA published its own report examining the need for reform of Chapter 11[3]. The LSTA was particularly concerned that, without a response, the Report might be used to change bankruptcy practice in ways that could undermine the position of secured lenders to the detriment of the loan markets generally. This article will briefly review both the Report’s more significant proposals and the LSTA’s responses, then show how both developments in the case law and empirical scholarship since the publication of the Report have continued to support the LSTA’s view that the Commission’s ad hoc approach to bankruptcy reform is misguided. 

The Commission’s View 

While recognizing that the Bankruptcy Code worked well for many years, the Commission noted that today’s financial markets and sophisticated products are very different from those existing in 1978 when the Code was enacted.  Companies’ capital structures are more complex and rely more heavily on leverage.  Asset values are driven less by hard assets and more by services, contracts, IP and other intangibles.  Claims trading and derivative products have changed the composition of the creditor class.  Although these developments are not unwelcome or unhealthy, the Bankruptcy Code was not originally designed to rehabilitate companies efficaciously in this complex environment.  The Commission cites anecdotal evidence suggesting that chapter 11 has become too expensive and is no longer capable of achieving certain policy objectives. The Commission noted a number of common themes raised by many of its witnesses: A perceived increase in the number and speed of asset sales under Section 363; a perceived decrease in stand-alone reorganizations; a perceived decrease in recoveries to unsecured creditors; and, a perceived increase in the costs associated with chapter 11. 

The LSTA’s View               

The LSTA countered that the U.S. bankruptcy system is working remarkably well.  It has played a key role in the economy’s recovery from the Great Recession.  Where the Commission perceives problems, the LSTA produced data that demonstrates that the current bankruptcy system is working well, notwithstanding the profound changes in the financial markets.  The LSTA argued that the primary goal of bankruptcy law is to maximize value then distribute that value according to preexisting, non-bankruptcy rights.  These rights, which largely grow out of state property and contract law, are embodied in the absolute-priority rule.  That rule, simply stated, requires that senior creditors be paid in full before junior creditors receive any distributions, and that junior creditors be paid in full before equity holders receive any distributions.  Many of the Commission’s proposals break from these foundational principles.  The Commission expresses concern that market changes have led to distributions of value in bankruptcy that are subjectively unfair.  They would use bankruptcy law to circumvent this perceived unfairness primarily caused by state-law private-property rights.  But, the LSTA argued, respecting non-bankruptcy entitlements wherever possible is fair.  And there are many good reasons (such as avoiding forum shopping) why it makes sense for bankruptcy law to steer clear, whenever possible, of departing from non-bankruptcy rights and priorities. 

The Commission’s Major Proposals Impacting Secured Creditors 

  • The Commission proposed limiting adequate protection at the beginning of a case to the amount a secured creditor would receive for its collateral in a hypothetical state-law foreclosure proceeding.  The LSTA believes that it would effectively require secured creditors to fund a debtor’s efforts at reorganization.  Currently, adequate protection in bankruptcy is typically measured against the going concern value of the collateral which is generally much higher than foreclosure value (and is the value against which secured lenders actually lend).  Because debtors would not be spending their own money but the secured creditors’, that will encourage wasteful and inefficient decision making and will make bankruptcy cases longer and more expensive.  This could also lead to a plethora of priming “debtor-in-possession” (DIP) loans, as third parties take advantage of the artificial equity cushion created by the lower valuation of prepetition lenders’ collateral.  This could materially disadvantage secured creditors.
  • The Commission’s proposed imposing a 60-day moratorium on 363 sales.  The LSTA believes that this proposal would harm the bankruptcy process by taking flexibility away from debtors and courts to address melting ice cube situations on a case-by-case basis.  Moreover, the Commission’s view is not based on empirical evidence of a problem: there is no reliable data demonstrating that bankruptcy sales realize less value for stakeholders than traditional reorganizations.  Similarly, proposals to impose limits on the terms of DIP loans will take away a debtor’s ability to agree to specific covenants in return for a lower interest rate and mean that lenders will require higher prices to compensate for the greater risk they are being asked to bear.
  • The Commission proposed instituting the requirement that senior creditors (including those that have not been paid in full) pay to junior creditors a redemption option value.  It would charge bankruptcy courts with the complex task of determining the value of the option.  The LSTA believes that the proposal would add enormous costs and complexity to the bankruptcy process, with little or no clear benefit.  The Commission’s proposal is premised on the notion that bankruptcy valuations systematically undervalue the debtor’s enterprise, but there is no reliable empirical support for that conclusion, and certainly none that would justify the added costs. 
  • There are also specific proposals by the Commission with which the LSTA agrees.  In particular, the proposals regarding credit-bidding, which would allow secured lenders to credit bid the value of their collateral even where such bidding could chill an auction; the cram-down rate of interest, which would require that any replacement loans and notes that are issued to a lender in a non-consensual cram-down plan of reorganization, would have to bear a market rate of interest; and the new-value corollary would all be helpful clarifications of and/or improvements to existing bankruptcy law. 

What has happened since the publication of the Report? 

While the Commission proposals were structured to be adopted as amendments to the current Bankruptcy Code, there is no appetite on Capitol Hill for corporate bankruptcy reform.   Indeed, the Judiciary Committees of both the House and Senate have largely ignored the Report; no hearings have been scheduled since the publication of the Report to discuss its findings and none have been scheduled.  The Commission appears to have pivoted to a different strategy, urging that its proposals should, where possible, be adopted unilaterally by bankruptcy judges in individual cases without legislation and that others be adopted by courts as best practices applicable more broadly. 

Is that strategy working?  The short answer is no.  Just eight cases in the past two years have directly cited the Report, and none of those citations endorse the proposals with which the LSTA disagrees; indeed, courts have tended to cite only those the parts of the Report with which the LSTA agrees or has no view.  For example, in In re Aéropostale, Inc., 555 B.R. 369 (Bankr. S.D.N.Y. 2016), the court agreed that the chilling effect of credit bids alone should suffice as cause [to limit credit bidding] under section 363(k). Id. (quoting American Bankruptcy Institute Commission to Study the Reform of Chapter 11, 2012-2014 Final Report and Recommendations 147 (2014)).  

Similarly, the Report’s sensible criticism of structured dismissals has proven influential.  Just in August, the court in In re Positron Corp., 556 B.R. 291 (Bankr. N.D. Tex. 2016) agreed with the Report’s criticism of structured dismissals.  The United States Trustee also looked to the Report to support its objection to a structured dismissal in In re Naartjie Custom Kids, Inc., 534 B.R. 416, 417-18 (Bankr. D. Utah 2015), although the court nevertheless granted the dismissal.  The Supreme Court is now reviewing the legality of structured dismissals in In re Jevic (Case no. 15-649).  The LSTA filed an amicus brief urging the court to overturn the use of structured dismissals that violate the absolute priority rule, a foundational tenant of the bankruptcy code. 

The other parts of the Report that have been cited cover a range of recommendations with which LSTA has no quarrel.  Courts that have expressed skepticism about the scope of Section 546(e)’s safe harbors have found the Report’s discussion of the purpose of the safe harbors persuasive.  At least one court has agreed with the Report’s criticism of the in pari delicto doctrine (when two parties are equally at fault).  Another court has agreed with its approach to capping rejection damages claimed by landlords.  In short, courts are supporting the Report’s conventional positions but the Commission’s more radical rethinking of bankruptcy has not taken root. 

Similarly, there is little new academic support for the Commission’s view of the role of secured credit in recent empirical studies, but there is support for the Commission’s more sensible recommendations.  For example, both the Commission and the LSTA recommended that the prime plus method for calculating cramdown interest rates adopted for chapter 13 cases in Till v. SCS Credit Corp., 541 U.S. 465 (2004), not be used in chapter 11.  A 2015 Article by Mark J. Thompson and Katie M. McDonough of Simpson Thatcher & Bartlett LLP deep dives into section 1129(b)(2), Supreme Court precedent, and longstanding practice to argue that Till is inapplicable to chapter 11.  20 Fordham J. Corp. Fin. L. 893 (2015). 

To be sure, while companies are entering bankruptcy more levered than they were decades ago, and fewer companies go through a traditional restructuring, recent studies suggest that these changes may be less the product of overbearing secured creditors than the unintended side-effects of the 2005 amendments to the code.  A recent study by Kandarp Srinivasan, Did Bankruptcy Reform Contribute to the Rise in Structured Finance? shows how BAPCPA’s expansion of the safe harbors led to a flash flood of securitization, which in turn created many of the assets that proved most toxic in the Great Recession[4].  Also looking at the impact of BAPCPA, Ken Ayotte has found that the changes to Section 365(d)(4), which shortened the amount of time that debtors have to accept or reject leases, significantly lower[s the] probability of reorganization for the most lease-intensive firms.[5]  Both studies suggest that any changes to the Bankruptcy Code can have profound and swift consequences for our economy.  Unless and until there is data suggesting that secured credit is creating specific bankruptcy problems, as opposed to problems related to the distribution of private property generally, reforms to the Code should be approached cautiously. 

Further counseling against materially reforming the Code is a recent study of retail bankruptcies from FitchRatings that suggests that secular challenges are driving one of the main sources of large-scale liquidations.  These challenges include e-commerce and discount retailers, declining mall traffic, and consumer spending shifts toward services and experiences, which, in turn, leave certain retailers without a real reason to exist.[6]  Discouraging secured lending or changing the rights of secured creditors in bankruptcy will have little impact on the overwhelming convenience of Amazon.com or consumer spending preferences.  Indeed, one could argue that swiftly and efficiently resolving companies that no longer have a place in the modern economy is a positive feature of the bankruptcy regime. 

Adding to the data suggesting that bankruptcy reform is unneeded, a recent study by Konstantin Danilov suggests that modern valuation practices tend to overvalue companies in bankruptcy[7].  Danilov first demonstrates that the Commission’s focus on companies’ absolute valuation, rather than their valuation relative to that of their peers, is deeply misleading.  Then he looks at 32 years’ of data and demonstrates that substantially more plans were confirmed when markets were overvalued.  In sum, the Report’s recommendations aimed at the alleged undervaluing of firms—especially the redemption option proposal—add complexity to the bankruptcy process without addressing a problem.  The bankruptcy code cannot change the fact that troubled companies in troubled industries are often worth only a fraction of what they were once worth.  It can create waste if it spends debtors’ resources on needlessly complex valuation processes rather than valuing debtors according to the same rules as their non-bankrupt peers. 

The Commission’s view is not without supporters.  The Commission’s proposals that deviate from the current absolute priority rule have found an ally in Douglas Baird.  In a forthcoming article, Professor Baird argues that relative priority, rather than absolute priority is better suited for reorganizations[8].  But not even Professor Baird blames secured creditors for the apparent changes to how bankruptcy operates.  He also recently published a descriptive study comparing modern bankruptcy practice to practice 30 years ago[9].  Although he finds that there are fewer reorganizations, and that equity holders are less likely to receive any distribution, he acknowledges that this does not mean that the outcomes became worse.[10]  Looking at why equity appears to receive less under modern practice, he notes that several changes to the management of corporations and managers’ understanding of their duties may lead them to be less zealous in negotiating deals for equity holders[11].  He notes that these changes might also explain some of the rise in Section 363 sales[12].  

Conclusion 

The Commission’s Report was an important and comprehensive study of Chapter 11.  Unfortunately, its admitted reliance on anecdote and perception rather than data and empirical research led to many unnecessary and potentially harmful proposals targeting secured credit.  In the two years since the publication of the Report, Congress has not taken up any of the proposals and neither case law nor new academic research have tended to support those proposals.  We continue to believe that, as Professor Jay Westbrook put it in his comprehensive study of secured creditor control,[13] [t]he idea that important recommendations will be made by the American Bankruptcy Institute Commission without hard data on the role of secured credit is problematic to say the least and might lead to wrongheaded reform.


[1] Elliot Ganz is General Counsel of the LSTA and Danielle D’onfro is a Lecturer in Law and Director of Continuing Legal Education at Washington University School Law School.  Mr. Ganz and Ms. D’Onfro collaborated on the LSTA’s response to the ABI Report.
[2] Available at www.abi.commission.org
[3] Available at http://www.lsta.org/uploads/DocumentModel/1860/file/lsta-abi-10615-final.pdf
[4] Available at, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2814717&download=yes
[5] Ken Ayotte, “Leases and Executory Contracts in Chapter 11,” 12 Journal of Empirical Legal Studies 637, 640 (2015)
[6] “Secular Challenges Spur U.S. Retail Bankruptcies”, available at https://www.fitchratings.com/site/pr/1012282
[7] “Are Chapter 11 Valuations Unfair? The Data Say No,” Wall Street Journal, Bankruptcy Beat, April 12, 2016. Available at http://blogs.wsj.com/bankruptcy/2016/04/12/commentary-are-chapter-11-valuations-unfair-the-data-say-no/
[8] “Priority Matters.” 165 U. Penn. L. Rev. __ (2016-2017)
[9] “Chapter 11’s Expanding Universe,” 87 Temp. L. Rev. 975 (2015)
[10] Id. at 980
[11] Id. at 983
[12] Id. at 984
[13] Jay Lawrence Westbrook, Secured Creditor Control and Bankruptcy Sales: An Empirical View, 2015 U. Ill. L. Rev., 845.

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