June 30, 2021 - By Elliot Ganz. Much ink, here and elsewhere, has been spilled about the decline in loan market norms over the past few years. One major driver, according to the theses of several law professors in two recent law review articles, is the breakdown of norms in restructuring and bankruptcy practice. In an article titled “The Rise of Bankruptcy Directors”, Jared Ellias, Ehud Kamar and Kobi Katiel show that many distressed companies, especially those controlled by private equity sponsors, prepare for bankruptcy by appointing bankruptcy experts to their boards of directors and give them the power to make key bankruptcy decisions. These supposedly independent directors (who are usually appointed repeatedly) often seek to wrest control from creditors of self-dealing claims against shareholders. In a second paper, “Purdue’s Poison Pill: The Breakdown of Chapter 11’s Checks and Balances”, Adam Levitin argues that the procedural checks and balances of bankruptcy are breaking down because of three interconnected trends: increasingly coercive tactics, the inability to appeal bankruptcy court decisions, and the ability of debtors to hand-pick the presiding bankruptcy judge. Following is a brief, high-level review of the two articles that describe the “weaponization” of bankruptcy and restructuring. Next time we will look at the authors’ proposed solutions.
In “The Rise of Bankruptcy Directors”, the authors reviewed hundreds of Chapter 11 cases filed between 2004 and 2019 and calculated that the rise of independent director appointments surrounding bankruptcy rose dramatically, from 3.7% of cases in 2004 to 48.3% in 2019. Half of the cases in which directors were appointed included portfolio companies backed by private equity firms. What is the significance of these appointments and how are they chosen? Bankruptcy directors are usually appointed in the months leading to the filing for bankruptcy and are given the power to make core bankruptcy decisions, such as negotiating the financing for the bankruptcy case. In about half the cases examined by the authors, the bankruptcy directors also investigated claims against company insiders. While creditors often begin their own investigations after the filing, according to the authors “they are racing against the clock as the bankruptcy directors typically negotiate a quick settlement and argue that the court should approve it to save jobs.” By appointing supposedly independent directors, the PE firms and their lawyers ”seek to use the asserted objectivity of these directors to wrest control of the self-dealing claims against shareholders from the creditors committee and the court.” The authors note that many of the directors are “super-repeaters”, on average being appointed in 17 cases each (with one director having been appointed in 96 cases (31 of which were associated with companies in bankruptcy) and that most of these cases have ties two leading bankruptcy law firms. The authors find that unsecured creditors on average recover 21% less when a company appoints such directors and conclude that the data support the claim that “bankruptcy directors are a new weapon in the private-equity playbook”, allowing sponsors to extract value from portfolio companies in self-dealing transactions.
In his recent article, “Purdue’s Poison Pill: The Breakdown of Chapter 11’s Checks and Balances”, Professor Adam Levitin homes in on the Perdue Pharma bankruptcy (which he believes is the most “socially important” bankruptcy case in history) as an example of a much broader breakdown of Chapter 11. Levitin posits that the convergence of three trends, including increasingly coercive tactics by debtors, the inability to effectively appeal bankruptcy court decisions, and the ability of debtors to hand-pick the actual presiding judge, has served to undermine the Chapter 11 process.
Noting that the bankruptcy process is deliberately designed to be coercive, Levitin asserts that the frequent use of pre-bankruptcy tactics such as super-quick pre-pack arrangements, Restructuring Support Agreements, pre-arranged DIP loans, asset sales, and the selection of stalking-horse bidders have made the process faster and ever more coercive. Levitin makes two important observations: coercive tactics are nothing new, but bankruptcy practice tends to “normalize” each new aggressive tactic. And, while none of these tactics is problematic by itself, when combined with the “increasingly illusory nature of appellate review” and the ability of debtors to handpick the judge for the case, all checks and balances to coercive behavior dissipate.
And what of appellate review? Levitin identifies several reasons why appellate review of bankruptcy cases is illusory. First, appellate remedies are very limited for some of the most important transactions in bankruptcy, including DIP financing and Section 363 asset sales; even if a sale or financing order is ultimately overturned on appeal, “the improper sale of financing itself cannot be reversed”. Second, since valuation issues, among the most important in bankruptcy cases, are largely determinations of fact, appellate courts are very unlikely to overturn them. Third, appeals are very slow and costly, often involving two levels of review (federal District Court and then Circuit Court) and often requiring the posting of an expensive bond. Last, two doctrinal obstacles significantly limit appellate review. First, the requirement that only “final orders” can be appealed “means that certain extremely important rulings …cannot be appealed in a timely fashion.” Perhaps most importantly, the judge-made doctrine of “equitable mootness” makes many appeals impossible to prosecute. In a nutshell, as the 3rd Circuit put sit, courts often do not entertain an appeal once a plan of reorganization is confirmed because “of its feared consequences should a bankruptcy court’s decision approving a plan confirmation be reversed.”
The third trend that contributes to the breakdown is the ability of debtors to choose the presiding judge. Levitin notes that venue shopping has long been a tactic used by debtors to gain an advantage but with the development of case assignment rules in several jurisdictions (notably the Southern District of Texas, Richmond, VA, and, effectively, the Southern District of New York), debtors are now able to hand pick a single judge or be guaranteed one of two judges. Indeed, Houston has become the dominant district for mega cases and, together with Delaware and New York, presided over 84% of all big cases in 2020. Just three judges handled 57% of all public company bankruptcy filings in 2020, one of whom, David Jones of Texas, handled 39% of all such cases alone. Levitin asserts that the assignment of so manty mega cases before a small number of judges concentrates an enormous amount of power into the hands of a small number of judges and raises issues of perceived impropriety given that debtors (like Perdue Pharma) pick judges whose precedents seem favorable and whom they believe will rule favorably on key issues. He also believes that concentration “captures” the repeat players who tend to participate in these bankruptcy cases. Lawyers who know they will face the same judges over and over are loath to make waves.
Before offering solutions, Levitin concludes by tying the three issues together. “Judge-shopping would be a problem on its own, but in conjunction with the lack of appellate review and debtors’ inclination to pursue ever more coercive and overreaching restructuring maneuvers, it has the effect of undermining the basic procedural integrity of the bankruptcy system.” Such a system, he writes, “upsets Chapter 11’s carefully calibrated balance between debtor and creditor rights…”
The problems outlined in these two articles profoundly impact the syndicated loan market. Next time we will review the author’s proposed solutions and discuss whether and how they can help restore some of the loan market norms we used to take for granted.