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Wednesday, September 24, 2014

False Premises of Bankruptcy Reform Agenda

The ABI Commission on bankruptcy reform has posted a short video that "identifies some key findings of the Commission to date." The purpose of the video, I suppose, is to try to begin to justify in advance the reforms the commission has been crafting since it was self-appointed in 2012, which are likely to be designed to transfer value from secured creditors, and lengthen the time and increase the cost of chapter 11 proceedings, and shift those to the secured creditors. The video should appear below, although my embedding skills are rudimentary at best: If for any reason there is no video above, it is currently on the commission home page, http://commission.abi.org/ .

The "findings" mentioned in the video are not factually supported, but are just false premises created to rationalize the anti-secured-claim agenda that the professionals who dominate the commission (there are virtually no clients, debtor or creditor, on the commission) have been sponsoring since the commission's earliest days.

For example, once the first few frames of vapid generalizations pass, one comes to the assertion that there is an "emerging consensus" that the Bankruptcy Code needs to be modernized. I have followed the commission's "field hearings" and see nothing of the sort. I have seen various constituencies expressing their points of view, which are often varying and opposed. There is no consensus among them at all. Any claim of consensus - which just happens to match the pre-existing viewpoints that dominate the commission - is just self-justifying and not objective fact.

Some of the quotes that the video displays to demonstrate the purported consensus are downright dieceptive.  For example, the video quotes one Danielle Spinelli to the effect that " there does appear to be widespread concern that the expansion of secured credit has had a deleterious effect on the bankruptcy process...." That quote is excerpted from a statement Spinelli read at a field hearing in November 2012, as a representative of the Loan Syndication and Trading Association (LSTA), not an organization likely to have argued for negatively impacting secured debt. When you read the statement as a whole, it is clearly taken out of context: Spinelli was describing what she observed to be transpiring on the Commission, not concerns that she shared or perceived to be emanating from anywhere else. She then proceeded to defend secured creditors' rights to credit bid. It's alarming that the Commission would stoop to such intellectual dishonesty to advance its agenda as to twist the words of a witness in that fashion.

Another sorry misrepresentation is the claim made in the video that "Debt and capital structures have grown more complex due to multiple layers of debt and complex intercreditor agreements not imagined in 1978." This is just nonsense with no factual support. The capital structures of today are not meaningfully more complex from those of the 70's and 80's when the Code was first crafted and implemented. A typical capital structure of a typical chapter 11 debtor may have a first and second lien secured by all domestic assets and a pledge of 65% of the foreign subsidiaries; there may be a layer of structurally or contractually subordinated unsecured debt and the equity. That capital structure differs little from the ones that appeared in pre-Code case law. For example, if you look at the capital structure of the Depression-era debtor described in my last post, you'll see a virtually identical capital structure, save only the stock pledge. That is not a meaningful increase in complexity. If anything, the older case presented more complexity because the first liens did not overlap the collateral held by the junior lien, and thus separate valuations were required of the different collateral packages; whereas, today, one merely has to value the entire enterprise one time and then follow the order of priorities.

And the reference to intercreditor agreements being more complex is another red herring. I had the unpleasant duty off and on in my associate days in the 1980s of reading collateral trust agreements and other intercreditor agreements and the subordination provisions of old-time indentures in various utility, transportation and manufacturing companies. Today's provisions may have different focal points, but they are not at all more difficult to work with than those of the earlier era. In many ways, because they are written with current law in mind, they are actually easier.

If cases had indeed grown more complex, one would see that reflected in cases taking dramatically longer. But they don't. The distressed debt market would show wide bid-ask spreads and low liquidity as investors were scared away. But it doesn't. The bit about increased complexity just has no objective support.

A lawyer is quoted complaining that "new lending" and "aggressive investing" have made it "significantly more difficult to restructure successfully in chapter 11". Again, there is no documented evidence to back that up. The chapter 22 phenomenon has not meaningfully changed over the life of the Code. Airline recidivism, for instance, has dropped precipitously since the early days of the Code.  And when a chapter 22 does occur, it is implausible that its occurrence can be confidently attributed to chapter 11 having failed to afford a "fix" for the business the first time around; equally or more plausible alternative explanations would be: (1) the business suffers from problems beyond the capacity of a legal fix (e.g., a lack of sales, or a misguided and expensive construction project, or a failed merger); (2) the first 11 should have been converted to a 7 to begin with; or (2) the balance sheet of the reorganized debtor should have been more conservative with the consequence that more junior constituencies should have seen their recoveries reduced or eliminated.

This lawyer's lament may reflect to some extent the economic reality that, when a debtor enters chapter 11 over-encumbered, a 363 sale tends to end cases sooner than some constituencies, including bill-by-the-hour professionals, might find in their interest. The argument appears to be that, in some hypothetical scenario that the secured creditors are cutting off, the company would somehow stay longer in chapter 11 and by doing so fix itself thereby enabling more creditors, or even equity, to recover. It is of course impossible to prove a negative, that is, to prove the imaginary alternate universe would not happen. But the burden of proof should be on those seeking to change the status quo that has worked well. I suspect that a sample of non-professional persons with chapter 11 experience - the executives and creditors, I mean - will find very few proponents of the idea that longer stays in chapter 11 are systematically better for businesses. The truth, as opposed to the myth that the self-interest of bankruptcy professionals aligns with, is that solvent companies "fix their businesses" all the time outside of bankruptcy court with far less professional expense. My post last fall about the SiriusXM restructuring makes this point in greater detail.

Except for the power to reject bad leases and contracts, there is really very little in the mythical "bankruptcy toolkit" that companies need to make operational fixes. Indeed, the principal operational fix that companies do - headcount reduction - is not something that anybody should be encouraging more of in chapter 11. I suspect the proponents of the "missed opportunities to fix businesses" would have a very hard time coming up with concrete examples of things companies can only do in chapter 11 and would actually do if they spent longer in chapter 11, other than taking longer to reject leases.

Ironically, a slide that complains too many cases end in a "quick sale or recapitalization" is promptly followed by two other slides that complain that chapter 11 cases have grown "too complex and expensive" and "too slow and costly". These positions are difficult to reconcile (unless the commission is going to propose radical changes in professional compensation, which seems unlikely given its makeup).

In fact, there is no evidence that cases have grown more expensive. In aggregate dollars, perhaps, but that is partly due to inflation and partly due to the vast increase in the size of the companies going through chapter 11. By a more useful metric, e.g., professional costs as a percentage of the liabilities resolved in chapter 11 cases (which is the fundamental point of reorganizing businesses), the reorganization process has gotten significantly cheaper, which makes sense. as more issues have been clarified over time by the courts and there is less to litigate, other than valuation. And I struggle to understand how a "quick" resolution of a problem is something the average citizen not in the bankruptcy industry should be upset about.

What has really happened is chapter 11 has grown more efficient, in large measure due to the resolution of various issues by the courts, both in the form of reported opinions, and also in the maturation of custom and practice in the major venues. The other source of efficiency is the greater role of market-driven creditors, who have produced a dramatic increase in reorganization efficiency with no adverse effects on operations or workforces. Like many industries in the 21st century, the bankruptcy professional industry has to adapt to an environment of increased efficiency. Seen in this light, the so-called reform agenda starts to look like a special interest group trying to use the legislative process to protect its economic position against the forces that affect the workforce generally.