Monday, November 17, 2014
A Dozen Reforms the ABI’s Bankruptcy Reform Commission Report Should Endorse
The ABI’s self-created commission to explore alterations of chapter 11 of the Bankruptcy Code is scheduled to deliver its report next month. To the extent the recent public statements of its co-chairs are representative, the commission appears to continue to be adhering to its initial agenda of weakening secured creditor’ rights on the premise that, as one of them told the Wall Street Journal, there has been an "'unmistakable’ progression of secured lenders’ power in bankruptcy.”
As I have repeatedly written, the word “unmistakable” is about the last one any unbiased observer would apply to claims that secured creditors have increased their advantage or unsecured creditors’ recoveries have declined meaningfully in recent decades.
1) Large corporate reorganizations in earlier eras often generated recoveries only for secured creditors. See my writeup of the Denver & Rio Grande railroad reorganization for instance.
2) Persons closely tied to the formulation of the current Bankruptcy Code in 1978 published articles at the time explaining that secured creditors would receive very strong protection under the new Code. That was the quid pro quo for subjecting them to comprehensive bankruptcy laws for the first time in the nation's history.
3) Claims of some kind of adverse change in the relative outcomes of secured and unsecured creditors are premised on a woefully mistaken analysis prepared by a law student with no experience of any sort, which has been brandied about without critical examination solely only because it serves the agendas of a number of different constituencies.
Rather, far from going astray in the past two decades, chapter 11 has actually become modestly more efficient in fulfilling its public purpose of reorganizing operating businesses with minimal disruption of the debtor’s operations and the constituencies who flesh out those operations. Part of this is due to the natural development of case law resolving statutory ambiguities and conflicts, fleshing out statutory standards or filling in statutory gaps, but a large part of it is due to the increased activity of distressed debt investors, which has led to more accurate and reliable valuations informed by secondary market liquidity and pricing, and that in turn has expedited plan negotiations and the resolution of the legal case. In addition, the impact of bankruptcy on smaller creditors has been greatly lessened due to the widespread use of first-day orders and other efficiencies. Although there are one or two substantive aspects of chapter 11 that I think could use a dose of reform, in general, I think the process of chapter 11 works far better today than it did during its first decade. Much more debt is being restructured either per day in bankruptcy or dollar of professional expenses than in restructuring’s early years. That's increased efficiency. Thus, I see no genuine case for reform, although there may be political or economic agendas that lead to calls for it. It's the classic question of public interest versus an industry's interest: the public at large gains from a more efficient resolution process, whereas various constituencies would benefit from making the process more inefficient or expensive, and getting secured creditors to absorb the increased cost.
In contrast, I think the most helpful thing the commission could accomplish would be to increase the Code’s efficiency and make it a more efficient mechanism for sucking excess debt out of the real economy. This would entail just two steps: first, to codify the best practices and ideas that have been developed in regard to those determinations that are most frequently litigated, thereby cutting down on uncertainty and variability and making cases more predictable and efficient; second, drawing upon the commission members’ real-world experience to cut through the myths and incantatory rhetoric that shroud certain formalistic, inefficient and wasteful practices in chapter 11 to, again, make it more efficient.
But before one even gets to the Bankruptcy Code, there is one reform of a different law that would make a huge difference in bankruptcy dockets, and that is, in the fashion of recent practice in sovereign debt issuance, to revise the Trust Indenture Act of 1939 to eliminate the need for 100% consent to compromise principal and interest payments in favor of a lower, but still quite high, super-majority threshold.
Now, turning to the Code itself, there are several obvious areas where the efficiency of reorganizations could be increased nationwide by codifying what are now a patchwork of individual districts' practices.
1. Codify First–Day Practice
This is an obvious and, I expect, uncontroversial reform. There are well-established procedures, forms and parameters for “first-day” and “second-day” orders that have been developed in Delaware and SDNY to pay numerous types of pre-petition claims generated in the ordinary course of business, and to insulate employees and other non-financial constituencies from the potential ill effects of a bankruptcy. These are beneficial to society as a whole because they reduce the scope of disruption from a filing and also enhance going-concern prospects. Obviously, any reform should ensure they remain subject to the consent of those who are called upon to foot the bill, i.e., the holders of cash collateral and the representatives of unsecured creditors. Enacting these practices into law will also enhance the administration of chapter 11 cases in venues outside of Delaware and New York, where occasionally less experienced judges get bogged down by formalistic doubts about the statutory authority for these eminently sensible motions and applications. It should be made unmistakably clear that pre-petition debts, secured or unsecured, can be paid post-petition in accordance with their terms, or consistent with the ordinary course of business pre-petition, without the need for motion practice or court approval, if the debtors’ business judgment is to do so, but subject to the consent of anyone whose cash collateral is being used to do so, and the unsecured creditors’ committee.
2. Codify Section 363 Practice
Section 363 sales are, economically, a perfectly sound way to resolve a distressed situation, when they transfer the operating business to a new entity and leave the legalistic, litigious bankruptcy process to deal only with disputes over the proceeds. Formalistic objections that are sometimes raised (“it’s not a plan’; “there’s no disclosure statement”; “it’s just helping the secured creditors”) are just that: formalistic, non-economic, non-substantive, matters of taste. There is nothing morally or inherently wrong with a resolution called a “sale” as opposed to a “plan”. Disclosure is a red herring in the plan process anyway (see point 4 below) and thrusting disclosure statements and voting into a sale process would make for useless inefficiencies. A case that removes the risk of insolvency from an operating business efficiently is a net positive for the economy at large, even if that produces no recovery for unsecureds, if that’s what the economics lead to. Value is what matters for recoveries, and concerns for “fairness,” whatever that means in the context of battles among different pools of capital, can be addressed by making sure junior constituencies get a fair chance to bid if they are at risk of being squeezed out. But this efficient method of resolution of financial difficulties should be cemented into the Code so that it can be implemented consistently and without confusion, in all districts. Issues like the ability of first lien lenders to credit bid post-Fisker, or the parameters of bidding protections, or whether a distressed company has to open its books to a competitor who may not be acting in good faith, should be codified so that the process becomes completely predictable in all districts.
If optically helpful, a new chapter could be created to contain the rules for sales of all or substantially all of the debtor’s operating business. It could provide timelines that are safe harbors, codify the authority of the buyer to select which pre-petition liabilities to assume, etc.
3. Codify third-party release terms.
This should be another non-controversial reform as the content of permissible third-party release terms is pretty well defined in the major districts and has received substantial judicial and U.S. Trustee attention. Again, codifying the state of play would make the best practices nationwide and further the efficient administration of reorganizations in other districts. As with first-day practice codification, making third-party releases uniform across the nation will indirectly address venue concerns, by minimizing uncertainty of plan proponents and constituents.
4. Codify 1129 Practice, but also Create A Few Clear Rules and
Safe Harbors to Streamline Confirmation Proceedings
Issues like post-petition interest, the 100% cap on senior classes’ recovery, the need for competitive bidding on new value plans, deference to market evidence in fixing cramdown rates, and other like issues have had judicial development since the Code was enacted and best practices should be codified. Further, clear rules should be enacted limiting the participation of out-of-the-money constituencies in confirmation litigation at the estate’s expense. Safe harbors should be specified such that, if a plan contains them, it is presumed to satisfy the corresponding confirmation standard, much as the Code now does for priority tax claims. For example, broadly accepted valuation methodologies could be safe-harbored, certain debt-service ratios could be presumed feasible.
More ambitiously, as opposed to the current treatment of out-of-the-money classes, which now have to be solicited if they are offered anything, and so are often given nothing and deemed to reject, a safe harbor could be created that deems the first out-of-the-money class to accept if they receive a standardized upside participation in the reorganized debtor, like warrants for X% of its equity with a strike price that implies full recovery for the senior classes). Also consideration should be given to establishing a clear rule on debt at emergence to mitigate the risk of chapter 22 -- say, for example a plan is presumed not feasible if it provides for debt > 4X last 12 months EBITDA.
5. Codify Clear Criteria for Substantive Consolidation Under Plans.
Deemed substantive consolidation is a reasonable approach to classifying claims and defining distributions in large complex chapter 11 cases where multiple debtors are liable to the vast majority of creditors. It usually reflects the reality of how creditors have interacted with and evaluated the creditworthiness of the debtors as a whole. But there really is no substantive basis for it – nothing in the Code speaks to it in any explicit way, and the judicial criteria for true substantive consolidation are extremely expensive to investigate and litigate. So a very efficient reform would be to write a clear, simple rule for when it is permissible (or required) for a plan to effectuate a consolidation just for purposes of the plan: just by way of illustration, such a rule might be that, when more than 75% of the assets of the debtors are held by debtors who are jointly and severally liable for more than 75% of the group’s funded debt, those debtors can be deemed to be one consolidated debtor for purposes of the plan.
Those are the codification suggestions. Now, more controversially, here are three suggested reforms that fall under the heading: "Scrape Away the Pieties and Dogmas and Look Reality in the Eye":
6. Stop Pretending that the Disclosure Statement Matters.
Whatever the vision that informed the Bankruptcy Code at inception, in practice the disclosure and voting process in chapter 11 cases is a sideshow and a formality. Far from being a failure, this is actually a testament to the effectiveness of other mechanisms for creditor involvement earlier in the process, such as official creditors' committees and cash collateral budgeting. By the time a disclosure statement is filed, the major constituencies have seen the data and analyzed it, their deals are done and the outcome is not the least bit in doubt. So the truth is, what is in the disclosure statement or not has no effect on the reorganization. The real decision-making and the concomitant disclosure happen well before the disclosure statement hearing, in emails among financial advisors, and in conference rooms and conference calls where presentations are made and analyzed by the key constituents and their advisors. The disclosure statement is in fact, whatever legal weight may be assigned to it, merely a record for posterity of what the debtor and the supporters of its plan have come to a consensus on. I doubt that anybody reads the disclosure statement except the professionals who create it. I don’t think I have ever known a judge to read the whole thing. Many of the sections are merely recitations of past events that are otherwise memorialized in one public repository or another. The hearing on its adequacy is at best a status conference for the judge to learn who is not on board and what the issues at confirmation are going to be. So let the judge hold whatever status conference s/he wants to, but cut the document that goes to creditors down to just a short plan summary, term sheet proxies for its exhibits, the financial projections and the going concern valuation. That is all that anybody really reads and it will get rid of the silly process of people filing objections that are speaking briefs for confirmation.
7. Recognize that Management is Biased – But Its Bias Is Consistent with Public Policy
The Code, and many pro-debtor judges, treat debtors in possession as if they were neutral fiduciaries. But it’s an open secret that management has an incentive to come out of bankruptcy with the most conservative capital structure possible. It makes their job easier and also makes any equity package they negotiate for themselves more valuable. This benefits senior creditors, to be sure, at the expense of potential upside for junior creditors. Everyone in the process knows this.
Two corollaries flow from it in regard to reform: 1) this is not necessarily a bad thing, because there is a public interest in seeing companies emerge with conservative balance sheets as opposed to having chapter 22’s due to insufficient de-leveraging in the first reorganization. A conservative capital structure actually furthers that policy, as long as it is in good faith, even though some constituencies suffer.
But the key is, are these plans and projections in good faith or is the debtor sandbagging revenue and expense reduction opportunities until post-emergence? Is there a consolidation that might generate higher value?
So, 2) let’s recognize this bias exists, and stop giving non-disinterested debtors such a controlling role in plan promulgation. Create a mechanism that, in an orderly fashion, previews recoveries to the court at an early stage and, if it appears that some significant constituency is going to be left out of the money, empowers the court to obtain an independent expert review of the projections, strategies and assumptions well prior to confirmation, and then -- if he or she is not satisfied with the conclusions of the review -- to authorize the pursuit of alternatives. Some activist judges do this already but it should be formalized to supply best practices, rather than ad hoc. Courts should encourage out-of-the-money constituencies to supply ideas and alternative perspectives to whomever the court appoints to perform the independent review.
8. Conform the Law to the Reality of Real Estate Chapter 11’s
Most real estate chapter 11 cases are just changes in ownership, with no impact on unaffiliated constituencies such as employees or trade creditors, and there is no benefit from any kind of a plan process. Often, the plan process just delays and makes more expensive the inevitable outcome of the first lien taking the property back. This reality should be faced up to and all real estate cases, save those with some appreciable proportion of trade debt, should be shuttled into orderly 363 sales to the highest bidder with the mortgagees being able to credit bid. Not just single-asset real estate. All real estate businesses – hotels, apartments, office complexes, malls, etc. If they don’t have a sufficiently large component of operating creditors, run them as orderly sales. This prospect will certainly reduce the number of bad faith, eve-of-foreclosure filings, gerrymandered voting plans, and absurd “Till in chapter 11” litigation.
The next three provisions can be loosely grouped under the theme of "cutting back on expense and bullshit".
9. Let Judges Bring Common Sense to Examiner Provisions
This is another reform that should be noncontroversial. Often the examiner motion is made for ulterior motives related to the prospective terms of a plan and solely to delay. Judges should have more discretion to squelch examiner motions late in the game. On the other hand, judges often use “examiners’ as “deputy bankruptcy judges” or mediators and thought should be given as to whether this is a sound practice. It’s certainly an expensive one. Last, perhaps more controversial because it would limit professional fee opportunities, examiner investigations are often duplicative of work either the unsecureds can do or have done (such as fraudulent transfer analysis), or the Justice Department or other governmental actor or the plaintiffs’ bar is contemporaneously doing, and the Code should inhibit such duplicative tasks. The examiner’s report in the Lehman bankruptcy is an extreme example of this problem, in that the examiner, one presumes in all good faith, ran up a bill of over $50 million to investigate matters that were separately investigated by multiple other private and public sector actors and generated a report of absolutely no consequence to the reorganization at all. That should not be allowed to happen again.
10. Eliminate 544(b) in Favor of a Uniform Federal Substantive and Procedural Standard, Which Should Be Modified to Eliminate Financial Speculation on Costly Litigation
One of the biggest fee-generators in a large chapter 11 is the pursuit of constructive fraudulent transfers. Of course, “constructive fraudulent transfer cases” have nothing to do with “fraud” – that is separately covered by laws voiding intentional fraudulent transfers. Rather, they are just attacks -- incredibly expensive hindsight attacks -- on valuation or on affiliate guarantees or other structural or documentary matters that are staples of sound credit policy. A case like the TOUSA fraudulent transfer litigation, for instance – it cost millions of dollars and many hundreds of hours of judicial branch resources and what real-world good did it accomplish? It just moved money around from one group of lenders to the enterprise to another group of lenders. It was really just a giant, bloated preference action in effect, if not in name. What federal policy would encourage investing tens of millions of dollars and hundreds of hours of judicial resources for nothing more than moving the recovery around between different sets of financial institutions, as opposed to the much less expensive option of living with the structure as it lay when the bankruptcy filing occurred? None that I can see, although it did generate good income for the professionals involved.
Because of 544(b)’s incorporation of state law (without specification of a clear rule for ascertaining which state), those attacks frequently produce excessively complicated, fee-generating issues of choice of law, deliberations over differing statute of limitations, and debates over whether 544(b)’s requirement of an unsecured creditor with a valid avoidance action exists or not. Those disputes are not consistent with the Constitution’s concept of a “uniform” law on bankruptcy or with the need for economy in administering a bankruptcy case. No cognizable federal purpose is served by these collateral procedural disputes. They simply delay the resolution of the merits and increase the cost of getting to that point. They should be eliminated by striking 544(b) and focusing instead on the federal counterpart, currently found in 548(a).
But even the federal substantive law needs refreshing. First and foremost, the alternative remedy of avoidance of the transfer – which transfer often occurred several years before the judgment might be entered and may have involved a large diverse quantity of assets and people – is outdated, impractical, and needs to be eliminated in favor of a simple damages award.
Secondly, to eliminate unproductive and inequitable speculation in lawsuits of this type, that simple damages award should be set by a fixed formula: the amount owed at the time of the chapter 11 filing to creditors on those claims that existed at the time of the transfer, and who did not finance the harmful transfer, plus interest and the plaintiff's costs of litigation. That wlill make them whole, no more, no less. Further, the payments should be made directly to the damaged creditors or their assignees, so that their recoveries are not diluted by other claimants of the estate that suffered no harm and may have financed the transaction in the first place.
By "inequitable", I mean the Moore v Bay paradigm whereby the existence of one unsecured claim with an avoidance action, no matter how small, enables the estate to seek to go after the entire transfer, even amounts well in excess of that needed to make the injured creditor whole, whereupon investors who are strangers to the case go out and acquire other claims against the estate, which may have had no injury from the transfer and may in fact have financed it to profit from the lawsuit). On top of that, you sometimes get cases, like Mirant, where a plan provides a 100% payout to unsecured creditors and yet fraudulent transfers are still pursued because the Code has been formalistically construed to require only benefit to “the estate”.
In other words, repeal Moore v Bay and have prosecution of avoidance actions be a creditors' remedy, not the estate's. These simple changes would end the unproductive and inequitable exploitation of antiquated legal rules for financial speculation.
11. Pay Professionals out of their Constituencies’ Recoveries.
Some of the Commission’s hearings have had to do with ways to control expenses in bankruptcy. Right now, unsecureds and equity committees consistently get paid out of cash collateral of senior secured creditors, and, in turn senior secured and DIP creditors get their professionals paid on top of principal and interest, which fees ultimately reduce unsecured recoveries. The combined effect is that no constituency has the combined ability and incentive to limit any professionals' activities, and thus expenses are essentially uncontrolled. I think the best solution that has been suggested, and even on rare occasions already implemented, is that, while all constituencies should have the right to appear and be heard through professionals, they should also have bear their own professional costs out of their own plan recoveries. Internalizing professional expenses will give every constituency an incentive to present only plausible arguments and theories and refrain from fishing expedition discovery, and in turn that will serve to streamline the proceedings considerably.
This last idea can simply be filed under "The Impossible Dream "
12. Treat Every Single Legacy Employment Claim as General Unsecured.
Finally, a reform that I think would be appropriate given the patchwork nature of the Code and of the circuits’ interpretation of it would be to treat all legacy employment claims as pre-petition general unsecured claims. By legacy, I mean pension, retiree medical, WARN, general employee litigation, indemnification of officers and directors for pre-petition litigation, and the like. . Right now, retiree medical claims are privileged as to priority for no sound policy reason given the existence of multiple Federal and State health insurance programs like Medicare, Medicaid, Obamacare, and so on; pension modification usually requires a separate non-bankruptcy litigation with the PBGC; the priority WARN claims receive varies based on facts and circumstances that may be litigated; indemnification claims are often upgraded under the plan because they can be, and no one wants to alienate the management. All of them should be seen as what they are, relative to the purpose of chapter 11 to reorganize the business in the way that makes it the strongest contributor to the economic future of the nation and the local communities: they are legacy liabilities that should be separated from the going concern, not burden it going forward. But politically, I would doubt very much that anything that put retirees behind reorganization would have much chance of success, so I left if off the list as a concession to that political reality.