The crux of the proposed changes to distributions of value to secured creditors under plans and in 363 sales is to create a "redemption option premium" ("ROP" for shorthand), the definition of which has been carefully labored over and resembles ideas that have kicked around outside of the commission for a few years. In broad summary, because it really is a very, very long definition, the immediately junior class to the class or classes receiving the "residual value" of the reorganized debtor would be entitled to receive value (form undefined) equal to the price (to be determined using the Black-Scholes option pricing method which I will discuss a little bit below) of a 3-year option with a strike price equal to the payoff amount for the entire senior debt plus interest at the non-default contract rate for the full three years. A couple of simple examples involving just one level each of secured and unsecured debt are sketched out in the report and it is asserted that where the senior creditors are recovering, say, 50% of their claim under the plan or sale, the impingement on their recovery would be quite small, and where they were recovering 90% of their claim, it would be larger.
However, the size of the proposed option - an option to buy "the entire firm" is a radical change from present practice where the norm might be to offer the obviously out of the money class a sub-10% equity stake or a warrant to buy a slightly larger stake, or at best a combination of both. So that is a several-fold increase that would certainly affect plan bargaining. True, the workings of the option pricing model will cause the value of the option premium itself to be a similarly small percentage of the total enterprise value, as I will demonstrate below, and the senior stakeholders may choose to dole out the value in another form. But, as I will show below, the opportunity for an out of the money class to come out of a bankruptcy with of an option to buy the entire reorganized debtor could lead to overly levered capital structures and also to otherwise irrational claims trading in the case itself.
Further, at fn. 763, the report observes that the requirement would "in theory" (whatever that means in this context) have to take precedence over contractual subordination. No policy justification is offered for these demands, they are merely logical implications of the concept of a forced transfer of value down the priority chain. They seem almost petulant, in all honesty, The whole purpose of contracts is to allocate risk. Subordination is just a form of insurance - why eliminate insurance held by senior secured creditors but not insurance held by other kinds of creditors? Yes, bankruptcy law authorizes breaking contracts - but those are the debtor's contracts; they're to be broken only to the extent they impede the debtor's reorganization, which insurance doesn't do; and in any case, the non-debtor counterparty is supposed to get a claim for damages from the breach and its allocable share of reorganization value to compensate it for the federal government destroying the contract. This aspect of the recommendations is especially radical and indefensible. The ideas of (a) wiping out deficiency claims that would be in the money if separately documented, and (b) wiping out contract claims against a non-bankrupt also raise a host of Constitutional questions.
The report itself, at p. 211, acknowledges that the ROP "requires further development", i.e., it's not ready for prime time and should not be considered ready to go into effect. And I think this post illustrates the accuracy of that recognition. To me, overall, the gain is not worth the candle, But, I could imagine that the ROP might -- if (a) it were simply a measure of value that you can pay a junior class to deem it to accept, and not an actual option to buy the firm, (b) it required the consent of the senior class making the give-up, and (c) were very clearly defined and allocated by statute -- be a useful option for plan proponents to get cases over faster. It would turn into a sanctioned form of "gifting" -- which ironically elsewhere the Commission rejects (which is a whole other angle for criticism of the ROP -- if voluntary gifting is bad, why is mandatory gifting good?). All these other radical changes would then be unnecessary, as it would be a voluntary give-up of the package of ROP value, deficiency claims, contractual subordination, and, since it would be voluntary, you would not need to remove 1129(a)(10) from the Code and it could keep on doing its useful job of streamlining the plan formulation process.