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Monday, July 27, 2015

Redemption Option Premium, Part II: Chapter 11 Valuation Dates are not "Arbitrary".

Last fall when the ABI commission on Bankruptcy Reform came out, I wrote a post about its proposal that out-of-the-money junior classes be thrown a bone in chapter 11 plans by instituting a "redemption option premium" ("ROP") that would require bankruptcy judges in a cramdown context to value a hypothetical three-year call option on the reorganized debtor at a price that would pay off all claims senior to that class in full.  As the commission's principal justification for the proposed mechanism was that it would be a superior alternative to what it portrayed as time-consuming and costly cramdown valuation litigation, I expressed the view that it was not nearly as efficient as portrayed because (a) it did not preclude anyone else in the case from precipitating the kind of litigation we have now, and (b) it was itself so complex that it would, in practice, require the same evidentiary inputs, and be as contestable, as the cramdown practice we have now. You can't value the ROP until you have valued the company, so you don't skip any valuation litigation.

Nor did I find, when doing some calculations of a hypothetical chapter 11 debtor, that it was generating a large amount (in fact, looking back, I should have noted that the premium value would often be less than the professional fees debating it might run up) so that the gain was hardly worth the candle.

The ROP proposal is tied, implicitly at least, to a companion proposal for eliminating the "minimum of one accepting impaired class" requirement for confirmation in 1129(a)(10), because letting voting control the confirmation outcome could, in a case with a simple capital structure, bar use of the ROP to ensure confirmation. I gave an example from my own restructuring experience of a situation where 1129(a)(10) was the key to efficiently reaching a consensual out of court restructuring of a luxury retailer, so I think its removal would be a negative development.

The June 2015 ABI Journal carried an article by two very respected restructuring professionals, Don Bernstein of Davis Polk and Jim Millstein of his eponymous financial advisory firm "explaining", but really advocating, the ROP mechanism. It emphasizes a different justification for the reform, which is evident from the first subheading:  "Focus:  The Timing of Valuations in Reorganization Cases". That focus identifies two motivations for the proposal:

1) debtors are spending less time in bankruptcy, due supposedly to secured creditors dictating the length of time the debtor languishes in chapter 11,  and thus supposedly being valued lower than they would be in "the fullness of time". They report that, "in 2013, debtors exited chapter 11 proceedings in fewer than 200 days, compared to close to 1,000 days in 1989."

They do not, notably, compare recoveries of junior classes between 1989 and 2013, which would seem to be necessary to prove their claim that reducing time in bankruptcy has resulted in reducing value to junior classes.  In other words, they assert that phenomenon A causes effect B, but only cite evidence of the pheneomenon, not of the purported effect or of a causal relationship.

As I explained in a series of 2013 posts, that causal proposition is not provable based on the data published to date.  One would have to go back to court files languishing in warehouses and not online, and do a bottoms-up reconstruction of recoveries in 1989 to generate a database from which the proposition could be examined.  Further, the choice of "1989" as a beginning point is suspicious, because it predates the first collapse of the high yield market and thus a 1989 dataset would consist of companies with balance sheets, capital structures and leverage ratios very different from those that wind up in bankruptcy today, whose increased leverage might explain any decline in recoveries that might be observed.  As well, chapter 11 debtors today -- as the Commission acknowledges elsewhere  -- have a much greater mix of intangible assets and overseas operations than those of the "1989" era making it even more questionable whether one could prove the asserted negative effect of getting through chapter 11 faster.

Without demonstrable evidence of a negative effect, what's wrong with efficiency?  In any other field of human endeavor, like package delivery, learning to read or medical diagnoses, getting an equivalent  result in less time would be considered progress.  Among restructuring professionals, many of whom of course get paid by the hour, it seems to be a bug instead of a feature to get things done faster.  Notably, the commission did not propose any fee reforms as companions to its bankruptcy-lengthening proposals.

If you will forgive the lack of creativity of a sports analogy, it's like arguing that, when a football team scores a touchdown quickly, it is usually scored by a wide receiver catching a long pass, but if you march slowly down the field, running backs score a higher proportion of touchdowns, and so, out of fairness to running backs, we need to slow offenses down, to achieve the "balance" that the inventors of football intended when they created both the pass and the run.  That is not something any one (other than running backs and their agents) is crying out for;  rather, the overarching goal of the game is to generate entertainment for the public by attempting to score touchdowns.  And the same is true in the reorganization context:  there is an overarching public policy goal to reorganize businesses so as to minimize disruptions to the broader economy.  If the team working on the reorganization succeeds in doing that fast, that just means they got across the goal line fast -- which is what they should be doing.

2)  The other proffered justification in the focus of the article is that the the valuation date in bankruptcy is an "arbitrary fortuity":  "Creating an entitlement to  redemption option value is intended to remove the fortuity of an arbitrary valuation date ...."    That is just overheated rhetoric.  "Arbitrary" means randomness, lacking in any order, evidence, reason or justification.  (Sometimes "arbitrary" is equated with "unfair" but that is not a wholly accurate understanding:  many dispute-resolution mechanisms, such as a coin flip, drawing straws or a lottery all have arbitrary results, but they may be entirely fair, if the parties involved have all agreed to be bound by the result, usually because they couldn't devise a process that would deliver an unbiased result in timely fashion in a more reasoned manner.  Conversely, a biased decision-making process -- e.g., Judge Y is highly likely to rule in favor of the party represented by lawyer X -- is ordered and predictable and thus not "arbitrary", but hardly fair or consistent with how judges are supposed to decide things.)

The valuation date in a bankruptcy is not random or lacking in order, reason, evidence or justification.  If you don't get misled by the false precision of the word "date" and understand the authors to refer more generically to the "timing" of valuation, that is pretty predictable.  In any given case, given an understanding of the debtors's liquidity and capital structure, the confidence the creditors have in management and its financial advisors, the debtors' overall industry environment including M&A activity, overall financial market conditions, the prospect for major avoidance, sub con, etc.litigation, and after a round of substantive discussions with the major parties in interest, an experienced restructuring professional will be able to predict with a fair degree of confidence what scenarios in the case are plausible and how long it's going to take for them to be sorted out. In some situations, all the major players have this understanding when the petition is filed. The scenarios are often obvious:  negative cash flow, no confidence in management, etc.  Or: complex capital structure, few distressed opportunities, lots of avoidance type litigation, all serving to keep the case running for years.

There is nothing "arbitrary" about when valuation occurs in bankruptcy cases.  I doubt either author would tell a client, who asked them to forecast when a given chapter 11 might reasonably be expected to be resolved, that "it's pretty arbitrary".  There are a number of economic variables, and a number of drivers in the legal process itself, but that is not arbitrariness, it is just complexity, which exists in all business valuation contexts. All of the economic variables flow from decisions the owners and managers took at some point or another in the life of the business or were known at the time to be risks of those decisions or being in that business; all that has happened is the variables interacted in a manner that the investors and managers failed to assess properly.

But that is no different from what every risk-taking investor faces every day.  It's no different than, say, buying the stock or a bond of a biotech company with a drug in Phase 3 trials, or a semiconductor company with a patent dispute or an auto company whose union contracts are up for re-negotiation, or American Express the month before Costco drops their favored status, or an E&P or copper miner in a world where commodity prices fluctuate.  There is nothing arbitrary about the date you find out the results of the trial or the result of the patent case; there is nothing arbitrary about Costco dropping Amex, or Saudi Arabia pumping more oil, or China stopping its copper purchases.  It's just a risk you bought into and didn't gauge correctly.

As I wrote in multiple posts about cramdowns last year, given how well-developed the capital markets of the 21st century are, it is an antiquated, anthromorphic or black-box fallacy to worry about "fairness" to junior classes of investors.  The vast majority are pools of capital allocated by institutions with widely diversified portfolios.  The given hedge fund or mutual fund that shows up as a "creditor" or "equity security holder" is really a pool of capital drawn from a much larger global universe of savings that is invested in literally dozens of other asset classes and millions of other individual securities and instruments managed by thousands of intermediaries. They have diversification to protect against the risk of an individual position being wiped out.

Therefore, it is unproductive and inefficient in the modern era to spend much time and money fighting about valuation of a single business to generate a small little recovery to one single investment among those millions.  It is much, much more efficient for policy makers in this context to establish clear rules, like the absolute priority rule, and then let markets do the valuation for the courts.  It may be more boring and less lucrative, but clearly that is the optimal policy for the economy as a whole. Let's keep making business reorganizations more efficient instead of letting outmoded concerns lead to novel and complex entitlements that are inefficient to compute.

Wednesday, July 22, 2015

"Lost in Translation" Article Published on Till and Momentive

My posts from 2014 on Till v SCS Credit Corp and Momentive Performance Materials have been consolidated and prettied up into appropriate form for a law journal by virtue of the yeomanlike diligence and assistance of Katie M. McDonough, an associate at my old firm. The Fordham Journal of Corporate and Financial Law has just published the resulting piece, which is entitled "Lost in Translation: Till v SCS Credit Corp and the Mistaken Transfer of a Consumer Bankruptcy Formula to Chapter 11 Reorganizations." It can be found at 20 Fordham J. Corp. & Fin. Law 893 (2015) on Westlaw and Lexis and eventually in other online databases like Heinonline and SSRD.  There is no ungated link, afaik.

In brief, the article criticizes bankruptcy judges and creditors' lawyers for failing to notice the significant statutory distinction between chapter 11 cramdown and chapter 13 cramdown, i.e., the presence of the judicially defined "fair and equitable" standard in chapter 11 vs. the absence of that standard in chapter 13. The article shows how the "fair and equitable" standard has been consistently interpreted by the Supreme Court to require creditors protected thereby to receive 100% recoveries in real economic terms, and how the Court has repeatedly recognized that market forces are the best measure of the "fair and equitable" standard.

The article also goes behind the opinions in Till to recount how, in the briefs and oral argument, the prevailing parties, the Solicitor General and every Justice all disavowed any comparison between chapter 11 jurisprudence and the consumer debt repayment context, and focused instead entirely on practical factors that were unique to the consumer bankruptcy context.  What kind of model of Supreme Court decision-making does one have that results in the Court overruling a century of its own precedent, not only without saying so, or mentioning the precedent in the opinion, but without taking any briefing or argument on the question and consistently saying it wasn't even pertinent to the case before them?  That is the question judges should be asking debtors' lawyers who try to import Till to chapter 11.  Until a debtor's lawyer comes up with something more persuasive than "ipse dixit", the proposition that Till created a new rule for chapter 11 cramdown is ridiculous on its face.

The article argues that recognition of these two inexplicably overlooked yet highly relevant facts will enable future courts to fulfill the intention of Congress in both chapters of the Bankruptcy Code, respecting the Till decision as a pragmatic solution to issues presented uniquely in cases brought under chapter 13, which has no "fair and equitable" constraint, while restoring the "fair and equitable" scrutiny of nonconsensual reorganizations required by the plain language of chapter 11. 

Many thanks to Katie for not only wielding the laboring oar in transforming the posts into an article, for doing ALL the footnoting, for handling the law review submission process with which I was completely unfamiliar, but especially for suggesting the article be written in the first place. 

Monday, July 6, 2015

Tsipras wins Exclusivity Extension Over Creditors' Objections - Still Needs DIP Loan

Back on January 4, in my first post of the year, I wrote:

"If the ultra-left Syriza party wins control of Greece's government this month, I expect Greece will default, for three reasons.  One, the core reason for Syriza's existence is to repudiate the terms imposed by the "Troika" (EC, ECB, and IMF) as part of the 2011 bailout and restructuring, so it doesn't really have a politically viable alternative to default, although I expect there will be an elaborate show of offers and counteroffers between its leadership and the Troika before a default occurs.  Two, even after the massive haircut inflicted on private creditors back in 2011, Greece was left with an unserviceable debt load, so it was inevitable it would get to the point of defaulting eventually, and there is a lot to be said on both sides to get it over with sooner rather than later, as opposed to the surplus-generating nations in the EU throwing good money after bad.  Last, those nations have to be worried about emboldening copycat repudiations by ultra-left parties in larger nations, especially Podemos in Spain, where there will be national elections in December, so it makes sense to let Greece make an example of itself that, one hopes, causes Spanish voters to avoid following in its shoes.

"The counter-scenarios are that either (1) the bureaucrats in the Troika are not politically strong enough to take an action that effectively throws a member out of the EU, in part because they are bureaucrats to begin with and in part because France, Portugal, Italy and possibly Spain may want to see Greece treated liberally so they themselves can receive similar treatment.  In this view, the Troika will ultimately cave and kick the can down the road a ways ....   The second counter-scenario is that, once Syriza comes to power, they will, like many before them,  soften their rhetoric, face up to reality and settle for some easy loan terms if the Troika pushes back hard enough and a deal will get done.  These are very possible, but at the end of the day, I think that, much like the Kirchners in Argentina, Tsipras will choose to play to the crowd with a populist repudiation."

And that is essentially what has happened year-to-date.  A lot of posturing to try to position the other side of the table as the one responsible for the fault.  But ultimately, as Tip O'Neill once put it, "All politics is local".  

I was apparently in the minority with this prediction.  I haven't understood why so many pundits did not see how this would play out.  Tsipras and Syriza have played out the textbook Left - Populist political strategy, dating back to Hitler and recurring through Latin American history from Castro and others right up to the present with the Kirchners and Chavez/ Maduro, and perhaps other episodes elsewhere about which I am not as well-read, which consists of the 5 following steps:

1)  Take one indebted nation in economic crisis;

2)  Demonize its foreign lenders / investors, and often the business and financial elite of your own country;

3)  Wrap yourself in the most ancient traditions of your nation, positing the economic negotiation as an existential, good vs evil struggle;

4)  Promise consumption subsidies and welfare payments to the poorer half of the electorate, and heavy nationalization of the economy, to win their vote;

5) Take power and repudiate the debt.

It wasn't an  insight gained from my career in debt restructuring, but just a knowledge of politics and history.  Perhaps those who held a more optimistic view were just talking their book, like Wilbur Ross, or just too steeped in financial market norms to see what was coming.  But, notwithstanding Syriza's ethnic slur of equating modern Germany to WW2 Germany, it's been Tsipras who has tracked Hitler's rise to power, not Merkel. Germany in this drama is more analogous to the creditor nations of the US and France, and Greece more like the debtor Germany in the 1930's, a fact Macron, the French Economy Minister, has apparently recognized.  I don't imply Tsipras will be invading anybody or sending anyone to the gas chambers.  I just mean his political strategy and rhetoric track those Hitler employed when he campaigned in the early 1930s, and other Left-Populists have used since.  If you want another, more American example, think of Huey Long, or on the right wing, George Wallace standing in the doorway of the University of Alabama administration building, positioning himself as the man fighting for local traditions against external forces whom he demagogues. All politics is local.

That said, I thought it might be useful to draw on my restructuring experience to point out how many similarities there are between what has gone on between Greece and its creditors and a contentious, "free-fall" corporate debt restructuring  here in the US, because it's apparent a lot of the media covering this are not able to get a handle on what is going on.  That's why I stuffed the title of this post with chapter 11 buzzwords.  And from this I will draw out one important point: notwithstanding the talk in recent years about the need for a "sovereign bankruptcy regime", the Greek episode reveals why that won't be an adequate solution; remember, all politics is local

Greece right now is like an administratively insolvent chapter 11 debtor who is unable to pay, not only its pre-petition debt (here, pre-Syriza debt), but its day-to-day operating expenses. It has been depleting its cash and engaging in emergency liquidity conservation measures, such as raiding accounts dedicated to other purposes and just not paying vendors, and now even those have been exhausted.  

The creditors have been unhappy with the debtor's business plan, which fails to generate any cash flow for debt service, and after months of negotiations, have lost confidence in management.  They hoped that the management would be replaced, but management instead sought an exclusivity extension.  The creditors objected, stating that the existing management was incompetent, as proven by the fact that revenue has gone down precipitously since management took over, and yet management refuses to take steps to bring costs in line with the reduced revenue. Similarly, management has declined to sell assets (i.e., privatize) to generate cash to fund operating losses. Nevertheless, the judge hearing the exclusivity extension, (i.e., Greek people) had a pro-debtor bias and granted the management the sought-after extension.  As we know, such orders are non-appealable.  

Having won this procedural victory, management still confronts the same substantive problem:  no money.  It is an iron law of life on this planet.  You cannot indefinitely consume more than you produce, unless you steal from someone else.  If you borrow in one year to fund consumption, thereafter you must include the resulting debt service in your expenses, and you either have to reduce consumption, reduce investment, liquidate assets (like privatizing ports or pumping out your oil reserves) or produce more than the year before.  If a nation borrows to fund investment, and invests wisely, it may be able to generate additional returns that service the debt.  But borrowing to fund consumption is by definition unsustainable over the long-term. Which is why Greece is where it is.

So the debtor needs a DIP loan.  To do that, it has to produce, yet again, a business plan and cash flow projections.  First, it has to show it will change its way of doing business to begin to generate positive cash flow. These are called "structural reforms" in sovereign debt parlance.  Second, it has to project the cash flow that will result from those changes, using assumptions the creditors find reasonable.  Third, it has to show how much of that cash flow it will allocate to service the DIP loan and as much of the pre-petition debt as is feasible.  For example, the creditors want to reduce the amount of cash flow that is being siphoned off to maintain the status quo of unproductive sectors of the economy, like nonworking people who are still able to work.  

Will Syriza do this? It is strictly a matter of political will. The most hopeful scenario is that, with this big electoral victory, Tsipras now has the political capital to cut the final deal.  The creditors can give him some more concessions, particularly writing down the debt which is unsustainable anyway, and in return he can accept more of their reforms, and they go on harmoniously, each side saying they got something more than when negotiations broke off.  In this context, the resignation of Varoufakis, the embarrassment he appointed as Finance Minister, is a hopeful sign. And all politics is local - now that his local status is solidified, Tsipras can face up to the reality of the larger problem.

I just don't know if Tsipras is that rational.  So far, he seems to be as mercurial as any national leader in history, one day purporting to make concessions and the next rhetorically destroying the environment for reasonable negotiations.  It's like he studies Richard Nixon's strategy in negotiating with Ho Chi Minh. 

The other concern is that, to the extent the rest of the EU in any way is seen to ratify Tsipras's strategy and tactics, that strategy will be re-enacted in the other low-productivity EU nations -- like Spain, particularly, where Podemos has already won many local elections recently and is consistently #1 or #2 in the polls for their November elections for national office.  But Italy and Portugal and even Ireland won't be far behind.  Once the norm of debt repayment breaks down, there isn't any logical stopping point.   So the creditors have to weigh the prospect of a rolling wave of debt repudiation cresting higher and higher if they work things out with an ultra-left Greece. 

If the negotiations of a consensual, going - concern reorganization doesn't work out, then we will see the sovereign equivalent of a chapter 7. The banking system and the government coffers will literally run out of euros in the next few days. Not just banks, but stores, businesses, government offices, will all shut their doors, as happens in a 7.  Yes, some parts of the country will continue to operate but massive amounts of GDP will cease to occur.  I don't think they can create a new currency fast enough to avoid this problem.  

And behind all this,there is the threat of further military incursions by Russia into places like the Baltic nations, which calls for as united a Europe as can be achieved.   

Angela Merkel has to be the George Washington, Abraham Lincoln and Alexander Hamilton of Europe, all at once, and all this month. She has her work cut out for her.