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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.