It being a rainy day and wishing to procrastinate some unappealing chores, I spent some time this afternoon looking to see whether the article I had published two years ago concerning the lack of statutory foundation for application of Till v SCS Credit Corp to chapter 11 reorganizations had been cited in the meantime. I know it was cited in the MPM Silicones briefing to the Second Circuit (thank you counsel) but otherwise I found four citations. One, in a brief in the litigation at the Second Circuit between the Elliott hedge funds and Argentina puzzled me and doesn't really have much to do with the main thrust of the article so I won't mention it here.
Two of the rest are by students so I'll take first the article by Bruce Markell entitled, "Fair Equivalents and Market Prices: Bankruptcy Cramdown Interest Rates" published last year in the Emory Bankruptcy Developments Journal. To its credit, the article is the first piece I have seen, other than my own analysis, that explicitly recognizes that the payout to a dissenting class of creditors under a chapter 11 plan must be judged by the "fair and equitable" standard. But, and this is a theme that runs throughout my criticism of his work, he fails to take on the full argument, namely that the term of art "fair and equitable" is missing from the plan confirmation standard of chapter 13 (unless some acknowledgment of this point is buried in one of the 240 footnotes). Which I have always contended is the critical reason why Till does not translate to chapter 11. It wasn't analyzing the words found in chapter 11.
Second, and more disingenuously, Markell does not provide a full discussion of the cases and authorities relevant to assessing the significance of market comps to the valuation called for by the "fair and equitable " Rule, and omits other unfavorable sources. For example, there is no mention of RFC v. Denver & Rio Grande Western Railroad Co., 328 U.S. 495 (1946) and its companion case Insurance Group Committee v. Denver &Rio Grande Western Railroad Co., 329 U.S. 607 (1947) which explicitly held that a creditors was entitled to receive "full compensation" on its prepetition claim and if that meant large profits, so be it. And consulted market prices while so holding.
So when Markell sits there and claims it's a "fact" that "rates for new loans have components not appropriate for a
cramdown, such as initiation costs and profit components." That's just nonsense based on the Supreme Court's precedents. And his only citation is to Valenti, the Second Circuit case on chapter 13s which of course are not governed by the "fair and equitable" standard he purports to be interpreting. Ignores the Supreme Court case on the relevant statutory term, cites a lower court on a different section of the Code. Nice.
Nor, is there any mention of the Supreme Court's holding in 203 N. LaSalle, that the fair and equitable rule required a market check before a debtor could cramdown a new equity capital plan on the secured creditor. Why should the rule be any different for debt? Markell does not address these inconvenient challenges.
Even his presentation of the precedent he does acknowledge is disingenuous. He lays out a homey matrix. The case law, he says, teaches three "apothegms": don't pay too little; don't pay too much and don't expect precision. Of course, these homey admonitions don't appear in the text of the Supreme Court's opinions. You know what does? "Full compensation". Which is a little more precise than "don't pay too much and don't pay too little". Those seem like disingenuous borrowings from the old "relative priority" doctrine that Case v Los Angeles Lumber, killed off in 1940.. That was the whole point of the Supreme Court forcefully re-stating the absolute priority rule back then, to create a rule of 100% payout to senior creditors before juniors got anything. . There had been widespread complaints that reorganization cases in the wake of the 1929 crash had been slow and inefficient and favored insiders, because the courts and the main players had all been operating on the notion of "relative priority" in which payouts were negotiated based on norms that everybody gave up a little, everybody kept a little and the relative priorities of senior to junior are mostly maintained. In Case, in his first opinion since joining the bench, and prompted by future Justice Robert Jackson, then acting as SG, Justice Douglas, threw fire and brimstone at the old norms and said in essence, absolute priority means absolute. And that was carried forth into the current Code, quite explicitly in the legislative history as the Supreme Court has recognized on multiple occasions. Markell seems to be aiming to get courts to think, hey, less than full value is OK, and it helps even out the recovery disparity. Spread the wealth, you know.. It's not OK. The court must aim for 100 cents and, of course, there are no guarantees, but a court can't intentionally aim lower.
Markell's article also propagates the fallacious argument that (my paraphrase) "there is no market for cramdown loans because they're, you know, nonconsensual." This is surpassingly superficial and sophomoric. You know what? There is no market for inheritances, or gifts, or divorce settlements, but tax courts and family courts use market transactions and comparable companies to value illiquid interests in businesses transferred via bequest, gift or divorce. There's no bargaining or consent in any of those contexts either. There's no market in tax certiorari proceedings, which are pretty nonconsensual too, but the courts look at recent market transactions in comparable properties in figuring out the value of your property; they don't just go "well, it's $X per bedroom in this town." This is basic human reasoning: research; compare and contrast, reason by analogy. It's not so hard that it needs to be replaced with a formula.
A loan has certain key terms. And there are on any given day, numerous loans that have some or all of those key terms: for some the rate, but also one needs to know the maturity, the covenants, the collateral, the prepayment right, etc. But the variations on each variable are small. There are thousands of people in the financial markets with expert knowledge of thees matrices of these variables on outstanding loans. The LSTA and market participants have worked to standardize heavily the forms of the credit documentation and have largely succeeded, except in certain financial definitions. Rating agencies routinely rate loans routinely, and the thousands of variations wind up being subsumed into a handful of ratings: BBB, BB-, B-, CCC+ etc. Prices and yields can be mapped against those ratings. In fact, outstanding loans are marked to market pretty much every day, with the exception of certain loans (typically revolvers and Term Loan As with low leverage that are not particularly relevant to this question) held by Federally regulated institutions. But Term Loan Bs, 1.5 lien loans, 2d lien loans, where the rubber meets the road for cramdown purpose are held by funds that per regulation or agreement with their investors and lenders, mark to market every day, typically relying on a service that disseminates the same valuation to all holders of a given loan. And then one can deduce that, to the extent the proposed exit loan shares characteristics of a given class of outstanding loans, it will likely be priced similarly by the market. Further, there are thousands of loans brought to the loan market as new issues every year and they are priced, quite simply, by reference to similar loans that have recently been issued. An exit financing is just one more of those and the market has easily absorbed them over the past decades. The fact that it's a "cramdown loan" is not relevant to its valuation by anybody at any time. To argue to the contrary is a naive and completely false argument.
So when Markell, out of thin air and, as far as I know, zero experience in the real world of holding and trading debt, says (without citation) "the market for bonds or loans generally is not the same market as
reorganization debt, given that reorganization debt has at least an
implicit assumption that the debt will be held to term and not traded" he is just blowing smoke, It's utter nonsense.
A reader might be interested in a roundtable discussion of Markell's article which can be found here, but I warn you, it's three academics, none of whom has a clue about the real world of arranging loans to companies emerging from chapter 11.
The second article is by a student at Cardozo Law Schol, Emma Guido, entitled "Till v SCS Credit Corporation: A "Prime-Plus-Plus" Method Tilling [sic] Courts to Consider Efficient Market Evidence." Ms Guido essentially advocates a compromise which is use Till and also look at the market when there is an efficient market; sensibly, she does not go all academic on what "efficiency" is. Rightly, she acknowledges that loans have risks and the Till formula does not adequately capture them. The article has all the benefits and limitations of a compromise approach. It does not display the striking errors and ball-hiding of Markell's piece. Of the three articles, I think this is the best. I think it still falls short of the simple approach. Ignore Till, get rid of the confusing word "efficient" and stick with tried and true chapter 11 practices that just say, courts should hear evidence from people who know what they 're doing in raising debt capital at the time of the confirmation hearing about how the loan will be valued, and why, and make the best estimate possible. As they do in every other litigated valuation they adjudicate. .
Another substantive discussion occurs in an article published by a then-student at Seton Hall Law School, Thomas Green, in an article entitled "An Analysis of the Advantages of Non-Market-Based Approaches for Determining Cramdown Rates: A Legal and Financial Perspective." Perhaps this is because my co-author was a Seton Hall Law School alumna and both had studied with Professor Stephen Lubben there. And this article quotes Lubben's textbooks often so presumably reflects some input from him.
The article is a fine product for a student note, albeit somewhat lengthy and fairly high-level. It is a lot like the article I thought I was going to write on Till, until I read the briefs and oral argument at the Supreme Court and realized that everyone who thought Till was meant to change chapter 11 practice was completely wrong. The article contains, for instance, a 16 page discussion of the Efficient Capital Markets Hypothesis, which links to the two words "efficient market" in the dicta in footnote 14 in the plurality opinion in Till. The thrust is, federal courts have routinely used the "ECMH" in securities cases adjudicating "fraud on the market" claims (glib again: this overlooks the enormous and costly disputes in those cases over every aspect of the evidence and the analysis), so let's compare the ECMH to "cramdown loans". Oops, Doesn't work well. Why not? Well, there's not as much liquidity and then is that whole "taint of bankruptcy" thing. and then also "fraud on the market" cases involve secondary market trading whereas.the debt being issued when a company comes out of a bankruptcy is more of a "primary" issuance. So, the author concludes, a judicial formula is indeed the best way to go.
But as I've written before, and as Markell also forthrightly points out, there is a huge gap between what lay people mean by "efficient" and what Economics textbooks mean by "efficient". This makes the use of the term "efficient markets" a potential source of confusion in courts. As the author writes, quoting Justice White, "The legal culture's remarkably rapid and broad acceptance of the ECMH is not matched by an equivalent degree of understanding." In economics, efficiency, is a state of perfection rarely encountered in transactions between humans and probably not very stable. It means no or imperceptible transaction costs,essentially liquidity, enormous transparency. Even so, economists have had to admit that there is no real-world example of a capital market that is perfectly efficient. At most as the author notes, they have concluded that movements in large cap equities in the U.S are consistent with the "semi-strong" expression of the ECMH.
Furthermore, as the author observes on a couple of occasions, the ECMH is something that aspires only to characterize secondary market trading, not primary security issuance. It's apples and oranges, or, more aptly, analyzing the trading of orange juice in the commodity markets vs buying an orange tree. Unfortunately, he does not make the leap (which, I understand, would have ruined the article) to say "the ECMH has nothing to tell us about market efficiency in the context of exit financing, so let's look elsewhere." Instead, he claims, it is the cornerstone of "footnote 14" and thus a court-imposed formula should set the price of "cramdown loans".
Personally, I think it's a obvious non sequitur to go from "Efficient Capital Markets Hypothesis" to "Judge sets the rate". I think the entire approach to the ECMH confuses the question. To me, the approach is simply what judges have been doing for decades: value the paper like any other economic asset -- a building, a patent, a business -- using the best evidence available. Often, that will be the market. Sometimes not.
The author completely fails to discuss what I have pointed out are the two biggest errors that the courts applying Till in chapter 11 have committed. First, the opportunity for gamesmanship, exacerbated by the fact that judges do not grasp the meaning of the word efficiency. I called this in the article "the loan market as Santa Claus" fallacy It plays out in all of these cases and the author even holds one up as a shining example of "how an efficient market analysis should work".
I understand he is a student, so I fault his faculty advisor for not having the common sense to see the absurdity of the reasoning.
In 20 Bayard Views LLC, he writes, the judge deemed the criterion of efficiency to be whether "other creditors are willing to lend on terms similar to those of the replacement notes under the plan.".NO! That bears no relation to anything in the ECMH or common sense. It's just backward reasoning, The ECMH would say, the prices that clear the market are the ones that are efficiently determined. Not one single individual's bid. I analogized this in my article to someone saying "I want to buy Facebook stock for $35 / share" when it was trading at $50. The investor's personal bid tells you nothing about efficiency of the $50. Also it leaves the debtor a loophole big enough to drive its whole business through. Obviously, if a debtor knows that is the standard, the first thing they do is propose off-market terms. Then those terms are "not available" in the market. As the judge here noted: relying on testimony from the creditors that no one in the market would make a 100% LTV loan, he intoned,. "the market is inefficient" NO! The market was efficient -- that's the sane result. Those loans lose money -- that's inefficient. It's insane to hold that case up as an example to be followed.
In contrast, the creditor gave the sensible explanation: "Look, if you want to pay us off, you can raise some senior debt, some mezzanine and some equity, and your all-in cost is somewhere around 11.68%. It's expensive but you can do it. The market will fill that order for an arms-length price." This reality-based explanation was lost on deaf ears unfortunately.
The second giant error the article shares with many courts is that there is no discussion of any of the century of Supreme Court cases interpreting the "fair and equitable" rule (none of which mentions the "Efficient Capital Markets Hypothesis" by the way). That means no discussion of what those cases have consistently held, which is that senior secured creditors get paid in full up to the value of their collateral, period, and that one should look at the market to determine whether a proposed plan is "fair and equitable". Which only makes sense. Think about it: if a debtor can not raise new equity capital for its reorganization without a market check, why is the market somehow forbidden territory for the debt it wants to issue coming out of bankruptcy? It's absurd to have opposite rules for the two types of capital
The article also offers a "policy argument" for the formula rate that consists of three points: (1) saves money on professionals; (2) it's predictable; (3) "hey, creditors knew they could get screwed in bankruptcy when they made the loan, so it's fair to screw them." To be fair, his more scholarly language is: "In sum, a bankruptcy petition inherently triggers numerous uncertainties,
and the Code expressly contemplates multiple scenarios
where a creditor’s expectations may be undermined."
This is glib and mistaken. The Code contains provisions that undermine a creditor's state-law contractual expectations. The Code does not contain any provisions that undermine the Constitutional protection of the value of a secured claim as of the petition date, or else those provisions would be un-Constitutional.
As for "Saves money on professionals", true, but so does a lottery, a coin flip, etc. Any and every rule that eliminates a trial will save money on professionals. But then there is that pesky Fifth Amendment thing about due process and takings of property.
"Predictable"? In my 30 years of practice, I had not noticed that the rule "you get paid in full if you're oversecured" was confusing anyone.. See Case v Los Angeles Lumber.
Anyway, regardless of the disagreement over the analyses, it was a privilege to be cited in the several articles.
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