The Slow Food Movement May Be Coming to Chapter 11

The ABI Commission's report on chapter 11 reforms was released today.  It certainly is a lengthy document, as one might expect from a committee whose membership is dominated by lawyers.   Much of it proposes not what I would call "reform" but simply "codification", which is generally welcome -- e.g., inserting the Countryman definition of an executory contract; selecting the "actual" as opposed to the "hypothetical" test for assumption;  blessing use of estate property to pay critical vendors or prepetition employee claims; overruling all of the "Till in chapter 11" decisions; codifying the "new value" exception to absolute priority;  and so on.   

The major changes proposed consist generally of reducing the rights of secured creditors during the administration of the case, and to some extent at the end as well, although in the latter instance the impingement on secured creditor rights is not as dramatic as many of the commission members' statements from time to time over the past two years advocated.

 

Also, section 363 practice receives a good deal of attention.  Some of this is in the nature of codification of procedural aspects such as length of time before a debtor can initiate a sale.  Prevailing interpretations that confer on certain contract counterparties leverage to block 363 sales, like patent and copyright licensors, would vanish.  363 sales are recognized to be plan-like in some respects, for example, the cutting off of claims is recognized to be like a discharge, with various notice and due process implications that flow from that; and the proposal to impinge on secured creditor recoveries in the plan context is carried over to the 363 context.

Other proposals strive to lengthen the time companies spend in chapter 11 - explicitly , early milestones for plan or sale filings would be forbidden from cash collateral and DIP financing orders; time to assume nonresidential real property leases would be extended to one year, etc.  Implicitly, certain other proposals with respect to distribution of value could produce longer cases, as it would take a long time to figure out how to bargain around them, or to the extent the proposals actually subvert bargaining, how to administer cases around them.  

In this last respect, that of elongating restructurings, the report adopts one of the oddest perspectives I have seen emanate from any industry.  In so many other sectors of the economy  -- making a car or a computer chip; getting a new drug on the market; getting your first-round draft pick onto the field; delivering a product from warehouse to consumer -- achieving your objective sooner and cheaper would be considered a good thing and something that the sector should strive for.  Here, the report (p. 221) includes a chart showing a general decline over time in the number of days companies spend in chapter 11 -- and portrays it as a problem that needs to be solved.   I was going to write, "I cannot think of any other industry where slowing the process down is considered a process improvement", and then I thought of the "slow food" movement  and realized there was at least one.  I could not write what I was going to write, but it did suggest an entertaining title for the post. (Note to self: if these proposals go through, open up restaurant in Wilmington Delaware.  More people will be spending more time there and will need places to eat.)

But the "slow food" approach to dining is an option, not a mandate.  None of us likes to go into a restaurant and have no choice but to accept slow service at a higher price than we think we need to pay.  Why should that be a characteristic of business reorganization?  

 I don't see any evidence in this report that increased efficiency of debt restructuring has had a negative effect on continuity of jobs or any other public interest implicated in reorganizations.   It is argued that earlier exits lead to lower recoveries by junior constituencies, but it is also recognized that the asserted correlation cannot be distinguished from what might be caused by normal economic cyclicality.  No one can pick the top of the economic cycle -- how many people even predicted the recent plunge in the price of a single commodity, oil?  It's pretentious to suggest that bankruptcy law changes are going to systematically improve the timing of a company's exit relative to the economic cycle.  It also needs to be recognized that these are purely distributional issues: there is no going concern value being lost by the economy as a whole.  It's just a question of in whose hands it winds up.

Which brings me to a related point.  Setting aside again involuntary creditors, the distinction between senior secured and junior unsecured classes that drives much of the report's most controversial recommendations seems to me to be largely fallacious and antiquated.  In the modern restructuring era, the specific names who show up as senior secured creditor in one case may be junior unsecured creditors in the next.  These claims are held by pools of capital - hedge funds being the most obvious example, but there are plenty of bank loan and high yield mutual funds too.  Even corporate financial institutions, like commercial banks, investment  banks or insurance companies, are just pools of other people's money.   Many of these entities have diversified portfolios of investments, such that it's fallacious to think of them as systematically always senior or always junior - with an exception for commercial banks who are required to follow safe and sound banking practices that typically, as interpreted by regulators, include taking collateral.  And even if there are less-diversified institutions that focus predominantly on  one kind of investment, for example a fund that is purely a distressed debt fund, they tend to be doing so ultimately for the economic benefit of stakeholders who themselves have diversified portfolios. The distressed fund may be seeded by an investment bank or a larger multi-strategy fund that doesn't want to have a permanent infrastructure or to have its name associated with distressed situations.  Or they may be pension funds or university or charitable endowments that have widely diversified portfolios.  The point being, don't get all worked up about senior creditors winning too often - ultimately, the investor class holds portfolios of investments and no one is being systematically screwed or privileged. Focus on making the process efficient instead, which generally means clear and predictable rules, in this case the absolute priority rule that the financial markets have had a century to adjust to.

I will comment on the anti-secured-debt proposals in the following post.

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.

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False Premises of Bankruptcy Reform Agenda

The ABI Commission on bankruptcy reform has posted a short video that "identifies some key findings of the Commission to date." The purpose of the video, I suppose, is to try to begin to justify in advance the reforms the commission has been crafting since it was self-appointed in 2012, which are likely to be designed to transfer value from secured creditors, and lengthen the time and increase the cost of chapter 11 proceedings, and shift those to the secured creditors. The video should appear below, although my embedding skills are rudimentary at best: If for any reason there is no video above, it is currently on the commission home page, http://commission.abi.org/ .

The "findings" mentioned in the video are not factually supported, but are just false premises created to rationalize the anti-secured-claim agenda that the professionals who dominate the commission (there are virtually no clients, debtor or creditor, on the commission) have been sponsoring since the commission's earliest days.

For example, once the first few frames of vapid generalizations pass, one comes to the assertion that there is an "emerging consensus" that the Bankruptcy Code needs to be modernized. I have followed the commission's "field hearings" and see nothing of the sort. I have seen various constituencies expressing their points of view, which are often varying and opposed. There is no consensus among them at all. Any claim of consensus - which just happens to match the pre-existing viewpoints that dominate the commission - is just self-justifying and not objective fact.

Some of the quotes that the video displays to demonstrate the purported consensus are downright dieceptive.  For example, the video quotes one Danielle Spinelli to the effect that " there does appear to be widespread concern that the expansion of secured credit has had a deleterious effect on the bankruptcy process...." That quote is excerpted from a statement Spinelli read at a field hearing in November 2012, as a representative of the Loan Syndication and Trading Association (LSTA), not an organization likely to have argued for negatively impacting secured debt. When you read the statement as a whole, it is clearly taken out of context: Spinelli was describing what she observed to be transpiring on the Commission, not concerns that she shared or perceived to be emanating from anywhere else. She then proceeded to defend secured creditors' rights to credit bid. It's alarming that the Commission would stoop to such intellectual dishonesty to advance its agenda as to twist the words of a witness in that fashion.

Another sorry misrepresentation is the claim made in the video that "Debt and capital structures have grown more complex due to multiple layers of debt and complex intercreditor agreements not imagined in 1978." This is just nonsense with no factual support. The capital structures of today are not meaningfully more complex from those of the 70's and 80's when the Code was first crafted and implemented. A typical capital structure of a typical chapter 11 debtor may have a first and second lien secured by all domestic assets and a pledge of 65% of the foreign subsidiaries; there may be a layer of structurally or contractually subordinated unsecured debt and the equity. That capital structure differs little from the ones that appeared in pre-Code case law. For example, if you look at the capital structure of the Depression-era debtor described in my last post, you'll see a virtually identical capital structure, save only the stock pledge. That is not a meaningful increase in complexity. If anything, the older case presented more complexity because the first liens did not overlap the collateral held by the junior lien, and thus separate valuations were required of the different collateral packages; whereas, today, one merely has to value the entire enterprise one time and then follow the order of priorities.

And the reference to intercreditor agreements being more complex is another red herring. I had the unpleasant duty off and on in my associate days in the 1980s of reading collateral trust agreements and other intercreditor agreements and the subordination provisions of old-time indentures in various utility, transportation and manufacturing companies. Today's provisions may have different focal points, but they are not at all more difficult to work with than those of the earlier era. In many ways, because they are written with current law in mind, they are actually easier.

If cases had indeed grown more complex, one would see that reflected in cases taking dramatically longer. But they don't. The distressed debt market would show wide bid-ask spreads and low liquidity as investors were scared away. But it doesn't. The bit about increased complexity just has no objective support.

A lawyer is quoted complaining that "new lending" and "aggressive investing" have made it "significantly more difficult to restructure successfully in chapter 11". Again, there is no documented evidence to back that up. The chapter 22 phenomenon has not meaningfully changed over the life of the Code. Airline recidivism, for instance, has dropped precipitously since the early days of the Code.  And when a chapter 22 does occur, it is implausible that its occurrence can be confidently attributed to chapter 11 having failed to afford a "fix" for the business the first time around; equally or more plausible alternative explanations would be: (1) the business suffers from problems beyond the capacity of a legal fix (e.g., a lack of sales, or a misguided and expensive construction project, or a failed merger); (2) the first 11 should have been converted to a 7 to begin with; or (2) the balance sheet of the reorganized debtor should have been more conservative with the consequence that more junior constituencies should have seen their recoveries reduced or eliminated.

This lawyer's lament may reflect to some extent the economic reality that, when a debtor enters chapter 11 over-encumbered, a 363 sale tends to end cases sooner than some constituencies, including bill-by-the-hour professionals, might find in their interest. The argument appears to be that, in some hypothetical scenario that the secured creditors are cutting off, the company would somehow stay longer in chapter 11 and by doing so fix itself thereby enabling more creditors, or even equity, to recover. It is of course impossible to prove a negative, that is, to prove the imaginary alternate universe would not happen. But the burden of proof should be on those seeking to change the status quo that has worked well. I suspect that a sample of non-professional persons with chapter 11 experience - the executives and creditors, I mean - will find very few proponents of the idea that longer stays in chapter 11 are systematically better for businesses. The truth, as opposed to the myth that the self-interest of bankruptcy professionals aligns with, is that solvent companies "fix their businesses" all the time outside of bankruptcy court with far less professional expense. My post last fall about the SiriusXM restructuring makes this point in greater detail.

Except for the power to reject bad leases and contracts, there is really very little in the mythical "bankruptcy toolkit" that companies need to make operational fixes. Indeed, the principal operational fix that companies do - headcount reduction - is not something that anybody should be encouraging more of in chapter 11. I suspect the proponents of the "missed opportunities to fix businesses" would have a very hard time coming up with concrete examples of things companies can only do in chapter 11 and would actually do if they spent longer in chapter 11, other than taking longer to reject leases.

Ironically, a slide that complains too many cases end in a "quick sale or recapitalization" is promptly followed by two other slides that complain that chapter 11 cases have grown "too complex and expensive" and "too slow and costly". These positions are difficult to reconcile (unless the commission is going to propose radical changes in professional compensation, which seems unlikely given its makeup).

In fact, there is no evidence that cases have grown more expensive. In aggregate dollars, perhaps, but that is partly due to inflation and partly due to the vast increase in the size of the companies going through chapter 11. By a more useful metric, e.g., professional costs as a percentage of the liabilities resolved in chapter 11 cases (which is the fundamental point of reorganizing businesses), the reorganization process has gotten significantly cheaper, which makes sense. as more issues have been clarified over time by the courts and there is less to litigate, other than valuation. And I struggle to understand how a "quick" resolution of a problem is something the average citizen not in the bankruptcy industry should be upset about.

What has really happened is chapter 11 has grown more efficient, in large measure due to the resolution of various issues by the courts, both in the form of reported opinions, and also in the maturation of custom and practice in the major venues. The other source of efficiency is the greater role of market-driven creditors, who have produced a dramatic increase in reorganization efficiency with no adverse effects on operations or workforces. Like many industries in the 21st century, the bankruptcy professional industry has to adapt to an environment of increased efficiency. Seen in this light, the so-called reform agenda starts to look like a special interest group trying to use the legislative process to protect its economic position against the forces that affect the workforce generally.

There is no Evidence that Unsecured Recoveries in Chapter 11 are Diminishing (Part 5: Changes in Subordination Methods and Use of First-Day Orders)

This is the 5th in a series of blog posts that analyze an argument, being presented to an American Bankruptcy Institute commission on reform of the Bankruptcy Code, that the recoveries of unsecured creditors are somehow declining due to a purported imbalance in favor of secured creditors.  The argument relies heavily on a law journal article published two years ago by a law student named Andrew A. Wood working under the tutelage of Professor Lynn LoPucki at UCLA.   So far, I have shown how the article contains, and thus the argument is based on, incredibly unreliable and error-riddled data; that the sample sets being contrasted are not properly comparable because they cover different lengths of time and different economic conditions; that the purported increase in the use of second lien debt in capital structures cannot be shown to have had any adverse effect on unsecured recoveries; and that valuation and intrinsic business merit have much more to do with low recoveries than inter-creditor balance does.   In this post, I will show that the Wood article's portrayal of declining unsecured recoveries results in large part from a sadly unsophisticated grasp of corporate finance and chapter 11 practice; more specifically, it omits from the tabulation of unsecured creditor recoveries all recoveries that occur outside a plan (for example under first-day orders), and it fails to comprehend that unsecured recoveries can vary based on structural subordination.

Likely Misclassification of “General Unsecured Creditors”

Wood has broken out “unsecured creditors” into multiple categories, as LoPucki did in his earlier article. Those categories are “Senior Unsecured”, “General Unsecured”, “Senior Subordinated” and “Junior Subordinated”.  Partly because there is no single classification regime that proponents have to follow in chapter 11, and partly because, I suspect, neither Wood nor LoPucki had much experience in negotiating chapter 11 plans, I fear that there may be significant mis-classifications in both studies, particularly between “Senior Unsecured” and “General Unsecured” which may have affected Wood’s calculations of average recoveries.   Wood states that he follows LoPucki’s earlier work in treating “all unsecured creditor classes to be general unsecureds unless words suggesting different priority, such as ‘subordinated,’, ‘junior’ etc.] were used” (Wood, p. 433).  That definition completely ignores, or obscures, the fact that, in cases involving multiple debt issuers within the same corporate family, absent substantive consolidation, unsecured creditors at different debtors may have different recoveries. In particular, where a holding company exists, debt issued there often has significantly lower recoveries than unsecured claims at one of its operating subsidiaries may have. Practitioners refer to the holding company’s debt as “structurally subordinated”.  However, Wood’s table of recoveries does not consistently distinguish and categorize the kind of unsecured claims that can be considered “general unsecured” – trade debt, senior unsecured notes and so on.  Sometimes he puts senior unsecured notes in the “general unsecured claims” bucket; sometimes he records recoveries only by one set of notes in a corporate structure with elements of structural subordination; and sometimes he ignores the notes’ recoveries altogether. 

His data for recoveries in the Lear Corporation case illustrate this inaccurate and inconsistent labeling.  His table shows a recovery of 100” for “Senior Unsecured” creditors and a recovery of “36-42%” for “General Unsecured”.  But Wood has misunderstood the classification of unsecureds in that case and as a result substantially mischaracterized the various constituencies’ recoveries, as I confirmed by examining the recovery table on page 15 of  the disclosure statement (docket 634).[1]  First, two groups of unsecured creditors recovered 100%: “Ongoing Operations Unsecured Claims” against the “Group A Debtors”, estimated to be $410 million; and “General Unsecured Claims” against the “Group B Debtors”, estimated to be $285 million. Second, “General Unsecured Claims” against the “Group A Debtors” estimated at $2.104 billion, were indeed estimated to receive 42%, but that class consisted almost entirely of (a) credit agreement deficiency claims totaling $737 million and (b) unsecured bonds totaling $1.29 billion.  Substantially all of the quintessential “general unsecured” creditors of Lear received a 100% payout.[2]  Worst, there was no class of unsecureds that received the “36%” payout included in Wood’s table; rather, that figure was erroneously copied by Wood from the liquidation analysis for general unsecured creditors of the Group B Debtors. 

An equally significant flaw with Wood’s table is its failure to recognize differences in unsecureds’ recoveries stemming from “structural subordination”.  I found numerous instances in Wood’s 42 cases where structural subordination of unsecured debt occurred but went unacknowledged, such that the structurally subordinated debt was classified as “senior unsecured” or “general unsecured”, even though there were significant disparities between recoveries of unsecured creditors at different levels of the corporate structure.  Cooper Standard, R.H. Donnelly, Simmons Bedding, Primus Telecommunications, NTK, Six Flags, and Charter Communications are all cases that I have discussed in earlier posts in which some class of structurally subordinate unsecured debt recovered less than more structurally senior unsecured creditors.  The occurrence of this phenomenon is so frequent that it ought to have been separately reported and analyzed. 

Further, notwithstanding the definition Wood recites, when I look at LoPucki’s study of 1991-1996 cases, I see a surprisingly large number of “100%” recoveries by “general unsecured creditors”, leading me to suspect that those are mostly trade and other claims that are not on account of long-term debt that happens to be unsecured.  I am skeptical that unsecured debt in those cases was consistently and accurately classified, given that it was not properly analyzed in the 2009-10 sample.  Instead, there may be substantial errors in, or inconsistencies between, the two studies in regard to how they classify unsubordinated unsecured debt when there are multiple debtors.  There is simply no way to tell if the studies are comparable, apples to apples, or even if similar claims are categorized consistently within the same study.  Thus, none of the bottom-line figures – whether they be “77%”, “53%” or 45” – are reliable.

I suspect that, were someone to have access to all the 1991-96 cases, one would see that a good bit of the purported difference in recoveries between the two eras can be explained just by this classification approach: the LoPucki study happened to cover an era with more instances of contractually subordinated unsecured debt, which, being junior, tended to have lower recoveries.  So, when his table segregated that kind of debt from the so-called “General Unsecured” category, arithmetically the latter showed a higher apparent recovery.  Whereas Wood, likely unaware that recent capital structures have comparatively little contractually subordinated debt but a meaningful amount of structurally subordinated debt,  has blindly applied the older taxonomy, unknowingly lumping a different kind of subordinated debt into the general unsecured category and thereby diluting that category’s recoveries.  But to prove that out would require one to examine all of the 1991-96 cases to see how each class of general unsecured was categorized, a task beyond the scope of this paper. 

At a minimum, the issue of failure to account for different modes of subordination consistently between the two studies illustrates how unreliable the two studies are, relative to how practitioners negotiate and understand the terms of chapter 11 plans. Further, stepping back from the errors, omissions and inconsistencies, a question is raised as to whether recoveries of unsecured creditors at a holding company that has no operating creditors and no secured debt are even relevant to the contention that secured creditors are usurping general unsecured recoveries.

Omission Of Other Payments To Unsecured Creditors. 

As practitioners know, there are numerous ways that unsecured creditors recover in chapter 11 cases that don’t show up in the recovery estimate tables in a disclosure statement.  There are payments of critical vendors; assumption of executory contracts and unexpired leases; and priorities of various priority claims for employees and retirees pursuant to first-day orders, to mention what are probably the largest ticket items.  There are many situations both under plans and in 363 sales where unsecured creditors “ride through” unimpaired economically, being assumed by the reorganized debtor or the acquirer.  Also, there are many situations in which an unsecured claim is insured, by a liability policy, for instance, or a letter of credit.  For example, in the first Journal Register case, where the debtor reported accounts payable of less than $19 million in its last 10-K before filing chapter 11, its newsprint supplier was owed approximately $2.7 million at the petition date, yet held a $3 million LC, according to the company’s critical vendor motion (docket 15).  Neither the LoPucki nor the Wood article includes any data or estimates about the recoveries unsecured creditors received through non-plan channels.

In many of the cases Wood sampled, I was struck by how small the “General Unsecured” class was under the plan.  Often it was a small fraction of the claims in the case, so small sometimes that it made no sense as a financial matter.  Most notably, in R.H. Donnelly, the General Unsecured class was only $19.5 million, according to the final disclosure statement (docket 463).  For a company with about $10 billion in funded debt, it is implausible in the extreme that they would only have $19 million in payables and other accrued liabilities. In fact, in its last 10-K before filing, RHD showed accounts payable and accrued liabilities of $216 million, 1100% greater than the Disclosure Statement figure.

Taking a case from the pool of low-recovery cases, I looked at Pliant and found it was similar. Pliant listed $93 million of accounts payable on its last 10-K balance sheet  before filing.  But the disclosure statement estimated the general unsecured pool at only $17 million. 

Something has to have happened during those cases to the rest of the accounts payable and similar liabilities.  The discrepancies are so large that further research is warranted into what happened to the rest of the general unsecured liabilities during those cases and the others of the 2009-10 vintages.  I suspect deeper research will show they were mainly taken care of through one or another of the methods I have mentioned above and likely received par or something very close to it.  For example, in Pliant, the debtor was authorized by the court’s order granting the critical vendor motion (docket 47) to pay up to $29 million in critical vendor claims --  almost double the amount of general unsecureds it identified in the disclosure statement.  If  $29 million in unsecured claims received payment in full outside of a plan, and $17 million received 17.5% under the plan, was the case in Pliant, then the unsecured recovery in the case, as opposed to the plan, was 69.5%, a radically different number than Wood’s table shows for that case.

Similarly, Building Materials was a case with recoveries estimated to fall in between Pliant and R.H. Donnelly, so I looked at payouts outside the plan there as well.  Its critical vendor motion was granted for up to $15 million in payments, while its total pool of unsecured creditors, according to the “best interests” analysis done by Peter J. Solomon and appended to the disclosure statement, shows less than $100 million in unsecured claims, so the actual recovery by unsecureds there was substantially higher than the 55% shown in the disclosure statement.

If other cases show similar facts, that would have significant repercussions for the thesis that unsecured creditors are somehow getting a bad deal in chapter 11’s.  It may be that, like drunks looking for their keys under a lamppost (because that’s where the light is), researchers have been looking for general unsecured recoveries in disclosure statements, because that’s where the recovery estimates are published, while in each case the real explanation for the apparent decline in unsecured recoveries may lie elsewhere on the docket.  It may well be the case that much of the purported difference in recoveries between the two samples in Wood’s article can be traced to the greater use of critical vendor and similar motions in the more recent sample.  And persons seeking to improve the lot of unsecured creditors in chapter 11 cases can either rest easier knowing their concerns are misplaced, or simply codify the judicially well-accepted practice of critical vendor and similar first day orders and ensure the result occurs in all districts and not just the most experienced ones.

There are many more avenues for unsecured creditors to be paid in chapter 11:  insurance, letters of credit, cure payments, statutory priority, etc.  While some of the methods for paying unsecured creditors outside a plan reflect choices made by prior bankruptcy legislation, all ought to be taken into account to assess the relative treatment of secured vs. unsecured creditors in the real world as opposed to uninformed academic studies or agenda-driven reform efforts based on statistical garbage as opposed to real fact.

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[1]           Bizarrely, Lear is one of the cases for which the UCLA-LoPucki Bankruptcy Research Database contains a figure for unsecured creditors’ recovery (56.4%) that is reasonably accurate  if one blends all unsecured claims and recoveries into one pot.  That the database was right to begin with makes it even harder to understand Wood’s deviation from it.

[2]           In addition to those recoveries, a further $100 million was paid out to unsecured creditors under “first-day” orders as well. It should also be noted, in evaluating the “42%” recovery estimate for the one impaired class, that, according to Lear’s February 14, 2013 press release, “since November 2009 when Lear resumed trading on the New York Stock Exchange following its emergence from bankruptcy … the Company's equity market valuation has more than doubled.”

There is no Evidence that Unsecured Recoveries in Chapter 11 are Diminishing (Part 4: Valuation Differences)

This is the 4th in a series of blog posts demonstrating flaws in an argument that the Bankruptcy Code needs to be reformed to restore some purportedly lost balance between secured creditors and unsecured creditors.  In the prior posts, I demonstrated that the thesis that unsecured creditor recovery in chapter 11s has declined in recent years is based on incredibly shoddy data that is far too unreliable to support the reform agenda, and that the purported increase in second lien debt cannot be the cause of the purported decline. In this post, I lay out two valuation-related points:  1) that the two sample sets that were compared to make the argument of a decline in unsecured recoveries are not properly comparable because they cover different lengths of time and different economic environments;  and 2) any decline in recoveries is driven much more by valuation and intrinsic business merit than by the mix of secured versus unsecured debt.

Mismatched Sample Periods

Wood has chosen to analyze reorganizations that took place over a shorter period of time – 2 years – vs. the 6 years in the LoPucki study.  This makes for a highly misleading comparison. This misleading comparison is partly responsible for the purported differences in recoveries.

First, the earlier period had much more economic growth than the 2009-2010 time period. In nominal GDP terms (nominal because the debt of a chapter 11 debtors is quantified in nominal dollars, not inflation-adjusted dollars),  nominal GDP was more or less the same at the end of 2010 as it was at the end of 2008, the period Wood studies, while it rose at an average rate of more than 5% per annum over the 1991-96 period.

More significantly, the Lopucki study measures recoveries during a 6-year bull market, but Wood only studies 2 such years.  The S&P 500 index stood at 330.22 at January 1, 1991, the outset of the period covered in the “Lopucki study”, and rose to 740.74 by the end of that period, December 31, 1996  -- a 124% increase.   In contrast, from its January 1, 2009 level of 903.25 to its December 31, 2010 close at 1257.64, the same index only rose 39%, slightly less than one-third the increase in value that occurred over the period of the Lopucki study (which is understandable given that the Lopucki study period was three times as long). Both periods had roughly the same IRR – 18%.  The only difference is that the 18% IRR runs for 6 years in the sample with the higher recoveries, in contrast to only 2 years in the one with lower recoveries. Since valuations performed by investment bankers for disclosure statements reference comparable public companies explicitly (and also rely on analyses such as discounted cash flow and comparisons to acquisitions of similar companies that implicitly reflect public market valuations), the 1991-96 period is going to have higher average valuations in it than the 2009-10 period.  That’s all. There was no imbalance in the Bankruptcy Code at work.  Recovery differences were just a function of compounding over a longer period.

I can understand why a student graduating in 2011 would not be in a position to wait four more years to publish research.  But there is no excuse for his professor, or the editors of the American Bankruptcy Law Journal, or Gotbaum, to disseminate such obviously half-baked work as remotely reliable, let alone a basis for fundamental legislative changes.  It’s ridiculous to draw any inferences from comparing a six-year period of 18% IRR to a two-year period of 18% IRR.

Wood is not blameless, though. He conspicuously ignores recoveries during intervening periods, for example, the 2001-02 wave of restructurings.  But there was some data readily available to him for that period, right in the Lopucki study. In footnote 70 of that 2003 article, LoPucki wrote that a preliminary study showed unsecured creditors were experiencing substantial declines in recoveries in 2001 and 2002, compared to the 1991-96 data set.  In the 90’s, he stated, unsecured creditors received full recoveries in 59% of the cases, and only 27% of the time did they recover less than half of their claim.  But in 2001-02, he stated, the proportions were essentially reversed, with unsecured creditors recovering less than half their claim 62% of the time, and getting par only 25% of the time.  Wood does not make any use of the 2001-02 data.  Had he done so, he would have recognized that recoveries for unsecured creditors in his 2009-10 dataset were actually better than those in the 2001-02 cases, with unsecureds recovering less than half their claim only about 53% of the time (adjusting for errors Wood made in several cases).  That completely vitiates his thesis that recent recoveries are being affected by recent increases in the use of secured debt.  But the fact that both 2-year samples showed lower recoveries than the 6-year sample obviously confirms that the difference in recovery is in part attributable to the length of the sample. 

It’s Valuation,  Not the Mix of Secured Debt.

I think most practitioners familiar with the cases in Wood’s sample can tell that the recoveries would not have changed much had there been less secured debt.  Every one of the 25 companies with below-par recoveries for unsecureds, save possibly Spansion, had a debt/EBITDA ratio of over 10:1 when it filed chapter 11.   That’s going to affect recoveries.  In fact, in contrast to the typical bell-curve distribution one would typically see in a sample, the cases he cites tend to fall into a barbell pattern of two groups with extreme results:  100% recoveries and very low recoveries.  That shows the proportion of secured debt was largely irrelevant to unsecureds’ recoveries.  Only a small minority of the cases wind up with sizable but still below par recoveries to unsecureds. 

Several of the companies come from industries that bore the brunt of the “Great Recession” like auto (Hayes Lemmerz, Lear and Visteon, each of which also had large pension and OPEB liabilities that I didn’t include in the debt/EBITDA ratio), and housing (WCI, Building Materials, LandAmerica and Luminent, the last two of which were basically out of business even though they had little secured debt).  Valuations of those companies were dramatically affected by the depressed condition of their respective industries. 

Secular changes in the media industry drove ION Media, Idearc, Readers’ Digest, Young Broadcasting and Journal Register into reorganization, and pre-petition secured claims were badly haircut in all of them. Some companies in the sample had badly shrunken or even negative cash flow and, again, the secured lenders were badly haircut in each of those (VeraSun, Linens, MagnaChip, Aleris). 

A surprising number of the filings either were chapter 22s (Bally’s, Hayes Lemmerz, Pliant) or, since emergence, the debtors have filed again (Idearc, Reader’s Digest, Buffets, Journal Register), indicating that there were fundamental problems with their businesses that impaired their value even with de-levered capital structures, i.e., independent of capital structure.

Ignoring Secured Creditor Recoveries. 

Neither the LoPucki study nor the Wood article tabulates secured creditor recoveries.  By ignoring them, Wood and LoPucki deprive the reader of essential data with which to evaluate the hypotheses that secured creditors are somehow taking more value from unsecureds than in past eras. There’s no way one can determine that declines in valuation are not responsible for declines in recoveries for unsecureds and equity, without examining what happened to recoveries for the secureds in those cases.  It is clear from Wood’s data, taking it at face value, that the recoveries for every constituency that he chooses to look at have declined.  So what happened to the secured creditor recoveries that he chooses not to examine? An analyst needs to know that to figure out if the decline was valuation-driven, or if the secureds were simply capturing more of the value. The only correct way to decide which is at work is to include an analysis of  secured debt recoveries in the 1991-96 time period and then compare the results to secured debt recoveries in the more recent time period.

Still, the declines in equity recoveries are instructive if one is trying to get a handle on causation of declines in recoveries.  Even if one subscribes to the dogma that secured debt takes away from unsecureds’ recoveries and blames increases in the former for declines in the latter, one must recognize that secured debt does not take away from equity any more than unsecured debt does, so shifts in the mix of secured debt vs. unsecured debt should not change equity recoveries (yes, if you are a good soldier in the war against secured creditors, you can conjure up Rube Goldbergian sequences of causation, where being secured makes a lender act differently and that changes the case dynamics and that causes losses, but in the real world, no: it’s valuation that determines the recoveries.). Since Wood’s data show declines in equity recoveries, so it seems fairly obvious that there is another explanation for pervasive declines throughout the capital structure, i.e., valuations were different.

In sum, even if declines in unsecured recoveries have happened, and are not the result of bad data, or artifacts of methodological decisions or mistakes, one cannot explain them with confidence as the result of developments in secured debt, if one has not analyzed the recoveries of secured debt!  This seems incredibly obvious but is completely missing from the Wood analysis.  However, an understanding of the specific business dynamics of the cases in his sample informs one that the quantity of secured debt was irrelevant in many cases to unsecureds’ recoveries. 

There is no Evidence that Unsecured Recoveries in Chapter 11 are Diminishing (Part 3: Pervasive Errors in Tabulation of Recoveries)

This is the third in a series of blog posts related to a commission appointed by the American Bankruptcy Institute which has been presented with arguments for reform of the Bankruptcy Code to benefit unsecured creditors at the expense of secured creditors.  In the first, I explained that the advocates of reform have relied heavily on a law review article written by a student named Andrew A. Wood under the tutelage of Professor Lynn LoPucki at UCLA Law School, which (1) presents data that purport to show a substantial decline in unsecured creditors' recoveries in recent years and (2) attributes the purported decline to a purported increased use of second lien debt in capital structures.   I then outlined the issues I have discovered with Wood's article.  In the second post, I gave a detailed refutation of Wood's claim that second lien debt had negatively impacted unsecured creditor recoveries.  Now, in this post, I will show numerous, large misstatements in Wood's article concerning the size of unsecured recoveries in the cases he studied.

Pervasive Errors in Tabulation of Recoveries. 

The Wood article and the database it relies on contain several material misstatements and omissions of recovery data.  In several cases that purportedly had low unsecured creditor recoveries, I found glaring errors in the data that substantially understated their actual recoveries. Many of the errors stem from not capturing a plan amendment that changed recoveries, or not being aware of the confirmation of a competing plan that altered them.

For example, here is what Wood says about the Six Flags case: “in the Six Flags bankruptcy, the General Unsecured [again, his capitalized terms] group was expected to recover between 31 and 42 cents on the dollar against Six Flags International [sic[1]], but only 3 cents against one subsidiary and 100 cents against another.”  (Wood, p. 436).  For those recoveries, he cites the company’s June 13, 2009 disclosure statement.  Six Flags, however, did not emerge until a year later.  In between, there were further amendments to the plan and disclosure statement, an intense valuation dispute, and, finally, a settlement in March and April 2010 under which a group of noteholders at holding company Six Flags Inc. agreed to fund payment in full, in cash, to all creditors at other estates (including an agreed amount in respect of prepetition and postpetition interest to the noteholders at the operating subsidiaries, giving those unsecured creditors a recovery of around 110 cents on the dollar). Wood does not appear to have been aware of those material developments. 

The Journal Register case is another example of missing a major development in the case that increased unsecured recoveries.  Wood reports the recovery by general unsecureds to have been 9 cents, based on the plan’s distribution of $2 million across a pool of $27 million in claims. However, as Judge Gropper’s publicly available confirmation opinion stated, the plan also provided an additional $6.6 million distribution to trade creditors, that was a “gift” from the secured creditors out of their own recovery to induce acceptance of the plan.  Wood simply ignores that larger amount, which more or less quadrupled the unsecureds’ recovery.

He makes the same mistake about Pliant, evidently unaware that the plan confirmed was not the one originally filed by the debtor, but the later one that gave Apollo control of the company.  In contrast to the “0.5 cents” recovery he shows, which comes from the debtor’s unconfirmed plan, the confirmed plan gave general unsecureds (including the 2d lien which was classified as unsecured) 17.5 cents on the dollar.

The Smurfit case is also a striking example of the huge inaccuracies in the article.  Wood lists the recoveries to “General Unsecureds” in the Smurfit case as “0-100%”.  In the text of the article, he states “When computing the average, I took the midpoint values for any of the cases that had a range of recoveries for a given class.” That would mean he included Smurfit recoveries at 50% in computing his average for the entire sample.  But,  if he had simply reported what is contained in the court-approved disclosure statement (March 28, 2010), he would not have needed to “take the midpoint”; instead, he would have seen the following in the table of recovery estimates for the US debtors :

Class	Description	Estimated Allowed Claims	Treatment	Estimated Recovery
2E	General Unsecured Claims (SSCE)	$2.8-3.1 billion	Impaired	64-71%
1D, 6C-14C	SSCC and Non- Operating Debtors (United States)	$11.2 million	Impaired	0%
3C, 4E, 5C	General Unsecured Claims: Cameo Container, Calpine Corrugated and SSPRI	$4 million	Impaired	100%
2D	Convenience Claims	$25-30 million	Impaired	100%

The “billion” in the first row is not a typo.  The author’s “0-100” range has as its endpoints two classes that are less than 1% of the pool of unsecured claims. Worse, the “0%” only applied to creditors of non-operating debtors!  By taking the midpoint of that range, he completely ignores the substantially higher recovery of 99% of the  unsecured claims in the case, 64-71%, and materially understates unsecureds’ recoveries.

He makes a similar error in the data for Building Materials Holding Corp.  The amended Disclosure Statement filed July 27, 2009, applying to the confirmed plan, shows recoveries for unsecureds to be 55.25% and no recovery for equity.  Wood, however, records recoveries for “Senior Unsecured” as “100 cents” and “General Unsecured” as “12.1 cents” and gives old equity 36% of the equity of the reorganized debtor.  I have no idea where he got the numbers he uses. To the extent he averaged “100” and “12.1” using equal weights, he got to almost the same number as the disclosure statement, but I cannot tell if that is what he did or just a coincidence.

The Luminent Mortgage distribution is also listed incorrectly.  The senior unsecured lenders received approximately twice as much value as he reports, owing to turn-over provisions in the company’s subordinated debt that the article completely ignores.  In that tiny liquidating 11, which involved only $13 million in assets, secured claims, which represented about 1/8th of the debt in the case, were held only by an affiliate and received a smaller distribution than unsecureds, which the plan valued at zero.

In the Hayes Lemmerz chapter 22, Wood simply failed to look hard enough for recovery data.  He footnotes that the financial data was not presented in the Disclosure Statement, which may be true, but in fact the information can be found in a Plan Presentation Exhibit (docket number 824), which shows recoveries for unsecured creditors of approximately 0-5% for several different classes (noteholder, PBGC, general, etc).  Significantly, relative to his thesis, the secured class receives no better dividend.  The value simply wasn’t there for anybody.

Those are the cases where Wood portrays recoveries as less than the 77% figure ascribed to the earlier era.  But turning to the cases with higher recoveries, I found still more material errors. 

Regarding the R.H. Donnelly case, he lists the recovery as 100% for “General Unsecured” and puts nothing in the column under “Senior Unsecured”.  But that plan identified only about $19 million of “General Unsecured”, and separately classifies over $9 billion of unsecured notes that he does not mention.  They recovered from 6 to 88 cents on the dollar depending on which debtor they had claims on.

Regarding Neenah Enterprises, there is a similar omission of the recovery to senior unsecured notes, which was stated in the disclosure statement to be 80%.

Regarding NTK, he lists as a 100% recovery for “General Unsecured” and “0.5-2” for “Senior Unsecured”.  A practitioner can tell at a glance that he has to have one of those numbers wrong.  No plan of reorganization containing such a large disparity is ever going to get confirmed.   In fact, upon inspecting the disclosure statement, one learns that the notes that got that pittance of a recovery had claims only against the holdco.  But there were also senior unsecured notes with claims against operating companies that had recoveries between 24 and 66 cents on the dollar – all of which his article totally omits.

Finally, he depicts Charter Communications as a 100% recovery for general unsecured creditors, with nothing in any column related to senior or subordinated unsecured debt.  But that well-known case had billions of claims based on unsecured notes issued at various levels in the corporate structure with recoveries ranging from 0-100% depending on their structural ranking -- all of which his table completely ignores.[1] At the debtor CCI, for instance, the final (May 7, 2009) disclosure statement reveals that the pool of “General Unsecured Claims” (class A-3) received 100% - but only had $1,019,317 in allowed claims, while a class of notes issued by that debtor (class A-4) that was owed more than $497 million received only 19.4%.[2]  At the same time, the unsecured notes in Class H-4, with over $2.5 billion in claims against a different debtor, received over 100% due to postpetition interest, so the results differ widely from the simple “100%” figure Wood reports.

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[1]           Strangely, Charter is one of the few cases where the UCLA database actually gives a figure for unsecured creditor recoveries, although it is less than half of Wood ‘s 100%.  Wood does not explain where the 100% figure comes from.

[2]               The class also got 3.9% from claims against a holdco debtor, according to the plan.  The trustee for those notes subsequently stated in its January 10, 2013 petition for certiorari to the Supreme Court to overturn the confirmation order that the class’s recovery was actually 32.7%.

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[1]           There was no debtor in the case named “Six Flags International”; I believe Wood was referring to the holding company, Six Flags, Inc.