Enforcement of Intercreditor Agreements In Bankruptcy

Enforceability of pre-petition Intercreditor Agreements in bankruptcy has drawn more attention with the increase in restructurings in bankruptcy in the wake of a troubled business climate. Of course, both first priority lenders and second priority lenders both desire protection during a restructuring. Not surprisingly, many lending arrangements involving multiple lenders take into account the potential of disputes and bankruptcy. Section 510(a) of the Bankruptcy Code upholds these arrangements providing that "[a] subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law." When it comes to subordination agreements during bankruptcy reorganizations, though, this provision must be read alongside the power of the bankruptcy court to confirm plans under §1129, approve sales under §363(b) and the mandate that the court appoint examiners in certain cases under §1104(c). Accordingly, whether, and to what extent, an intercreditor agreement falls under the protections of 510(a) and the authority of the bankruptcy court under other provisions has been the subject of several recent cases illustrating the limits of parties’ abilities to make arrangements prior to bankruptcy.

In one recent case, the Bankruptcy Court for the Southern District of New York acknowledged that a second priority lender had standing to object to a proposed sale of assets despite the existence of an intercreditor agreement, but concluded that a secondary lender could not prevent a sale of assets that is supported by “good business reason[s].” In re Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010)(concerned a proposed sale of assets in bankruptcy of a power plant that provides electricity to the Boston, Massachusetts area to a buyer who would take the assets free and clear of creditors’ claims). See also, In re GMC, 407 B.R. 463, 498 (Bankr. S.D.N.Y. 2010)(“[t]his is hardly the first time that this Court has seen creditors risk doomsday consequences to increase their incremental recoveries, and this court – which is focused on preserving and maximizing value, allowing suppliers to survive, and helping employees keep their jobs – is not of a mind to jeopardize all of those goals.”). Ultimately, the court determined that “[t]he Debtors’ assets are simply being sold; the First Lien Lenders will receive most of the proceeds in accordance with their lien priority; and the remaining consideration will be subsequently distributed under a plan."

In another recent case, the the United States Bankruptcy Court for the District of New Jersey held that a court can irrespective of a prepetition subordination agreement confirm a nonconsensual bankruptcy reorganization plan that meets the requirements of §1129(a). In re TCI Holdings, LLC, 428 B.R. 117 (Bankr. D.N.J. 2010)(when “the requirements of section (a) and (b) of [1129] are met with respect to more than one plan, the court shall consider the preferences of creditors and equity security holders in determining which plan to confirm.”). Essentially, the bankruptcy judge acts as a tiebreaker where the parties to the dispute are unable to negotiate an agreement among the competing interests at stake.

The treatment of intercreditor agreements by courts has important implications for lenders when it comes to drafting these agreements. Basically, attorneys should be mindful that general contract principles control issues such as interpretation of agreements and waiver even in the context of bankruptcy. See, e.g., In re Erickson Ret. Cmtys., LLC, 425 B.R. 309, 316 (Bankr. N.D. Tex. 2010)(“Michigan Retirement System Entities are sophisticated commercial entities who knowingly waived all legal and statutory rights that would be in conflict with their obligation to "standstill" until the Ashburn and Concord Project Lenders' indebtedness is paid in full.”). The In re Boston Generating court’s holding that a second lien holder has standing to object to the sale of assets in bankruptcy is a reminder to counsel that if a waiver of such rights is desired, it should be expressly and clearly stated in the agreement. Notwithstanding this holding, bankruptcy courts will enforce waivers when clearly stated in the intercreditor agreement. In re Erickson Ret. Cmtys., LLC, 425 B.R. at 316.

These cases as a whole serve to remind us that these disputes during bankruptcy typically revolve around creditors seeking to enhance returns even in the face of an intercreditor agreement that states otherwise. Pre-bankruptcy lender agreements are typically designed to ensure that lenders obtain specified restructuring benefits. The cases demonstrate that despite the involvement of legal counsel, agreements between lenders are commonly ambiguous and create interpretation issues which can lead to the delay of reorganization plans of the debtor, sales of assets and other bankruptcy decisions that preserve the value of the debtor’s assets. As I remind my students often, clarity in contract language at the outset, when possible, will speed up the resolution of disputes later.

- JSM

Call for Papers--Debtor-Creditor Law Broadly Understood

Call for Papers—AALS Section on Creditors’ and Debtors’ Rights

The Future of Debtor-Creditor Scholarship

Both domestically and internationally, for both well-known businesses and anonymous consumers, world events lately have thrust issues of debt, creditor rights, and debtor protection into the spotlight. The field of debtor-creditor scholarship has perhaps never been as fertile as it is today. Its future will ultimately become the responsibility of those having entered the academy during this most robust period. This year’s program is designed to highlight the contributions of those who have just begun to toil in this field, to reveal for the section the newest ideas from recent newcomers, to give these developing scholars an opportunity to present their thoughts and receive feedback in a friendly and receptive forum, and to give more experienced section members a chance to mold and inspire these developing producers—and the future of our section—with constructive questions and comments.

The Section on Creditors’ and Debtors’ Rights thus issues a call for papers on the topic of debtor-creditor scholarship, most broadly understood, for presentation at the AALS Annual Meeting in New Orleans in January 2010. Proposals are welcome from a wide array of perspectives with a connection to creditors’ rights and debtor protection. Proposals may be in any stage of production, from early-stage idea to mid-stage working draft to polished paper, though work that will not be published by January 2010 will be strongly preferred. The section does not plan to publish the papers in a symposium, so presenters are free to seek publication elsewhere. Strong preference will be given to proposals from those who will not yet have been awarded tenure by January 2010 and to those whose work is not already well known within the section. We would anticipate three presentations of 15-20 minutes, each followed by 10-15 minutes of questions and comments from the audience. The Section’s brief business meeting will conclude the program.

Deadline for submission is Monday, August 31, 2009. Please email proposals to section chair, Jason Kilborn, at jkilborn-at-jmls-dot-edu. Selections will be made by late September by the Executive Committee of the Section (chair Jason Kilborn, chair-elect Katie Porter, secretary/treasurer Rafael Pardo, executive committee members Michelle Arnopol Cecil and Alan White, and immediate past chair Jean Braucher). Pursuant to AALS policy, presenters will have to cover their own travel expenses and registration fee for the annual meeting (typically with support from their home institutions), as the Section is prohibited from reimbursing for such expenses.

Bankruptcy Commercials

Lawyer advertising has always received a bad rap. Its hard enough to tell whether lawyers are capitalizing on people's misfortunes when charging clients to sort out their problems (I don't have a problem with charging clients, but I do recognize the perception outside of business circles that lawyers make money on the heels of tragedy). That being said, I don't know how you produce a "classy" commercial. If you use empathy, it just looks shallow -- i.e. the single mom at a table with a stack of bills at 2:00 in the morning and the voice over of someone that sounds like a televangelist talking about no hope, and "there's a way out." If you try a business approach, you just look like a non-caring SOB that is going to get paid -- i.e. two attorneys posing, usually in front of bookshelves, sitting 3/4's on a desk, or some other office setting, and telling you "you have rights," (by the way that we will convert into dollars in our pocket). I point this out because I am not really sure what to do with this one. Is it anger, comedy, both or neither?



Here is another.


Marc (MLR)

Banker's Cognitive Dissonance

Photo by darkpatator.

Jamie Dimon just doesn't get it. I suppose it's his job as CEO of JPMorganChase not to get the point about the need for reasonable mortgage modification to avoid unnecessarily wasteful foreclosures that are deepening (causing?) the current economic mess we're in. The Financial Times reported yesterday that Dimon strongly opposes--surprise, suprise--current bills in Congress that would allow bankruptcy judges to value claims secured by principal residences at the realistic, current value of the home, rather than the fanciful, contrived value on which the mortgage was based. This isn't the place for a drawn-out explanation of "mortgage strip-down," but suffice it to say that the current bills bring the treatment of principal residence mortgages into line with the treatment of other secured claims (it's actually more involved than this, but this is the takeaway point for non-specialists).

As a policy matter, thess bills essentially punish banks (and MBS securitization trustees and servicers) for unreasonably refusing requests for modifications of distressed mortgages (that in most cases help the banks/investors to avoid major losses in foreclosure). If the lending industry had responded to Congress and supported reasonable modifications before, these bills wouldn't be in the hopper. But these banker folks are now infamous for their unreasonableness (recall, these are the same rocket scientists who valued my home at a discount to actual recent sales prices for identical homes in my townhome association because the other places had been on the market too long!). Now, Dimon will have to lie in the bed that he and his like have made. One of these bills very likely will pass, probably the Durbin bill, behind which even Citigroup and other lenders have thrown their support.

Dimon invites us to feel sorry for the banks, whom this bill would put "at the mercy of the vagaries of the courts." This is ridiculous, as the bill does no such thing--the market value of the property defines the value of the bank's claim. There's no judge discretion or beating up on mortgagees going on here; it's simple market economics. And by the way, Dimon clearly has no problem with borrowers being at the mercy of the vagaries of the market . . . What goes around, comes around.

Dimon's main argument against this bill is the same old, tried-and-true argument that every economist/banker/fill-in-the-conservative-blank levels against any kind of consumer protection or market regulating legislation: it will make banks less willing to lend for fear that loans will be modified or destroyed in bankruptcy. For Heaven's sake, when will bankers stop making this utterly ludicrous argument. First, perhaps a bit less lending is exactly what the doctor ordered, at least less lending to the droves of people who should never have received loans on the terms that these banks and brokers foisted on them in the past several years (leading to our current predicament). Second, no amount of consumer protection has ever inhibited banks from lending, either here or in other countries, even after banks have made their "sky is falling" arguments before passage of legislation (see, e.g., the broad-ranging adoption of consumer bankruptcy in Europe over the past 20 years--lending certainly hasn't ground to a halt there!). Finally, the Durbin bill (as amended in the deal to secure Citigroup's support) applies only to mortgages already existing--not to prospective mortgages. This tired argument about "we will be hesitant to lend if you pass this law" is totally off the mark with respect to the Durbin bill.

My favorite comment: Dimon warns that passage of the bill will "lead to an increase in personal bankruptcies." Well, no @#$%, Sherlock! That's the whole point. We wouldn't need more bankruptcies if the bankers would act reasonably in dealing with the foreclosure crisis, but since they've amply demonstrated that they're incapable of dealing with it responsibly, Congress is stepping in. This is like criticizing the release of a new cancer drug for fear that it will lead to more doctor visits by sick people. Indeed!

Oops!

Law.com reports that Bank of America and Citibank stand to lose in excess of $51 million because Bank of America, acting on its own behalf and as Citibank's agent, terminated both banks' financing statements against the former law firm of Heller Ehrman in August 2007, some 14 months before Heller Ehrman filed bankruptcy. As we all know, UCC § 9-317(a)(2) and 11 U.S.C. § 544(a)(1), collectively, generally give a bankruptcy trustee (or a debtor-in-possession) priority over any security interests that were unperfected when the debtor filed bankruptcy. That's bad enough news for Bank of America's and Citibank's apparently unperfected-at-filing security interests. (Bank of America and Citibank have argued that an October 2008 "correction" revived their perfection well before Heller Ehrman filed bankruptcy and had the effect of making the banks perfected when Heller Ehrman paid them. Heller Ehrman counters that the "correction" did not cure the banks' lapse in perfection.)

But, wait, it appears to get worse. Less than 90 days before Heller Ehrman filed bankruptcy, and well after Bank of America terminated its and Citibank's filings, Heller Ehrman paid the banks $51 million of the firm's outstanding debt. Under 11 U.S.C. § 547(b), the payment looks like an avoidable preference, which the banks may have to refund to the bankruptcy estate.

With Pillsbury Winthrop Shaw Pittman on one side and Greenberg Traurig on the other, this dispute figures to be hotly contested and should be interesting to follow.

(Hat tip to Scott Burnham.)

Economic Trouble Hits the Little Blue Guys?

Photo by unfolded

This post is both silly and serious. On the silly side, I just couldn't resist noting that the W$J today announced that Smurfit-Stone has warned its lenders that it may seek bankruptcy. I can't see that name without thinking of the little blue guys of my youth (I had a small collection of the cute little characters). On the serious side, Smurfit is a sort of bellwether for the economy, as it produces cardboard boxes of every size and shape. When consumers stop buying things that go in boxes, companies like Smurfit are on the other end of the chain of businesses that suffer. When the pain reaches that far, we know we're really in serious economic trouble (as if that weren't clear already). Brace yourself for many more announcements like Smurfit's in coming months.

Bracing for the Wave of Retail Bankruptcies

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I don't want to seem too gleeful about this, but we insolvency professionals are likely to be in the spotlight for a while during this Year of the Bankruptcy. I'm surprised it took so long for the W$J to come out with the first such story of 2009, but today's Marketplace section (on B1) announced a Wave of Bankruptcy Filings Expected From Retailers in Wake of Holidays. The current period, unprecedented in so many ways, will likely see an unprecedented and massive restructuring of the U.S. retail sector. Much of the activity will be liquidations, it seems to me, whether out of bankruptcy altogether, under Chapter 7, or even in liquidating Chapter 11 plans. Our unsustainable reliance on out-of-control consumer spending seems to have met its demise. Or maybe this will be a temporary lull, with consumers pulling out the stops once the job market rebounds. One way or another, 2009 will be a rough one for many. Here's hoping that this year can also be marked as the Year of the Great Recovery.

GM, Chrysler & Tribune Creditors Go to "The Barbershop"

Photo by Elaron

As predicted, at least two of the Big Three auto makers are headed into an out-of-court workout orchestrated and likely financed by the U.S. government. My new favorite quote is from Nancy Pelosi: "We call this the barbershop. Everybody's getting a haircut here . . . ." She included management in the list of parties who will be called on to make concessions--including dumping those fancy corporate jets (talk about bad PR!)--in exchange for government financing of the workout (let's just call it DIP financing, shall we). The W$J story aptly compares the workout procedure to bankruptcy, which is, of course, exactly what's going on here, though the informal process will lack both the psychological stigma of "bankruptcy" and the muscle that the Bankruptcy Code would provide in dealing with leases and intransigent holdout creditors. The primary purpose of Chapter 11, in my view, is to allow a majority-approved workout plan to be forced--"crammed down," as we say--on dissidents. I guess the gravitas of the U.S. government will be the 800-pound gorilla in this deal.

I'm getting closer to figuring out who will be sitting in the barber's chair in the Tribune Company bankruptcy, too, especially in terms of employee retirement and other claims. It seems that we have good news and bad news.

The good news is that, while 100% of the company's stock is held by an Employee Stock Ownership Plan (ESOP), very little time has passed since that plan took over the compay's equity, so employees apparently have made no concessions or contributions to the plan, which will now likely be wiped out in the bankruptcy. While the employees are technically the beneficiaries of the stock held by the ESOP, the trust obtained the stock through a $250 million loan from the company, so employee rights in the stock would have vested only over time as the the company reduced the ESOP trust's debt by making annual contributions to the ESOP. Since this hasn't happened yet, the employees will really lose next to nothing in terms of retirement assets--thank goodness. Most of this is explained in a wonderful note by Corey Rosen, executive director of the National Center for Employee Ownership. Ironically, from the employee retirement assets perspective, it's probably actually a rather good thing that the company sought bankruptcy earlier rather than later (before it put lots of employee retirement contributions into the ESOP black hole). The compay's "pension plan," which closed last year, seems to be safely outside the bankruptcy case in a fully-funded $1.8 billion trust (beneficiaries with "frozen" pension rights should be safe). The same is true of the 401(k) plan set up by the company, but to which the company discontinued making employer contributions when the ESOP was set up.

The bad news seems to be that the the primary part of the three-part Tribune employees' future retirement plan seems to be up in the air now. The first, a "cash balance," low-risk money fund that will hold planned 3% annual cash contributions (the first to be made in 2009), will apparently be unaffected (though one wonders what future contributions will be). As for the second part of the plan, employees can continue to contribute themselves to a 401(k) account (though employer contributions were suspended last year). The cornerstone of the company's post-2008 retirement plan, however--the ESOP--will in all likelihood be gutted in the bankruptcy. In addition, as described in this fantastic New York Times summary of the situation, the "little guys" with the most to lose are those who recently accepted buy-outs and severance deals. This includes folks like a reporter mentioned in the NYT story who just sent in his paperwork to accept a buy-out equal to 49 weeks' pay (severance for more than 24 years of work)--a deal that is now in jeopardy as these types of people join the ranks of unsecured creditors. Luckily for these folks, up to $10,950 per person of such claims, earned within 180 days of yesterday (the filing date), will be § 507(a)(4) "priority" unsecured claims, which get to budge in line ahead of the general unsecured creditors (probably including the banks and bondholders).

It's a sad, rainy day in Chicago today. One of the most beloved institutions in town is in bankruptcy, and our governer was arrested by the FBI this morning, charged with corruption (more "pay-to-play" allegations leveled at yet another Illinois governer). I, for one, am looking forward to a brighter 2009!

Tribune Company List of Creditors--Where's Zell?

The plot thickens? The Tribune Company's bankruptcy petition and related statements are online, courtesy of the L.A. Times. As I mentioned in my earlier post, Zell's stake in the company is reportedly represented primarily by a $225 million 11-year subordinated note. I went hunting for this obligation in the "Consolidated List of Creditors Holding the Thirty Largest Unsecured Claims Against the Debtors," and I couldn't find it. The range of claim amounts is quite broad, from the $8.57 billion owed on the senior bank facility all the way down to a $1.69 million claim by Paramount Pictures Corp. for "trade debt" (maybe licensing fees or something?). Where's Zell's $225 million note? I wouldn't expect to find Zell's name on the list--doubtless, he made the loan through one (or more) of his companies. But of the several mentions of "subordinated promissory notes due 2018" (which would precisely describe the notes I would expect to find reflecting Zell's stake), all five are listed as much smaller amounts ($3.3 million, $2.8 million, down to $2.16 million). These notes are held by companies named "Tower XX, LLC" (where XX is a two-letter combination that differs for each company), c/o Equity Group Investments (which I believe is Zell's company). The five notes add up to only $13.4 million--a far cry from the $225 that the reports I had seen suggested for Zell's position. Is the remainder broken into dozens of notes for less than $1.691 million (the smallest claim on the list)? Curious.

Tribune Bankruptcy and Absolute Priority

Photo by matt1125

The Tribune Company, owner of the flagship Chicago Tribune, as well as the L.A. Times, Baltimore Sun, WGN News, and other assets (including the Chicago Cubs) has finally entered Chapter 11 bankruptcy--a destination toward which it has been slouching for months. It thus seems to have become the latest victim of private equity's debt-fueled LBO rampage, joining Mervyn's and perhaps Bally. Tribune Company Chairman and CEO (and architect of the recent ill-fated going-private deal) real estate tycoon Sam Zell said that he expects creditors to take a significant haircut: "[s]ome elements (of the credit structure) will have no recovery."

As mad as the creditors are likely to be about this, the shareholders--especially the employees--are likely to be hopping mad when the facts emerge about how this company will restructure. Tribune Company is "America’s largest employee-owned media company," and many employees were unhappy about Zell's takeover/privatization of the company, as well as his capitalism-heavy-journalism-lite management refocus, and now they'll have reason to be really upset. While Chapter 11 may well not mean the demise of the company, it will almost surely mean the complete or near complete destruction of whatever value the employee's ownership stake (equity) might have had before the filing. The reorganization will almost certainly result in a debt-for-equity exchange, where current equity gets squeezed out (at least for the most part) and big debtholders take over that equity in exchange for discharge of debt. The absolute priority rule will almost certainly prevent equity (shareholders) from retaining any significant stake if some significant group of creditors will have "no recovery." Unless every creditor class can be convinced to vote in favor of a plan that leaves some value for equity, the company will be unable to confirm a Chapter 11 plan. Indeed, one wonders what Zell plans to do about his own equity stake.

Maybe there are more surprises waiting in the wings here, but this is yet another sad day in a long string of sad days for the Tribune Company's employees, who seem to have been largely involuntary passengers on Zell's pirate ship to Chapter 11.

Update: A little surfing answered my question about Zell's personal stake and added an interesting twist to the case. Zell's $315 million (!) investment in the going-private deal was structured as a $225 million subordinated 11-year note and a $90 million warrant to purchase up to 40% of the company's shares within 15 years from the Employee Stock Ownership Plan that now owns 100% of the Tribune Company's equity. Thus, Zell's $90 million warrant is likely worthless (or nearly so) after the bankruptcy filing (for the reasons discussed above), but his $225 million note is debt, which will likely be promised some distribution in a Chapter 11 plan. I intend to follow this (for me, local) case in the days ahead, focusing on the word "subordinated." While Zell's note now is likely subordinated only to the other company debt (both public bonds and bank loans), it might well ultimately be equitably subordinated under Bankruptcy Code § 510(c)(1) to the ESOP's share interest, which Zell's going-private transaction has now all but completely destroyed. Stay tuned!

Bally's Yo-Yo Bankruptcy Diet

Photo by Boso

I just can't resist the pun opportunities presented by Bally's second bankruptcy filing in 14 months. Apparently, Bally has not internalized its own core message to its customers: you have to burn more calories than you take in (in other words, burn off more debt than you take on). With $1.4 billion in assets and only $479.5 million in net revenue for the 9 months ended September 30, 2008, Bally's $1.5 billion in debt leaves its balance sheet looking almost as flabby as it did when the company went on its first crash bankruptcy diet in 2007. Bally's personal trainer--Bankruptcy Judge Burton Lifland in the Southern District of New York--now has the second case, even before he had finished up the final details on the last one! Rather than focusing on toning up its balance sheet, Bally appears ready to throw in the towel and pursue a negotiated sale. One hopes the new owners will impose a stricter nutrition/workout regime on Bally, unlike the bloated hedge-fund firm that now owns it (these hedge funds are becoming infamous for their force-feeding of other formerly fit companies like Mervyn's).

Bankruptcy as "Digging a Hole Far Too Deep"?

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People just don't seem to understand bankruptcy. Given the smear campaign of recent years, it's not surprising that consumers would fear and distrust a "bankruptcy" filing by GM and Chrysler. But today, a key leader with decision-making authority on the future of the U.S. auto industry seems to have revealed her own misunderstanding. House Speaker Nanci Pelosi rejected a GM/Chrysler bankruptcy as "digging a hole far too deep."

I've got news for Nanci and others who might feel this way: GM and Chrysler are already in a "hole far too deep." Bankruptcy is not the cause of financial ruin; it's a response to the financially ruinous situation in which debtor-companies already find themselves. Indeed, bankruptcy in the form of U.S. Chapter 11 (and a growing number of similar laws around the world) is a response designed to overcome the problems that GM and Chrysler face, to facilitate a rehabilitation and get them out of the hole. It accomplishes this, in part, by making it starkly apparent that the end is nigh unless everyone stops playing chicken and seriously considers the shortest "haircut" they're willing to take (that is, the best concessions they're willing to offer to save the company), and irrational holdouts can get a deal "crammed down" on them by a majority vote of the more deal-welcoming creditors. Lenders, bondholders, suppliers, employees, retirees, shareholders, etc., all are forcefully seated at a "no B.S. zone" bargaining table and sternly instructed that if they leave, there's a cliff on the other side of the door.

The "hole far too deep" is where GM and Chrysler are now and where they and their various constituencies (not the least of which the U.S. economy) will be if solutions like a bankruptcy-like workout are not seriously considered . . . and soon.

That being said, for the reasons I mentioned before, I'm afraid an irrational overreaction by the market for GM/Chrysler's products might well scuttle its business if a Chapter 11 filing is made. The solution points up the misunderstanding inherent in Pelosi's comment: GM and Chrysler are already in what might be called informal bankruptcy. Either they respond to Harry Reid's demand to produce a workout proposal that the Treasury can fund by the beginning of December (an out-of-court workout, an informal "bankruptcy" that keeps that psychologically troublesome word out of the press), or they face literal "bankruptcy," which would strengthen the debtor-companies' hands with respect to their creditors, but might well destroy the "goodwill" upon which their business depends. Either way, GM and Chrysler are already in a "bankruptcy" hole, and their leaders and advisers need to go back to Capitol Hill, this time with a serious proposal for a sustainable workout, not just a handout.

Little Guys v. the Big Three in Bankruptcy

Photo by gemsling

We've really wedged ourselves between a rock and hard place with all the bankruptcy reform rhetoric of the past few years. Now that we've convinced many consumers that bankruptcy is to be avoided at all costs and can never be an acceptable part of responsible financial administration, we really need to convince them that a bankruptcy by GM and/or Chrysler would be an O.K. thing--indeed, a normal market mechanism for regulating their financial distress, far superior to government intervention. As far as I can tell, the only real problem with using the world-famous Chapter 11 to solve GM/Chrysler's problems (just as we did successfully for Continental airlines, for example) is that consumers would react irrationally, equating a Chapter 11 filing (reorganization with a view to renewed financial health) with "going belly up" or some similar rhetoric of "failure." So bankruptcy is no good for David, but it's O.K. (probably essential) for Goliath, but in an ironic twist, Goliath's business depends upon lots of Davids buying Goliath's goods, and policymakers have bent over backwards to convince David that a bankruptcy filing always reflects poorly on the filer. What a mess!

O.K., there's one more big problem. Businesses are finding it harder and harder these days to reorganize in Chapter 11 because they can't find debtor-in-possession (DIP) financing to support their turnaround efforts. If average businesses can't find DIP financing, where do you think GM/Chrysler can turn for a loan . . . ? The Treasury, of course!

So at the end of the day, lawmakers on Capitol Hill have been loudly rejecting calls for a non-bankruptcy workout loan (or other rescue infusion of cash) for GM and Chrysler, but the Treasury would be the most likely (perhaps only) financier of a GM/Chrysler bankruptcy . . . and going into bankruptcy would produce (arguably) irrational resistance by customers who would be repulsed by a GM/Chrysler bankruptcy filing.

Seems to me we ought to get off of this merry-go-round with an out-of-bankruptcy restructuring for GM/Chrysler, funded by loans from Uncle Sam, assuming Uncle Sam's analysts can conclude that GM and Chrysler have some hope of a sustainable, competitive business down the road. That's the big question, and an interesting article in today's W$J on the latest report concerning residual value suggests that GM and Chrysler have a serious burden to carry in convincing Uncle Sam that they can make decent cars and government financial support for their business in or out of bankruptcy is warranted.

Is Congress Afraid or Unwilling to Compare?

Photo by nromagna

I recently found yet another striking illustration of the stark contrast between U.S. and European legislative efforts to explore comparative (foreign) solutions.

When the U.S. Congress was considering the wholesale revision of the Bankruptcy Act in the early 1970s, the Bankruptcy Commission report contained a section on "Contemporary Bankruptcy Experiences in Other Nations." I was excited to see this early openness to comparative analysis . . . until I read the two-paragraph section. After a number of observations on how different the "legal, economic, and social conditions" are in the U.S. and elsewhere, and without saying anything about the approach(es) taken by foreign systems, the report concluded glibly "the bankruptcy experience of other countries is not a useful resource." [H.R. Doc. No. 93-137, Pt. I, at 66 (1973)] Sigh. Granted, at least in my area of interest (consumer bankruptcy), there wasn't much to compare in the early 1970s, but one might have expected a bit more effort from U.S. policymakers . . .

In contrast, when Denmark set out to consider adopting the first consumer insolvency law in Continental Europe, it took careful account of comparative lessons to be learned. Like the U.S. commission's report, the 1982 report of the Danish commission assigned to explore this issue contains a section on "Foreign Law." [Betænkning on Gældssanering, nr. 957 (1982)] This section, though, is not two paragraphs, and it doesn't dismiss all foreign legislation as "not a useful resource." Instead, it undertakes an impressively sophisticated analyis of consumer bankruptcy legislation and practice in England, Ireland, the U.S., Canada, and New Zealand (11 pages). Though the approaches of these "Anglo-American" systems was ultimately rejected as inconsistent with Danish-Continental legal philosophy and practice, at least they considered--quite carefully and sensitively--relevant foreign models.

Note that the language of all of the systems considered by the Danes was English. So there's one less excuse for the U.S. Commission's failure to consider these comparative models. But it gets better! Midway through the Danish report's comparative consideration of U.S. law, it directs the reader to consider a lengthy passage from the legislative history of the U.S. Bankruptcy Code, enacted a few years earlier. The entire page-and-a-half passage is reproduced in English! The message is clear and impressive: Any educated reader of this Danish report would read English well enough as to not require a translation of the legislative history of the U.S. law. Stunning. Granted, a country with a language not widely in use, like Danish, might be expected to take seriously the notion of English proficiency, but the contrast between the attitudes and abilities of the Danish and U.S. bankruptcy commissions is shocking.

Unlike in the early 1970s, U.S. legislators now have a wealth of comparative analysis of both legislation and practice in European bankruptcy systems, especially consumer bankruptcy. Doug Boshkoff pioneered this area of research with his 1982 empirical article on the discharge process in England (Limited, Conditional, and Suspended Discharges in Anglo-American Bankruptcy Proceedings, 131 U. Pa. L. Rev. 69 (1982)). The rapidly developing consumer insolvency systems in Continental Europe have also been explored in detail in recent years (see, e.g., here and here).

So when Congress returned to the drafting table to revise (many would say deform) the consumer bankruptcy law in 2005, did they consider comparative experience then? I searched in vain for any comparative reference in the legislative history of BAPCPA (the 2005 reform law's acronym). So is Congress afraid, or does it just not care . . . ?

Yet Another Reason to Hate the IRS (and OCC)

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As if it weren't hard enough to get banks to offer workouts to overindebted consumers! While I find the premise of the following story hard to believe, apparently major credit card lenders want to forgive significant portions of credit card debt that borrowers can't currently repay, but the Office of the Comptroller of the Currentcy and the IRS have conspired to prevent this.

Currently, when overburdened debtors (or their counselors) call up asking for a workout, credit card lenders will generally only agree to reduce interest rates and penalties and perhaps extend repayment terms to reduce payments. I had always attributed this to avarice and irrational refusal to accept the economic reality that borrowers would repay more if only they were given a bit of a break. As it turns out, I might well have been wrong, as explained in this letter describing a new pilot program to expand credit card debt forgiveness. According to the Financial Services Roundtable (whom I don't trust, by the way) and the Consumer Federation of American (whom I emphatically do trust), lenders appreciate the economic reality point, but the OCC and IRS inhibit lenders from offering significant reductions of principal. They do this by (1) requiring OCC-regulated lenders to demand payment of reduced principal amounts (and book the loss) within three to six months maximum, which (2) triggers a requirement that lenders send a 1099-C "Cancellation of Debt" tax form to borrowers, which in some cases might require the recently forgiven debt to be recognized as taxable income to the hapless debtor [NOTE: most debtors in this position will have been insolvent before (and probably still after) the forgiveness, in which case the COD/forgiveness "income" is excludable from taxable income, see IRS Pub 4681].

For decades we've been trying to convince lenders to act more reasonably in extending workout terms to borrowers WAY over their heads in debt, and now this. Just when you solve one problem, the IRS and some other regulatory agency create another one.

Though the accounting principle in play here doesn't strike me as so intrusive as to have prevented realistic debt forgiveness by banks, I nonetheless hope the OCC and IRS go for this proposal to eliminate the problem, however slight. The FSR/CFA letter promises that "virtually all of the largest national credit card banks" have agreed to offer "significant reductions in the principal [credit card] debt owed" to see if collections increase (my bet: they will!). Speaking as a proud paternalistic supporter of government intervention, I really hope the OCC and IRS get out of the way on this one!

Update 11/12/08: The proposal was rejected in what seems to me like record time for government bureaucrats. Hmmm.

Long-Term Solutions, Deleveraging, and Mortgage Modification

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So the Dow has bounced back over 400 points in the latest roller-coaster move. It's hard in these trampoline-like days to tell at any given moment whether we're still falling or bouncing back. Apparently, investors were heartened by rumors that the Feds are considering longer-term solutions to the credit crisis, including a "new government entity to help Wall Street unwind its disastrous credit bets" (a "bad bank" or latter-day Resolution Trust Corporation to take on the worst toxic mortgage-related securities and other investments). The basic idea seems to be that banks need to jettison once and for all the disastrous investments they have made, put the losses behind them, and go and sin no more.

Or banks could just get a reality check! That this crisis is of their creation is now clear. That they continue to foster the illusion that they need not act rationally to cooperate in its resolution is maddening. One of the most informed and engaging experts on the mess in the home mortgage market, Alan White at Valparaiso, has a fantastic new post today over at the Consumer Law & Policy Blog reminding us of just how irrational and stubbornly unwilling to accept reality the major mortgage banks are being. Though they claim to be on board with the notion of acknowledging reality and writing down mortgages to the (vastly lower) value of the collateral-homes, they are backing up these words with action in only a small fraction of cases. Sure, they'll cut people a break on interest and maybe fees, but modify mortgages to reduce principle--Heaven forbid! White presented to Congress evidence that banks are taking the necessary bottom line action and writing down mortgage principle in only 2% of cases. As White explains, the half-hearted Hope for Homeowners program is a cruel joke, offering relief to those facing foreclosure only if their banks were willing to accept the reality of property values and forego some of the principle on their mortgage loans (which has, not suprisingly, not happened in most cases). The FDIC is doing the right thing and setting an example by aggressively modifying IndyMac mortgages (FDIC is now the conservator of IndyMac), so why can't this reality check be extended to the broader market?

When asked about their willingness to take decisive action along the lines of the FDIC-IndyMac program, major commercial bank representatives explained, according to White, "take 10% off the loan balance, rather than foreclose at a 40% loss? This was described as the least-preferred option, and none were willing to answer what percentage of their loan mods involved any principal write-down." Ridiculous, even reckless in this era when the bottom line--the point at which the financial crisis will hit bottom and truly bounce back--depends on establishing that mortgage collateral is fairly valued at levels that allow folks to stay in their homes or allow the banks to recoup real value in foreclosure sales (rather than evicting people, taking huge losses, externalizing even further losses onto communities and the entire housing market, and then asking for redemption from the Feds in the form of a new RTC . . . revolting!). Entertaining the fantasy that the housing market will bring back the losses that are causing this spiraling financial crisis (the root of all the ills from sub-prime bond investments and credit-default swaps, etc.) is, in a word, irresponsible.

So what's the Fed to do? Well, the Fed can't do much, judging by yesterday's stock dive (Dow up 140 points on Tuesday on rumors that the Fed wills save AIG; Dow down 450 points on Wednesday because the Fed saved AIG!!??). A higher authority should step in and do at least one simple thing: amend § 1322(b)(2) of the Bankruptcy Code to treat claims secured by home mortgages just like most other secured claims; that is, allow the claim to be written down to the value of the collateral (the home), rather than forcing the law to continue to entertain the fantasy that the claim and the home are worth the inflated price originally paid. Better yet, allow mortgages to be forcibly written down to the value of the home without bankruptcy, but in any event, the special-interest gift to mortgage lenders and MBS investors in § 1322(b)(2) seems increasingly unwarranted. The notion that subjecting mortgages to "lien stripping" in this way would drive up rates was refuted, in my view quite convincingly, by a clever analysis presented in a recent paper (versions one and two) by Adam Levitin and Joshua Goodman, in which they explain that allowing forcible modification of mortgages in bankruptcy would likely result in an interest rate increase of at most 15 basis points (0.15%)!

Rather than waiting for Treasury and the Fed to turn the financial system upside-down based on questionable regulatory authority, the real regulatory power center of our political system, Congress, should introduce law(s) based on a new policy for mortgage bankers and investors in mortgage-backed securities: GET REAL!

Lehman/Merrill/AIG the Day After--What Crisis?!

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Not to say "I told you so," but notice that stocks are up the day after all of that hoopla broke on Wall Street (granted, not as much as they were down yesterday, but give it some time). If the biggest impact of this imbroglio on the "little guy (or gal)" will be a hit to the value of 401(k) and other retirement savings, the fact that stocks are already headed back up should come as a relief. And again, with crude futures headed toward the $90 mark, the economic future for Mr. and Ms. Average U.S. Consumer seems notably brighter.

In other good news, it looks like Barclay's is back at the Lehman bargaining table after all (as a surprise to no one who knows the Chapter 11 process). This breaking story from the W$J has it exactly right when it notes that shepherding the sale of Lehman's investment-management and capital-markets businesses through Chapter 11 allowed the parties to get what they wanted (walling off the toxic assets from the good ones) with less complication (and therefore probably a higher price). Would it be putting too sharp a point on it to call this "laundering"? By the way, if Barclay's is buying these crown jewels for $2 billion, one wonders how Lehman arrived at its $639 billion valuation of its assets, as mentioned in its bankruptcy petition (hat tip to CreditSlips and Steven Lubben). Indeed, could it be that Lehman was actually $20 billion in the black (in light of the reported $613 billion debt) when it filed yesterday (or at least as of May 31, 2008, the date of the valuation statement)? Doubtful. These valuation figures must be the sort of fairytale numbers that GAAP allows companies to get away with. For shareholders pouring over the Lehman petition hoping to find some ray of hope for a distribution, don't get your hopes up. The asset figure must be wildly on the high side, and though the Chapter 11 process will likely enhance the value that buyers like Barclay's are willing to pay for Lehman's "good" assets, the total kitty at the end of the day is likely to be nowhere in the region of $600 billion. The lawyers and other professionals who will have to manage this humongous case (ten times larger than Enron; six times larger than WorldCom) and sort out the millions of swaps, repos, and other complex contractual arrangements certainly will make out like bandits, though.

Lehman Chapter 11 = Reorganization?

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The 158-year-old Lehman Brothers investment bank has gone up in smoke in the biggest bankruptcy filing in U.S. history . . . or has it? One of my students today observed that Lehman had filed for protection under Chapter 11 rather than Chapter 7 of the Bankruptcy Code. Does that mean the firm intends not to liquidate and go out of business, but rather to remain in operation, reorganize its business, and emerge as a leaner, meaner firm still operating under the august Lehman name? This topic lies at least on the periphery of the commercial law, and besides, how can any self-respecting business and financial blog avoid discussing today the events of this past weekend?!

The Lehman case offers us a nice opportunity to make an often forgotten observation about the fluid division between reorganization (Chapter 11) and liquidation (Chapter 7) in U.S. business bankruptcy. Yes, the holding company at the top of what must be a mind-bogglingly complex Lehman org charge has filed under Chapter 11, but this does not mean that the firm intends to rehabilitate itself and reemerge as so many other companies have done. If Lehman intends to have an orderly sell-off of its assets and units, why not just file for chapter 7 and be honest about it, one might ask. So-called "liquidating Chapter 11s" and other strategies involving the use of Chapter 11 to administer asset sales are not at all uncommon. Chapter 11 offers at least two substantial and related advantages over Chapter 7 under Lehman's circumstances (and there are doubtless others): First, while a Chapter 7 filing would most likely mean a turnover of the company's assets to an appointed trustee with little or no connection to or knowledge of Lehman's complex activities, the "debtor-in-possession" model of Chapter 11 will allow the firm's managment, who are intimately familiar with the firm and its business, to wind down operations and negotiate asset sales from a position of maximum strength and knowledge. They can carefully and deliberately choose to sell assets in productive, related units (e.g., the broker-dealer and investment management units), maximizing their value in part by ring-fencing them off from the "bad" assets that have laid low Lehman and so many other investors recently. Chapter 11 will provide time (at least several months, if not longer) for emotions to cool, assets to be surveyed, and values to stabilize. Announcing a turnover to a trustee and a piecemeal firesale might well spook the markets even further into believing that a wholesale loss of value is at hand, depressing the value of Lehman's assets (and similar assets held by others) and disrupting Lehman's other operations. Second, Chapter 11 allows Lehman to remain in largely uninterrupted operation. Its talented employees can continue to administer the firm's operations (to a limited extent) and maintain their value to squeeze as much return as possible from the firm's assets and minimize a piling-on of further debt and loss. At the end of the day, a filing under Chapter 11 here in all likelihood will lead to something of the same result as Chapter 7 (sell-off), but in a much more orderly, flexible, potentially creative and value-maximizing way, still under the chaos-minimizing effects of the automatic stay and court supervision.

Does it make sense here to leave the same scoundrels whose poor judgment created this mess in charge? Shouldn't a disinterested trustee step in and take charge? More so than in many other cases, it seems to me, this mess wasn't all the fault of Lehman management. Yes, they made a bad bet in choosing to go all-in on mortgage-backed bonds, but investment banking is all about taking on stomach-wrenching risk. I have neither seen nor heard of any indication that Lehman's woes are in any way tied to accounting scandal or fraud of any kind--which is a breath of fresh air after the sad events of recent years. Lehman became the leading underwriter of mortgage-backed bonds, which as we all know now turned out to be toxic investments when scads of ordinary borrowers started defaulting on their mortgage loans, which given the unexpected (and unheard of) downward trend in home values led to a serious and spiraling crisis. Oops! A bad call, yes; mismanagement, not so much, it seems to me. Worse yet, Lehman and other banks had ratcheted up their risk by increasing their leverage (the ratio of outstanding debt to assets) to by some accounts as much as 100-to-1. The leverage scissors basically shredded Lehman. On the debt side, losses on credit-default and interest-rate swaps and other complex investments it had made with borrowed money translated into huge losses through the magic of leverage (each dollar of loss was effectively amplified by 100 at a leverage ratio of 100:1), and on the asset side, mortgage-backed securities that it carried on its books turned out to be worth even less than it had thought (reducing the "1" in the leverage ratio to a fraction, severely exacerbating the problem).

So even with the value-maximizing effects of Chapter 11 rather than Chapter 7, the last-in-line shareholders seem almost sure to receive no distribution in a Lehman bankruptcy, and even the holders of Lehman debt (perhaps even preferred unsecured debt) might get very little if the leverage ratio is as high as I have heard. A penny on the dollar is not an overly pessimistic expectation for unsecured debt holders, it seems to me. I guess even a penny is better than nothing, and the choice to file under Chapter 11 may produce that penny that a Chapter 7 might well have left on the table.

The Joy of Comparative Commercial Law

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Thanks so much to the Commercial Law blog folks for inviting me to be their guest for a while! I am thrilled to have a chance to discuss topics outside my primary area of scholarship, though I am delighted to have been granted license to talk about bankruptcy and comparative insolvency law, as well. In my first post, then, I thought I'd mention something at the intersection of commercial law stricto sensu, bankruptcy, and my love for all things comparative law.

In the course of researching for the book I'm co-authoring on international bankruptcy, I got to explore the different approaches to the treatment of secured creditors in bankruptcy around the world. I have to admit that I was surprised to find that in many countries, when the rubber really meets the road (i.e., in the borrower's bankruptcy), secured creditors are not the king of the hill, as in U.S. law. Quite a few bankruptcy laws subordinate secured claims to (1) administrative claims arising in the reorganization/liquidation process (e.g., fees for trustees, lawyers, appraisers, auctioneers, etc.), (2) taxes and other public debts, (3) employee wage and benefit claims, and even certain kinds of other unsecured claims (in the Czech Republic before January of this year, secured creditors enjoyed priority in insolvency cases in only 70% of the value of their collateral, with the remaining 30% reserved for unsecured creditors!). One of my favorite curious subordination laws is section 134(4) of the new Russian Bankruptcy Law, which subordinates secured claims to two kinds of unsecured claims if they arose before conclusion of the security agreement: (1) compensatory tort claims for personal injury and associated "moral harm" (emotional damages) and (2) claims for compensation for the use of intellectual property. One wonders whether the unique IP exception was designed to buttress Russia's bid to join WIPO or some other international IP or trade pact.

Along similar lines, I sheepishly admit that after teaching Secured Transactions for years, I was unaware of the substantial differences between "fixed" and "floating" charges (consensual liens) in English law. As a gross over-generalization, a "floating" charge is a blanket lien, generally on all of an enterprise's property, which "crystallizes" into a "fixed" charge and divests the debtor of unfettered control over the property upon default--for a more detailed exploration of the not-altogether-clear distinction between fixed and floating charges, see here. Floating charges are often subordinated to a variety of different unsecured claims in places like England, Australia, Bermuda, and the Cayman Islands, and in England, floating charges created after 15 September 2003 are subordinated to general unsecured claims as to a percentage of the collateral proceeds, capped at £600,000 [this clause has been edited--see comments]. Indeed, in Sweden, the equivalent of floating charges (företagshypotek on immovables and företagsinteckning on movables) created after 1 January 2004 are limited to 55% of the value of the debtor-company’s unencumbered assets (with the remaining value reserved for unsecured claims).

These kinds of significant limitations on secured creditors' rights are anathema in the United States, and given my U.S. training, I had been a strident "secured creditors über alles"-type guy. Having been exposed to these very different approaches from countries that I regard as populated by reasonable-minded, intelligent, generally commerce-friendly people, however, really opened my mind and made me think twice. For more of this kind of mind-opening study, take a look at the proceedings from a recent World Bank conference on secured transactions and insolvency law reform here.

We have a lot to learn from our friends around the world, and it's so darned FUN to travel (at least mentally) to exotic places with unfamiliar commercial and insolvency law systems. I hope to share some of my joy in the travel-and-learning process during my visit. Thanks again for having me!

Commercial Law Welcomes Jason Kilborn as Guest Blogger

Commercial Law is pleased to welcome Jason Kilborn as a guest blogger. Kilborn is an associate professor of law at the John Marshall Law School and a leading expert on comparative bankruptcy -- with a book in the works on cooperative cross-border bankruptcy. His two most recent articles are Comparative Cause and Effect: Consumer Insolvency and the Eroding Social Safety Net and Out with the New, In with the Old: As Sweden Aggressively Streamlines Its Consumer Bankruptcy System, Have U.S. Reformers Fallen Off the Learning Curve?

We look forward to Kilborn's insights on comparative and domestic topics!