A few of Chrysler’s secured creditors have found a backbone and decided to fight the Executive Branch’s unconstitutional actions of turning one of the most basic principles of the Bankruptcy Code on its head – the absolute priority rule.  The Indiana State Teachers Retirement Fund, Indiana State Police Pension Trust, and the Indiana Major Moves Construction Fund (collectively, the “Indiana Funds”) have filed a Motion seeking the appointment of a Trustee so that “an independent, disinterested person [can make] business decisions that are in the best interest of [the debtors’] estates…  The basis of the Indiana Funds’ motion is that the Treasury Department is causing Chrysler to ignore “fundamental principles of bankruptcy law by allocating distributions according to the government’s political agenda rather than the creditors’ legal priority.  The motion, among other things, alleges that the government has no authority to take the actions it has in these cases under any statute, including, but not limited to, TARP (i.e., the Troubled Asset Relief Program) or EESA (i.e., the Emergency Economic Stabilization Act).

Back to the beginning:  TARP was suppose to be for financial institutions, but after Congress failed to pass legislation to assist the auto industry, the Treasury Department (Paulson) stated that the auto companies could be considered financial institutions under TARP.  This semantics game provided Chrysler $4B on a junior secured basis – junior to the senior secured creditors (“Senior Secured Creditor”), who are owed a whopping $6.9B (the Indiana Funds are part of the senior secured creditors group – owed roughly $43 million of the outstanding $6.9B).  The Government’s $4B loan was at 5% interest with a December 30, 2011 maturity date, with an option to accelerate the entire amount due if Chrysler failed to put together a restructuring plan acceptable to the Obama Administration by February 17, 2009. 

On February 17, 2009, Chrysler submitted to the Government a restructuring plan  that sought to restructure as a stand-alone US entity by restructuring its debts, raising additional capital and completing an alliance with Fiat.  Upon reviewing the business judgment of Chrysler’s management, the Obama Administration said that Chrysler’s restructuring plan was not viable, and that Chrysler would have 1 month (30 days) to reach an agreement with the Senior Secured Creditors, the Treasury Department, VEBA, the unions, other creditors, and Fiat.  After this point, the President’s Auto Task Force took over certain negotiations for Chrysler with the Senior Secured Creditors and the union. 

President Obama also characterized the Senior Secured Creditors as speculators who were unwilling to make sacrifices; however, as the Indiana Funds’ motion makes clear, the Indiana Fund only invests in first lien secured debt, which, under the UCC, is suppose to be among the safest forms of investment.  Also, the Indiana Funds’ were willing to take a 50% haircut – much more than what the unions were willing to accept. 

Understandably, the Indiana Funds view the Chrysler situation as unfair because they are victims of breaches of fiduciary duty by Chrysler’s management, and abuse of power by the Executive Branch to further its political agenda.  And they are right to do so – and the other Senior Secured Creditors should be just as angry as the Indiana Funds.  The actions of the Government raise too many questions, such as, how can the Treasury Department and unions, which are unsecured, get anything before the Senior Secured Creditors are paid in full?  Indeed, how can the union get more than the Senior Secured Debtors?  How will a plan with these terms be confirmed without the consent of the Senior Secured Creditors (it can and shouldn’t)?  Can the Government change, and should it be able to change, the laws for its own purpose to achieve a political end?  How can capitalism endure if the legal framework can be altered at the whim of the Government?  The questions can go on and on, but it will certainly be interesting to see how either the Court rules on Indiana Funds’ motion – certainly the ruling may help answer some of these questions.

According to an article in Bloomberg.com, Obama Said to Plan for Chrysler Bankruptcy, Alliance , Chrysler may now file for bankruptcy as early as tomorrow.  If anyone thinks that Chrysler will just do a quick 363 sale to Fiat (or some new entity), they have another thing coming.  While the “major” secured creditors may be willing to roll over (and Big Labor gave some concessions), there is no telling what the “minor” secured creditors (e.g., those who have mold liens, etc.) may do.  Also, let’s see how the unsecured creditors are going to be adversely affected in a Chrylser bankruptcy — I say strap yourself in and get ready for a bumpy ride.  The real question is:  what happens at the end of that ride if Chrysler still has high labor cost, adequate quality and uninventive vehicles?  I think we all know.

There was an interesting article in the New York Times on Saturday, April 26, 2009, at Detroit Would Prefer Any Auto Bankruptcy to Be Handled Locally (April 26, 2009) discussing the possible venues for either a GM or Chrsyler bankruptcy filing.  No doubt Detroit would prefer a GM or Chrysler filing to occur there for political reasons, but the reality is that there are only 2 venues that can efficiently handle such large cases:  Delaware or S.D.N.Y.  The reality is that those two venues are probably about the same, excluding some unfavorable case law in the Third Circuit, and both have extensive experience in automotive cases, a sophisticated bench and bar in automotive bankruptcy cases, and have large courtrooms with state of the art audio-visual systems.  Also, while Detroit is considered the home for automotive, both GM and Chrysler are large multinationals that have substantial business connections in numerous locations in the US and abroad, so DE and NY are certainly as good of a place as any to file for bankruptcy.  I’ll be surprised if either of the automakers files for bankrutpcy in Detroit (FYI:  as of tonight it is looking less likely that Chrysler will file for bankruptcy at all, but GM is a different story with the aweful GM Exchange Offer), and, from my vantage point, the venue of choice for the automakers is either DE or NY.

Congressman Nadler (D, NY) and Cohen (D, TN) introduced the Business Reorganization and Job Preservation Act of 2009 , H.R. 1942, which seeks to amend the Bankruptcy Code by repealing to pre-BAPCPA the following sections: 365, 366, 503(b)(9) (repeals altogether), and 546(c). The purpose of the Act is to increase the changes of retailers to reorganize successfully. For an article discussing changes need to the Bankruptcy Code to increase the likelihood of retailers reorganizing see Suggested Amendments to US Bankruptcy Code.  Certainly, this is one of the most encouraging Acts proposed since BAPCPA from the retailers’ perspective, but the real question is:  will it be adopted?  Unfortunately, probably not, at least not without some strong, unified and consistent lobbying from the retail industry.

In the last post, we discussed the basics of claims trading. In this post, we will look at the topic of insider trading of bankruptcy claims and how that issue is addressed by the Bankruptcy Court. We also will look at the implications of bankruptcy claims trading and how distressed investors can protect themselves so that they do not run afoul of applicable laws.

Insider trading of bankruptcy claims occurs when the purchaser of a claim has acted on material, non-public (i.e., confidential) information. While trading securities on insider information is prohibited under federal securities laws, the prevailing view is that the securities laws do not apply to claims trading. Nevertheless, bankruptcy courts have imposed harsh sanctions (including, but not necessarily limited to, disallowance, subordination, and/or other adverse treatment) when trading claims on insider information has been established.

Members of official committees of unsecured creditors in a chapter 11 bankruptcy need to be cognizant of the prohibition of insider bankruptcy claim trading. Committee members should, and likely will, receive commercially sensitive or proprietary information from the debtor and others. Given that a committee member is a fiduciary who owes both the duties of care and loyalty to its constituency body, he or she is required to hold sensitive or proprietary information in confidence. Failure to hold such non-public information confidential would likely not only negatively impact communications between the debtor and committees, but also likely cause harm to the debtor. However, there have been some courts willing to allow committee members to participate in claims trading if appropriate screening walls have been established.

Trading Restriction Orders

In large chapter 11 cases, often the debtor has generated large net operating losses (NOL) in the months and years preceding the initiation of the chapter 11 proceedings. Subject to certain limitations, the Internal Revenue Code (IRC) provides that NOLs can be used as either carry-backs (i.e., a corporation can use the NOLs to offset taxable income for up to two (2) previous taxable years) or carry-forwards (i.e., a corporation can use the NOLs to offset taxable income for up to twenty (20) taxable years into the future).

The positive tax consequence of NOLs can be lost or restricted (i) if there is a change in ownership through a transfer of a debtor’s stock by its holders, and (ii) if there is a change in ownership through the conversion of debt to equity pursuant to a confirmed plan of reorganization. Essentially, if pre-emergence trading in claims and equity results in persons who are not Qualified Creditors or historic stockholders receiving more than 50% of the equity in the reorganized debtor, the IRC’s more stringent restrictions, which are listed in Section 382, on prospective NOL treatment may apply.

Because of the potential positive tax consequences to the debtor, NOLs are property of the estate that must be protected and preserved. However, since the value of NOLs may be quickly and adversely affected by equity and claims trading, bankruptcy courts in recent years have been willing to enter orders that restrict the trading of a debtor’s debt and other securities during the pendency of the debtor’s bankruptcy proceedings so that the debtor’s NOLs are protected and preserved.

The Bond Market Association and the Loan Syndications and Trading Association have developed a Model NOL Order that attempts to protect a debtor’s NOL by permitting trading of claims, as long as it does not substantially change the ownership structure of the debtor. The Model NOL Order restricts the trading of equity, but permits the trading of claims until (i) the debtor files a plan of reorganization that relies on the Section 382(l)(5) exemption, which is the NOL is preserved as long as debtor’s existing shareholders and/or qualified creditors (held claim for 18months or claim arose in ordinary course of debtor’s business) own at least 50% of the value and voting power of stock after plan confirmation, and (ii) a “sell down” order is entered by the bankruptcy court. Assuming a 382(l)(5) Plan is confirmed, and a party required to comply with the “sell down” order fails to do so, such claim holder forfeits his or her right to any distribution on the portion of his or her claim subject to sell down.

Implications

Restrictions on claims trading, while beneficial to the debtor (e.g., to preserve NOLs), is not beneficial to the distressed debt investor (e.g., hedge funds and private equity firms). Many prognosticators have speculated that the next tide of chapter 11 cases will see a substantial increase in activity by and from hedge funds. Whether this is true or not no one now knows for sure; however, between some recent rulings on claim trading restrictions and hedge fund disclosures, hedge funds may very well be less inclined to be active players in bankruptcy proceedings. In fact, these recent trends may persuade hedge funds to assist debtors in reorganizing outside of bankruptcy.

Corporate defaults are at a 2002 level, and likely will rise as the US economy is headed into the most severe recession in perhaps more than 80 years, which likely will cause a substantial increase in the filing of chapter 11 cases. Although the rate of Chapter 11 filings has increased in 2008 from 2007 levels, as the liquidity crisis eases allowing for the next tide of chapter 11 cases, it is of the utmost importance for distressed debt investors to retain sophisticated bankruptcy counsel who understands fully these recent trends in claims trading (and disclosure requirements) so that these investors are in a position to make informed investment and planning decisions.

The distressed debt investor is cautioned to consult with experienced bankruptcy counsel prior to developing and effectuating a claim trading strategy.

Holders of bankruptcy claims have routinely been willing to sell their claims at a substantial discount in exchange for a prompt and certain cash payment rather than facing the uncertainties of the bankruptcy process and the possibility of a payment in the distant future. Claim purchasers must be wary of the consequences of acting on “insider” information and acting without good faith. Additionally, claim traders must be aware of whether an order has been entered in the bankruptcy proceeding restricting the trading of claims and securities of the debtor. This is the first of a two-part series that is intended to (1) give a brief overview of claim trading by examining claim trading strategy and claims trading restrictions, and (2) discuss the effects restrictions will likely have on distressed debt investors (e.g., hedge funds).

Generally speaking, purchasers of claims, or distressed debt investors, may be classified as either passive or active investors. Passive distressed debt investment needs little discussion as it is based on straightforward, rational economics. A rational distressed debt investor may be motivated to purchase the claims against a debtor if, and only if, he or she believes, after taking into account the time value of money, that the distribution expected to be paid on the purchased claim will be greater than the purchase price of such claim. Assuming (i) the transfer of the claim is absolute, (ii) the requirements of Fed. R. Bankr. P. 3001(e) have been satisfied and (iii) no other motivational factors are involved, this type of investor will likely be an inactive player in a bankruptcy case.

An active distressed debt investor is an investor who is seeking to “actively” participate in the debtor’s bankruptcy proceedings by, for example, forcing a sale of the debtor’s assets or affecting plan voting. In order for an active distressed debt investor to accomplish his or her goals, he or she must have standing (i.e., be a party-in-interest) in the debtor’s bankruptcy proceedings.

As is common in many bankruptcy cases, a person who does not have a direct financial stake in a debtor’s bankruptcy proceedings may wish to purchase some or all of the debtor’s assets. If this type of potential purchaser is unable to purchase provides for him or her to purchase some or all of the target-debtor’s assets. The problem facing this type of potential purchaser is that since he or she is not a “party-in-interest,” he or she is precluded from proffering a plan of reorganization. How can the potential purchaser get around this conundrum? By purchasing a claim of virtually any size of the target-debtor. Once the potential purchaser purchases a claim of the target-debtor, he or she becomes a party-in-interest in the target-debtor’s bankruptcy proceedings. Once a potential purchaser becomes a party-in-interest, and upon the expiration of the exclusivity period, he or she has standing to proffer a plan of reorganization that provides for the sale of the target-debtor’s assets.

Another type of active distressed debt investor is one who purchases a large number of claims to gain leverage to bargain the plan terms with the debtor or who seeks to file a competing plan of reorganization. This type of investor is usually seeking to affect the size and/or timing of distributions set forth in a plan of reorganization.

Other active distressed debt investors may purchase claims in order to affect plan voting to advance a personal agenda. To the extent this type of active investor is able to affect plan voting, he or she may be able to gain substantial leverage over the plan proponents or even other creditors; however, this investor must be careful that he or she does not act in bad faith, which could then designate (i.e., disqualify) a vote of that investor.

This, of course, begs the question of what is “good faith” with respect to plan voting. Since Congress chose not to include the definition of “good faith” in the Bankruptcy Code, its definition has been developed by case law, and thus, is nebulous. One Court stated that:

“Good faith voting does not require nor can it expect, a creditor to act with selfless disinterest…. The test then, consonant with the United States Supreme Court’s standard, is whether a creditor has cast his vote with an “ulterior purpose” aimed at gaining some advantage to which he would not otherwise be entitled in his position…. Ulterior or coercive motives that have been held to constitute bad faith include pure malice, strikes, blackmail, and the purpose to destroy an enterprise in order to advance the interest of a competing business.” In re Gilbert, 104 B.R. 206 (Bankr. W.D. Mo. 1989) (internal citations and quotations omitted).

Another simplistic way to state that a plan vote was made in “good faith” is to argue that it was not made in “bad faith.” Unfortunately, this leads to a similar problem in that the term “bad faith” is not defined in the Bankruptcy Code.

In a frequently cited case involving trading claims, In re Allegheny International, Inc., 118 B.R. 282 (Bankr. W.D. Pa. 1990), the court disqualified votes by Japonica Partners, an investment firm, and confirmed the debtor’s plan. Japonica was not a prepetition creditor of the debtor, but after approval of the debtor’s disclosure statement and after balloting had commenced, Japonica purchased enough claims in two classes to wield a blocking position and to qualify Japonica as a party who could file a competing plan; however, those two classes were diametrically opposed to each other in litigation filed by the Creditor’s Committee against the secured lenders. Japonica presented its own competing plan, which provided that Japonica would acquire control of the debtor. Neither the debtor’s nor Japonica’s plan received sufficient affirmative votes for confirmation.

Japonica’s purpose was to gain control of the debtor, which the court found to be bad faith. The critical fact that resulted in the court’s disqualification of Japonica’s votes was that Japonica was a voluntary creditor who purchased claims to give it unique control over the debtor and the bankruptcy process. Another indication of Japonica’s bad faith was the timing of its purchase and the amounts it paid for the claims. As Japonica approached the attainment of a blocking position, the amount it paid for the claims it purchased increased and then decreased after the critical percentage was reached. Japonica purchased almost exactly the amount it required to block the debtor’s plan.

The court concluded that the facts and circumstances surrounding Japonica’s purchase of claims—Japonica’s intent to take over the debtor, the timing of the purchases, the amount paid for the claims, Japonica was an “outsider” prior to its purchase of claims, and Japonica’suse of its veto power to improve its position—established that Japonica’svotes were acquired and cast in bad faith and would be disqualified.

Other cases have been more relaxed in finding bad faith in the conduct of plan voting. In contrast to the holding in Allegheny International is the holding of In re Marin Town Center, 142 B.R. 374 (N.D. Cal. 1992). In the Marin Town Center case, as in Allegheny International, an “outsider” purchased an undersecured creditor’s claim for the purpose of blocking confirmation in hopes that the creditor could acquire the debtor’s main asset. The fair market value of the asset approximately equaled the amount paid for the claim. The court held that merely exercising a blocking position does not constitute bad faith. The creditor must be exercising the blocking position “for the ulterior purpose of securing some advantage to which the creditor would not otherwise have been entitled.” Id. at 378. “Section 1126(e) does not require a creditor to have an interest in seeing the debtor reorganize.” Id. at 379.

Questions of good faith and bad faith are factual in nature, and sometimes the line between the two is not always clear. The distressed debt investor is cautioned to consult with experienced bankruptcy counsel prior to developing and effectuating a claim trading strategy.

I am active as lead or co-counsel  representing the Official Committees of Unsecured Creditors in many chapter 11 cases.

Counsel to Official Committees of Unsecured Creditors

“Decoupling” Issues in Bankruptcy

By:  Bradford J. Sandler and Kari Coniglio[1]

In recent years, the structured credit markets have created derivative instruments in which economic rights can be decoupled from their governance rights.  Decoupling is a term used to describe the separation of economic rights from voting rights in various instruments.  More specifically, debt decoupling is “the unbundling of the economic rights, contractual control rights, and legal and other rights normally associated with debt, through credit derivatives and securitization [sic].”2  The most common, and perhaps simplest, derivative instrument is the credit default swap (“CDS”).  A CDS permits parties to hedge against credit risk by transferring the inherent risk of purchasing a credit instrument to another party.  The rapid growth of the CDS market has caused many to question the unintended consequences CDSs have, or at least may have, on financially distressed companies.3  This article provides a basic understanding of the mechanics of a CDS and touches on several issues that a CDS creates in bankruptcy and in out-of-court workouts.

A Basic Credit Default Swap

The mechanics of a CDS are straightforward.  Under a CDS, one party, called the protection buyer, pays a periodic (usually biannual or quarterly) fee to another party, called the protection seller, for a certain term, in exchange for protection against the occurrence of a credit event of a reference entity.4  If a credit event occurs for the referenced entity, the protection seller agrees to make the protection buyer whole (less fees paid to the protection seller) in accordance with the terms of the CDS.  Fundamentally, this transaction is designed to transfer the risk of the occurrence of a credit event of the reference entity from the protection buyer to the protection seller.5
For example, suppose Debtor obtains a $10 million loan from Bank.  Bank, as the holder of the loan, is entitled to payment over time according to the terms of the loan; however, Bank also bears the risk that Debtor will default under the terms of the loan.  Therefore, to hedge against that risk, Bank may seek to enter in to a CDS with another  party (which we will refer to as the Mystery Group) to protect itself from a default on the loan.
In such a CDS transaction, Bank is the protection buyer because it is purchasing protection in the event of Debtor’s default on the loan.6  Mystery Group is known as the protection seller because it is selling the protection to Bank.7  Importantly, Debtor is not a party to the CDS and may be, and typically is, unaware of the transaction.8
In exchange for the protection, Bank will pay Mystery Group a fee based upon the spread of the CDS.9  The spread is based upon the probability of a default by Debtor – therefore, the higher the probability Debtor will default, the higher the annual fee Bank will pay to Mystery Group as part of the CDS.  Bank will continue to pay this fee until the CDS contract expires by its terms or until a credit event occurs.
Typically, CDS contracts provide that bankruptcy of the Debtor, the restructuring of the Debtor or the Debtor’s failure to pay in accordance with the underlying obligation, constitutes a credit event (although some CDSs exclude restructuring).10  Therefore, if Debtor becomes unable to pay its obligations under the loan from Bank, a credit event will occur which would permit Bank to recover from Mystery Group under the CDS.11  If the parties choose a physical settlement after the occurrence of a credit event, Bank will need to deliver the note or bond representing the loan to Mystery Group, who will then pay the par/stated value of the underlying obligation.  Alternatively, if the parties choose a cash settlement, Mystery Group will pay Bank the difference between the par/stated value of the obligation and its market price.12  In our example with $10 million in protection, if the underlying obligation were worth 12% upon a credit event, Mystery Group would have to pay Bank $8.8 million ($10 million x (100% – 12%)).  As this example shows, a CDS is akin to an insurance policy protecting against the occurrence of a credit event.13
A CDS is an example of debt decoupling because the protection seller obtains the economic rights under the obligation, while the protection buyer maintains voting and all other rights.  As is discussed below, this decoupling through a CDS changes the traditional debtor-creditor relationship and often leaves Debtor confused by what appears to Debtor as the irrational actions of the creditor.

Implications of CDS on Distressed Companies

In a typical debtor-creditor relationship, a creditor’s repayment depends upon the success of the debtor.14  Therefore, typical creditors have incentive to work with the debtor, extend repayment terms, waive default rates and do whatever it takes to keep the debtor afloat long enough to maximize the return to the creditor.  Decoupling places debtors in the awkward position of not knowing the identity of the true creditor-in- interest.  For example, if Debtor is aware that it will be unable to repay its obligation to Bank on the maturity date, Debtor will likely attempt to workout an extension with Bank.  While in the typical debtor-creditor relationship, the creditor may be willing to discuss an accommodation for Debtor, in our situation, Bank may actually want to see Debtor fail; it might make more sense for Bank to try to force Debtor into bankruptcy (either alone or with others by filing an involuntary bankruptcy petition) so that it can trigger a credit event under the CDS and collect par value from Mystery Group. 15
If a credit event occurs and is followed by a physical settlement, the protection buyer with whom Debtor has been negotiating will be replaced at the proverbial table by the protection seller, who will likely be completely unknown to Debtor.  The protection seller may have a very different agenda from the protection buyer, which no doubt will cause undue chaos for Debtor.
In our hypothetical situation, the relationship of the expiration date of the CDS and the date of a potential credit event also will likely impact the behavior of Bank.16  The closer to the expiration date of the CDS, the more likely the protection buyer will want to see Debtor fail.  These apparently irrational acts17, which are atypical to the traditional debtor-creditor relationship, are actually quite rational to Bank because upon the occurrence of the credit event, Bank will be paid in full by Mystery Group, and Debtor will be forced to deal with the consequences.
Within bankruptcy18, Bank’s actions will likely continue to appear irrational to Debtor (and others) leaving Debtor clueless as to the motive behind these actions.  Furthermore, within bankruptcy, Bank may gain an advantage over other creditors due to the apparent risk of loss Bank suffers.  For example, bankruptcy law provides that a class of creditors votes in favor of a Chapter 11 plan if “at least two-thirds in amount and more than one-half in number” of the particular class vote in favor of the plan.19  Although Bank faces no risk of loss due to the CDS, bankruptcy law gives Bank the power to vote all $10 million worth of its debt.20  The protection of the CDS may make Bank likely to vote in favor of a risky plan that places other unprotected creditors at a greater risk of loss, or perhaps not to vote at all and possibly make it more difficult for the debtor to confirm its plan.21  That is, unprotected creditors may wrongfully be assuming that each creditor in the class to which they have been assigned for plan purposes are in the same situation, only to be ultimately surprised to see the way a protected creditor voted.

Another interesting issue in bankruptcy arises with the formation of the creditors committee.22  In a complex Chapter 11 bankruptcy case, the United States Trustee appoints a creditors committee promptly after the bankruptcy filing.  Typically the committee consists of the seven largest unsecured claims against the debtor.23  The committee has the authority to, among other things, perform an investigation of the debtor, and participate in formulation of a plan.24  Without knowledge that a protected creditor has no incentive to act in the best interests of the estate as a whole, the United States Trustee may select a protected creditor to be a member of the committee, even though such a creditors exposure is significantly less than the other unsecured creditors and even though such a creditor may wish a different, if not contrary, result from the other unsecured creditors.
There can be no doubt that the lack of transparency of CDS transactions can only make it more difficult for a debtor to reorganize efficiently.

Disclosure

Bankruptcy is intended to be a transparent process.  Chapter 11 debtors are required by the Bankruptcy Code to file reports and maintain records documenting the flow of money during a case.25  Attorneys and professionals working for the debtor are required to disclose their compensation and apply for court approval before receiving payment during the case.26  Additionally, every entity or committee that represents more than one creditor is required to file a notice in the bankruptcy case.27  Each of these requirements is a part of the Bankruptcy Code and/or the Bankruptcy Rules because transparency is an important element of the bankruptcy process.  The current ability of creditors to hedge their risk through CDS places the debtor and other creditors in an unfair position of not knowing with whom they are truly dealing and why they are behaving as they are.  While those who would argue transparency is not critical because the settlement procedure takes place shortly after the occurrence of a credit event, it is in the early days of a bankruptcy proceeding that debtor-in-possession financing and, more currently, 363 sale issues are addressed, and thus, transparency is important from the beginning of the bankruptcy proceeding so that a debtor has a fair ability to reorganize.     In order to level the playing field, the Bankruptcy Code and/or Rules should be amended to require an additional disclosure: disclosure of any CDS (or other like instrument in which rights have been decoupled).28  However, because it is likely that, due to cash settlements for CDS, the debtor and other creditors will never know of the CDS, the Code and/or Rules should also provide a penalty for failure to disclose.  For example, failure to disclose could result in disallowance or subordination of a protected creditor’s claim.  This solution, while it is merely one small solution for the host of bankruptcy issues as a result of a CDS, will at least give the debtor and other creditors an understanding of why the protected creditor is behaving in a particular manner, and give them the ability to formulate an appropriate strategy to level the playing field so the debtor can have a fair chance at reorganizing.

1  Mr. Sandler (www.beneschlaw.com/bsandler) is a partner in the Business Reorganization Practice Group of Benesch Friedlander Coplan & Aronoff LLP, and is resident in the firm’s Philadelphia and Wilmington offices.  Ms. Coniglio (www.beneschlaw.com/kconiglio) is an associate in the Business Reorganization Practice Group at Benesch Friedlander Coplan & Aronoff LLP, and is resident in the firm’s Cleveland office.   2  Debt, Equity and Hybrid Decoupling: Governance and Systemic Risk Implications, Henry T.C. Hu and Bernard Black, European Financial Management, Vol. 14, No. 4, 2008, 663-709.   3  The CDS market notional amount in 2001 was approximately $632 billion and was approximately $62 trillion in 2007, according to the International Swaps and Derivatives Association.   4  CDS contracts are typically, but not always, based upon the International Swaps and Derivatives Association (“ISDA”) 2002 Master Agreement and Credit Derivative Standard Terms.   5  Of course, the protection buyer is assuming the risk that the protection seller can satisfy the obligation underlying the CDS upon the occurrence of a credit event of the reference entity.  If the protection buyer is concerned about the protection seller’s ability to satisfy the CDS, the protection buyer may require that the protection seller secure the CDS with collateral.  6  See Credit Derivatives and the Future of Chapter 11, Stephen J. Lubben, American Bankruptcy Law Journal, Fall 2007, 81 Am. Bankr. L.J. 405, 411.   7  See Id.   8  See Id.   9  See Id.   10  See Credit Derivatives and the Future of Chapter 11, Stephen J. Lubben, American Bankruptcy Law Journal, Fall 2007, 81 Am. Bankr. L.J. 405, 412.   11  Note that many credit events are public information, and readily confirmable – e.g., the filing of a bankruptcy petition.  Additionally, the recovery from the protection seller depends on the solvency of the protection seller.  In effect, while the protection buyer is shorting the underlying obligation upon which the CDS is based, the protection buyer is gambling that the protection seller will be able to satisfy its obligations under the CDS upon a credit event of the reference entity (i.e., in the above example, the Debtor). 12  “Today, most credit default swaps are settled through a cash payment by the credit protection seller to the protection buyer.”  See Debt, Equity and Hybrid Decoupling: Governance and Systemic Risk Implications, Henry T.C. Hu and Bernard Black, European Financial Management, Vol. 14, No. 4, 2008, 663-709. at 680.   13  While credit default swaps may be akin to an insurance policy, they are not insurance policies for several reasons:  (i) a CDS does not require the protection buyer to actually own the underlying security, and (ii) the protection buyer does not have to incur an actual loss.    14  “Both loan contracts and bankruptcy laws are premised on the assumption that creditors are averse to downside risk, but otherwise have an economic interest in the company’s success and will behave accordingly.”  Debt, Equity and Hybrid Decoupling: Governance and Systemic Risk Implications, Henry T.C. Hu and Bernard Black, European Financial Management, Vol. 14, No. 4, 2008, 663-709. at  683.   15  See 11 U.S.C. § 303(b) (providing the requirements for commencement of an involuntary bankruptcy case against a debtor).   16  “[R]ecall that credit default swaps are often relatively short term instruments that expire without value to the protection buyer if no credit event occurs before maturity.”  Credit Derivatives and the Future of Chapter 11, Stephen J. Lubben, American Bankruptcy Law Journal, Fall 2007, 81 Am. Bankr. L.J. 405, 427. 17  Since the debtor is generally unaware of the existence of a CDS transaction, what appears to be irrational from the debtor’s perspective may be quite rational from the protection purchaser’s perspective, and likely would seem rational to the reference entity if it had full information. 18  Note that under BAPCPA, credit default swaps, like other swap agreements, are treated favorably.  See e.g., 11 U.S.C. Sections 101(53B)(A), 362(b)(17), and 560. 19  11 U.S.C. § 1126(c).   20  See Credit Derivatives and the Future of Chapter 11, Stephen J. Lubben, American Bankruptcy Law Journal, Fall 2007, 81 Am. Bankr. L.J. 405, 428-29. 21  See Credit Derivatives and the Future of Chapter 11, Stephen J. Lubben, American Bankruptcy Law Journal, Fall 2007, 81 Am. Bankr. L.J. 405, 428-29. 22  See 11 U.S.C. § 1102.   23  See 11 U.S.C. § 1102(b)(1).   24  See 11 U.S.C. § 1103(c).   25  See Fed. R. Bankr. P. 2015. 26  See Fed. R. Bankr. P. 2016. 27  See Fed. R. Bankr. P. 2019.   28  Interestingly, the Financial Accounting Standards Board has issued FAS 161 that will require, beginning November 15, 2008, the disclosure of, among other things, the nature, extent and fair value of derivatives, to improve the transparency of financial reporting.  See FAS 161 (2008).

Struggling Retailers Require a Level Chapter 11 Playing Field -  Suggested Amendments To US Bankruptcy Code 

By Bradford J. Sandler and Kari Coniglio
Benesch Friedlander Coplan & Aronoff LLP

 

We are in the worst recession since WWII, and perhaps since the Great Depression.  Daily economic news highlights the status of the tight credit markets, tight labor markets, declining consumer spending, declining capital expenditures, failing real estate prices, rising consumer and commercial bankruptcies, and other depressing economic news that transcends global borders. The negative economic news has surfaced as a reality to consumers, businesses and industries, including, but certainly not limited to, the banking industry, automotive industry and retail industry.

Fortunately, the United States has some of the best, if not the best, bankruptcy laws in the world to assist distressed businesses to reorganize, but some peculiarities of the Bankruptcy Code make it difficult for certain businesses to reorganize. Due to a confluence of factors, including, but not limited to, businesses being overleveraged, the aforementioned poor economic data, and changes to the Bankruptcy Code (the “Code”), retailers have significant odds against their ability to successfully reorganize.  Cases in point: Sharper Image, Circuit City, Mervyns, Linens n’ Things, eToys, KBToys, Domain, Kitchen, Etc., Goody’s, Steve & Barry’s, Levitz; and the list of once great (or even not so great), but now extinct, retailers goes on and on, and no doubt, there will be others to join this growing list.

While the Bankruptcy Code provides a mechanism for distressed businesses to reorganize, the mechanism does not assist all businesses equally, and since the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), retailers have had a very low success rate in bankruptcy. Some bankruptcy attorneys have concluded that Chapter 11 is no longer an effective tool to reorganize a retailer.[1]

There can be no question that since BAPCPA was passed, retailers are left with little cash at the outset of a bankruptcy, and they are forced to make critical operational decisions in shorter, arguably unrealistic, time periods, leaving little chance of successful reorganization. Specifically, BAPCPA made five major changes that likely can be attributed to the large number of liquidating retail cases and the few successful retail reorganizations post-BAPCPA[2]:

1) Section 365(d)(4) of the Code has been amended to provide a strict outside limit on decisions to assume or reject leases;

2) Section 366 was amended to prohibit the use of an administrative claim as adequate assurance of payment for utilities, and to give utilities the ability to demand adequate assurance with courts having the ability to change only the amount of assurance;

3) Section 503(b)(1)(B) now provides administrative priority for ad valorem taxes;

4) Sections 507(a)(4) and (a)(5) have been amended to increase the monetary limits on priority wage and pension claims; and

5) Section 503(b)(9) was added to provide administrative priority for goods shipped to the debtor within the 20-day period prior to the bankruptcy filing.

In this article, we provide Congress with some guidance to further amend the Bankruptcy Code in order to balance the interests of creditors and debtors, thus increasing the ability for retailers to reorganize in Chapter 11.

Section 365(d)(4) And The Time To Assume Or Reject Leases

Prior to the effective date of BAPCPA, debtors in possession had an initial 60-day time period in which to assume or reject unexpired leases of nonresidential real property.[3]  Courts, upon a showing of cause, could expand the initial 60-day window indefinitely[4], and, in practice, this was done routinely in retail cases.  Under the current version of Section 365(d)(4), a debtor in possession has an initial 120-day window to assume or reject its leases; however, the court’s discretion is now limited to a one-time extension of up to 90 days.[5] In other words, a debtor in possession has a maximum of 210 days following the date of the order for relief to determine whether to assume or reject leases.

Retailers that may have hundreds of locations spread across numerous states need time to study the markets and the value to the estate of each store location to adequately and appropriately determine which locations should be assumed and which locations should be rejected. In order to balance the rights of a debtor in possession retailer with the rights of its landlord, Congress should amend Section 365(d)(4)(B)(i) to provide generally for an extension of the initial 120-day period for cause with a maximum of three additional extensions of 120 days each, which would give a debtor approximately 16 months to evaluate its leases.  

No doubt landlords may be apoplectic when they hear this suggestion (compared to the current state of the law)[6]; however, the current law is inflexible and makes it unrealistically challenging for large retailers to effectively evaluate leases.

The “for cause” language, which gives courts significant discretion, will enable courts to provide sufficient time for large retailers to completely assess each lease before making a critical decision, while the time limitation will provide more protection to landlords than that which existed pre-BAPCPA.

Section 366 And Cash Payments To Utilities

Prior to BAPCPA, courts frequently provided utilities with administrative expense priority as adequate assurance of future payment. Confusing language added to Section 366 now has a majority of courts ordering cash payments of anywhere between two weeks to two months worth of service to be paid to the utility as adequate assurance. Courts have also interpreted the amended language to leave the form of adequate assurance up to the demands of the utility with the court having the ability to merely modify the amount of assurance.[7]  The justification for these protections to utilities rests upon the idea that utilities are forced to continue to provide service to the debtors; however, nothing prohibits a utility from terminating service based upon post-petition defaults in payment or lack of adequate assurance at anytime after the 31st day following the entry of an order for relief.

From the debtor’s perspective, an order requiring the debtor to provide cash upfront in amounts that may reach up to two months worth of services typically provided by the utility is a severe hardship that dwindles the availability of much needed cash early on in the Chapter 11 process. Therefore, to balance the interests of the debtor and the utilities, Section 366(c)(1)(A)(i) should be amended to specifically provide that “a cash deposit, not to exceed an amount equal to the average value of services provided to the debtor over a twoweek period as averaged over the 12-month period immediately proceeding the bankruptcy filing,” is adequate assurance of future payment.  Further, a new clause (vii) should be added to Section 366(c)(1)(A) providing for “such other form of security that the court deems appropriate upon a showing of cause by the utility, the debtor, or the trustee.”[8]

These amendments will balance the competing interests by still providing utilities with cash payments, but limiting the amount so as to not drain the debtor’s limited resources at the inception of its case. Further, these amendments will reinstate the courts’ power to modify the type of assurance based upon the equities in the case. 

Administrative Claims And Priority Treatment For Taxes And Wages

Although the amendments providing for administrative claim treatment for ad valorem taxes and increased limitations for priority wage claims may adversely impact some retailer’s ability to reorganize, in reality these provisions do not significantly impact a debtor and therefore they should not be amended or removed from the Code.[9] 

Section 503(b)(9) And Administrative Priority For Prepetition Goods

Perhaps the most deadly BAPCPA amendment for retailers is the addition of Section 503(b)(9) which provides administrative priority in the value of goods provided to debtors in the 20-day period immediately proceeding the bankruptcy filing.[10] Retailers often receive high volumes of inventory with significant turnover rates[11], which means that at the time of a bankruptcy filing, a retailer may have received a significant volume of goods within the 20-day period before the bankruptcy filing resulting in a large administrative claim.

Unlike reclamation rights which require that the goods still be in the debtor’s possession13 (and, for the most part, are of little practical value), section 503(b)(9) does not limit the administrative expense to the amount representing the value of goods still on hand.  This new provision leaves debtors saddled with significant administrative expense claims that must be paid in full at confirmation.[13]

The only way to avoid these massive claims would be for the retailer to suspend deliveries during the twenty days prior to the bankruptcy filing, which would similarly diminish the amount of cash on hand for the debtor, and practically speaking, may not be possible if the retailer wants to continue normal operations. On a slightly different note, it is also unfair to treat this new 503(b)(9) class of claimants differently from others who might provide beneficial pre-petition services to the debtor during the same 20-day window set forth in Section 503(b)(9).  Section 503(b)(9) creates a privileged class to the detriment of others similarly situated, and is the only provision that provides an administrative claim for conduct arising prepetition. For all of these reasons, Section 503(b)(9), should be stricken from the Code. 

Preferences And Their Effect On Suppliers

Although not a new addition to the Code, preferences under Section 547 create problems for debtors and suppliers with few benefits for the estate overall. The current version of Section 547 essentially leaves any creditor who received payments from a debtor within the 90-day period immediately proceeding the bankruptcy filing at risk of being pursued when the debtor is unable to pay unsecured creditors in full.[14]  While the overall goal of preferences was to deter creditors from taking aggressive collection actions against a distressed debtor,[15] the current (as well as the pre-BAPCPA) version of the Section leaves suppliers who have extended credit terms in order to give debtors more leniency in payments unable to demonstrate the ordinary course defense. As a result of this anomaly, the application of the Code actually discourages suppliers from extending credit terms to a distressed entity, which may, in the aggregate, push the debtor towards bankruptcy. Therefore, Section 547 should be amended to include an additional defense that provides that a trustee may not avoid a transfer “to the extent the transfer was made pursuant to contractual terms existing between the debtor and creditor or to the extent the transfer was made according to extended trade credit terms provided by the creditor.”

This additional defense, which will protect creditors who have acted in good faith, will encourage suppliers to work with a distressed debtor to potentially avoid bankruptcy and avoid a potentially adversarial relationship between the parties in the ultimate event of bankruptcy. Further, it will leave open the ability to recover preferences from overly aggressive creditors.

Conclusion

As Congress contemplates changes to the Bankruptcy Code to provide relief to consumer debtors, it should also consider making changes that will provide struggling retailers (and others) with a greater likelihood of a successful reorganization in Chapter 11. Such changes would no doubt also inure to the benefit of employees and consumers, and thus, achieve the likely policy goals of Congress.

 

[1] See Matters of First Impression — Business: The Death of Retail Chapter 11? BAPCPA in Practice in Retail Bankruptcy Cases, Panel: Laura Davis Jones, Ivan Gold, Jay R. Indyke, M. Steven Liff, Peter M. Schwab, 18th Annual Winter Leadership Conference.

[2] See The Disappearance of Retail Reorganization in the Post-BAPCPA Era, Lawrence C. Gottlieb, Sept. 26, 2008, p. 2 at N.1 (stating that only two retail cases have been successfully reorganized since BAPCPA).

[3] See 11 U.S.C. § 365(d)(4) (2004).

[4] See id.

[5] See 11 U.S.C. § 365(d)(4) (2009).

[6] We also suggest, in the alternative, that the number of extensions and/or length of extensions could be tied to the number of non-residential real estate leases to which the debtor is a tenant.

[7] See e.g. In re Viking Offshore (USA) Inc. 2008 WL 782449 at *3 (Bankr. S.D. Tex. Mar. 20, 2008) (declining to answer question of whether court continued to have the authority to modify the form of assurance rather than merely the amount).

[8] Further, Section 366(c)(2) should be amended to provide that the utility may discontinue service if it has not received adequate assurance “satisfactory to the court” in order to clarify that the court’s ability to modify the form of assurance has been reinstated.

[9] For example, the Code currently provides priority for $10,950 in prepetition wage and pension benefits. An employee earning twice the current federal minimum wage of $6.55 an hour would need to work over 835 hours, or approximately five and a half months of 40 hour work weeks, without pay to reach the new limitation. Therefore, it is unlikely that any retailer would face a substantial number of employees with claims reaching the new amounts (which is periodically adjusted to reflect changes in the Consumer Price Index).

[10] See 11 U.S.C. § 503(b)(9).

[11] See The Disappearance of Retail Reorganization in the Post-BAPCPA Era, Lawrence C. Gottlieb, Sept. 26, 2008, p. 7. 

[12] See e.g. Matter of Adventist Living Centers Inc., 52 F.3d 159 (7th Cir. 1995) (providing that an element to reclamation is a demonstration that the debtor had possession of the goods at the time of the reclamation demand).

[13] See 11 U.S.C. § 1129(a)(9)(A).

[14] Subject to certain jurisdictional amounts set forth in Section 547(c)(9), as periodically modified by Section 104.

[15] See In re Thompson Boat Co., 173 F.3d 430 (6th Cir. 1999), quoting H.R.Rep. No. 595, 95th Cong., 1st Sess. 373 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6329 (discussing legislative history to Section 547 “indicates that Congress’ purpose was ‘to leave undisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor’s slide into bankruptcy.’”)

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