Among a number of issues addressed by an American Bankruptcy Institute Commission tasked with making recommendations to the federal legislature regarding bankruptcy law was a subject that has been on the minds of many bankruptcy professionals over the last few years. It is also certainly a subject that has been on the minds of countless unsecured creditors and junior lien holders, who have variously shouted out in anger and frustration, something to the effect of—Why did I just get shafted!?!
It has been obvious to anyone following corporate bankruptcy news that senior creditors have been enjoying a vastly increased role in driving the Chapter 11 process, and have also been reaping its greatest benefits. The particular issue here that was taken up by the Commission (which published its long-awaited report, covering many other issues as well, in early December) was to determine whether unsecured creditors and junior lien holders, who are more and more “out of the money” in today’s bankruptcies, can be offered some way to get more “in the money” if a reorganized company turns out to be more successful than can be reliably assumed at the time of a major bankruptcy event, like an asset sale under Section 363 or the confirmation of a plan of reorganization.
As their reasoning goes, legislative changes are warranted when the general business and financial market landscape significantly changes in a way that disrupts the general spirit of bankruptcy law—specifically, that a balance be maintained between the interests of debtors and lower-level stakeholders as opposed to the interests of senior creditors. With the combination of all of the financing issues prevalent today for companies with liquidity troubles, the Commission asserts, the environment has indeed changed from the time of its last true reality check (1978), and thus the law should adapt accordingly.
Sure, being a creditor of a bankrupt entity is never ideal, but since when did Chapter 11 restructurings (not Chapter 7 liquidations, mind you) come to mean that the smaller guys get sent home with a pat on the head and little or nothing in their pockets? On the other hand, what’s wrong with the secured creditors taking everything on the table, if that’s what is required to satisfy their claims? After all, bankruptcy law priority rules clearly set them apart on a higher tier, essentially requiring that they be paid in full before anyone else gets a taste.
But debtors undergoing a Chapter 11 reorganization are not simply a stack of dollars in a vault waiting to be divvied up—they are a value proposition that can deliver perhaps more or perhaps less to its pre-petition creditors over a period of time, depending on how well they bring in money and reduce costs. If senior creditors are driving the Chapter 11 process, and have more of an interest in exiting the bankruptcy case quickly with pockets stuffed as full as possible, then it becomes less likely that the version of the value proposition that most benefits all the non-senior-lender parties who hold a stake in the debtor will be discovered and given the full opportunities it might otherwise find.
Enter the ABI Commission and its new junior-creditor-friendly concept, The Redemption Option Value Rule. Under this rule, junior creditors could receive an appropriate benefit if the valuation of a company at some reasonable time after a “363 sale” or Plan Confirmation takes place turns out to be greater than it was at the time the valuation snapshots for those Chapter 11 milestones were taken. Sort of like how you can profit by having a securities redemption that pays you the higher, current market price for an option that you were able to obtain at a lower price, back when the company’s market valuation was lower. Plans of reorganization could be passed with distribution provisions to lower-tiered creditors essentially containing an asterisk at the end—these classes will get some upside if the reorganized entity turns out to be more valuable than the current “best guess” valuation upon which the plan is based.
Additionally, in an attempt to address other concerns, the Commission puts forth ideas for some other legislative changes that would undoubtedly take a little steam out of what some regard to be secured creditor steamroller tactics, by restricting some of the ways in which cases can currently be pushed through very quickly–so quickly, some would argue, that an educated conversation about valuation and prospects is impeded. Now, the skeptic in us might cry out against an apparent ABI pro-lawyer bias here (after all, longer case lives translate into higher aggregate professional fees, right?), but it is far from conclusively proven that quicker, cheaper, and more expedient means better when it comes to bankruptcy cases. Is there no wisdom that can be taken from Tolkien’s Treebeard, the old leader of the Ents, who always cautioned that “One should not be too hasty”? A reorganized company is not a cooked burger stuffed into a bag and handed to a driver through a window. It should represent the best solution to a set of problems that are unique to the company and its interested parties; is it not worth a little extra time and money to get it right? The overarching purpose of bankruptcy law is to create the right environment for that solution to be discovered, and this seems to be the driving principle behind the Commission’s thoughts on these matters.
Critics (and I suppose here it’s reasonable to say “realists”) point out that the various proposals, especially the Redemption Option Value, have not been fully thought through. There are a host of unanswered questions, some of which are acknowledged by the Commission itself, and numerous contradictions, discrepancies, and the like would still need to be adequately addressed in a way that doesn’t trample over well-settled fundaments of law, including basic contractual rights. (We’re talking about third party contracts here that could end up subordinated as a result of this new rule, not debtor contracts which are already by nature subject to rejection in a bankruptcy.) To succeed, the measure will need a rally of support, including some compelling arguments in defense against those who would shoot it down as impractical, unfair to senior creditors, or an unnecessary meddling with a proven process. What’s more, it’s taken quite a while just to get here–so, don’t expect a fully vetted proposal being passed around congressional offices any time soon.
Whether Congress will ultimately even take heed remains to be seen, of course. But quite possibly, some years from now, a lot of creditors will be much happier with their outcomes in bankruptcy cases than they would be otherwise, and if they look deeply into the matter they may come to find that it is the ABI Commission they have to thank for that.
Brad Daniel is a Director at BMC Group, an information management firm specializing in financial and legal transaction support. He has 25 years of restructuring experience, with a broad exposure to all aspects of bankruptcy case administration and reorganized-company/trustee support. His expertise in both bankruptcy legal matters as well as systems integration and rapid application development…
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