The Rise of Bankruptcy Directors

Jared Ellias is Professor of Law and Bion M. Gregory Chair in Business Law at the University of California Hastings Law School; Ehud Kamar is Professor of Law at Tel Aviv University Buchmann Faculty of Law; and Kobi Kastiel is Associate Professor of Law at Tel Aviv University, and Lecturer on Law at Harvard Law School. This post is based on their recent paper, forthcoming in the Southern California Law Review. Related research from the Program on Corporate Governance includes Independent Directors and Controlling Shareholders by Lucian Bebchuk and Assaf Hamdani (discussed on the Forum here).

Over the past decade, an important new player has emerged in corporate bankruptcies: bankruptcy experts who join boards of directors shortly before or after the filing of the bankruptcy petition and claim to be independent. The new directors—typically former bankruptcy lawyers, investment bankers, or distressed debt traders—either receive the board’s power or become loud voices in the boardroom shaping the company’s bankruptcy strategy, including investigating self-dealing claims against shareholders. We call them “bankruptcy directors.”

In a new paper forthcoming in the Southern California Law Review, we study this phenomenon using a hand-collected sample of all large firms that filed for Chapter 11 between 2004 and 2019 and disclosed the identity of their directors to the bankruptcy court. To our knowledge, it is the largest sample of boards of directors of Chapter 11 firms yet studied.

We find that the percentage of firms in Chapter 11 proceedings claiming to have an independent director increased from 3.7% in 2004 to 48.3% in 2019. Over 60% of the firms that appointed bankruptcy directors had a controlling shareholder and about half were under the control of private-equity funds.

The rising prominence of bankruptcy directors has made them controversial. Proponents tout their experience and ability to expedite the reorganization and thus protect the firm’s viability and its employees’ jobs. Opponents argue that they suffer from conflicts of interest that harm creditors.

Our findings explain why bankruptcy directors are controversial. After controlling for firm characteristics, we find that the recovery rate for unsecured creditors, whose claim is typically most at risk in bankruptcy, is on average about 20% lower in the presence of bankruptcy directors. While we cannot rule out the possibility that the firms appointing bankruptcy directors are more deeply insolvent and that this explains their negative association with creditor recoveries, this finding at least shifts the burden of proof to those claiming that bankruptcy directors improve the governance of distressed companies.

We also examine a mechanism through which bankruptcy directors may reduce creditor recoveries. In about half of the cases, these directors investigate claims against insiders, negotiate a quick settlement, and argue that the court should approve it to save the company and the jobs of its employees. We supplement these statistics with two in-depth studies of cases where bankruptcy directors defused creditor claims against controlling shareholders: Neiman Marcus and Payless Holdings.

Finally, we consider possible sources of pro-shareholder bias among bankruptcy directors. Shareholders usually appoint bankruptcy directors without consulting creditors. These directors may therefore prefer to facilitate a graceful exit for the shareholders. Moreover, bankruptcy directorships are short-term positions and the world of corporate bankruptcy is small, with private-equity sponsors and a handful of law firms generating most of the demand. Bankruptcy directors depend on this clientele for future engagements and may exhibit what we call “auditioning bias”.

In our data, we observe several individuals appointed to these directorships repeatedly. These “super-repeaters” had a median of 13 directorships and about 44% of them were in companies that went into bankruptcy when they served on the board or up to a year before their appointment. Our data also show that super-repeaters have strong ties to two leading bankruptcy law firms. Putting these pieces together, our data reveal an ecosystem of a small number of individuals who specialize in sitting on the boards of companies that are going into or emerging from bankruptcy, often with private-equity controllers and the same law firms.

These findings support the claim that bankruptcy directors are a new weapon in the private-equity playbook. In effect, bankruptcy directors help in shielding self-dealing transactions from judicial intervention. Private-equity sponsors know that if the portfolio firm fails, they could appoint bankruptcy directors to handle creditor claims, file for bankruptcy, and force the creditors to accept a cheap settlement. Importantly, the ease of handling self-dealing claims in the bankruptcy court can fuel more aggressive self-dealing in the future.

Our findings have important policy implications. Bankruptcy law strives to protect businesses while protecting creditors. These goals clash when creditors bring suits that threaten to delay the emergence from bankruptcy. While bankruptcy directors may aim for speedy resolution of these suits, their independence is questionable because the defendants in these suits appoint them. Moreover, bankruptcy directors often bypass the system of checks-and-balances that Congress created when they purport to handle tasks typically performed by the unsecured creditors committee, such as investigating claims against insiders.

We argue that the contribution of bankruptcy directors to streamlining bankruptcies should not come the expense of creditors. The bankruptcy court should therefore treat as independent—and thus worthy of judicial deference—only bankruptcy directors who, in an early court hearing, earn overwhelming support of the creditors whose claims are at risk, such as unsecured creditors or secured creditors whom the debtor may not be able to pay in full. Bankruptcy directors without such support should not prevent creditors from investigating and pursuing claims.

The creditors will likely need information on the bankruptcy directors to form their opinion, and bankruptcy judges can rule what information request is reasonable to create standardization and predictability. However, disclosure is no substitute for creditor support. Requiring disclosure without heeding creditors on the selection of bankruptcy directors will not cure bankruptcy directors’ structural bias.

Some might argue that our solution is impractical or otherwise lacking. In the article, we answer this claims. More importantly, our solution is the only way to ensure that bankruptcy directors are truly independent. If it cannot be made to work, bankruptcy law should revert to the way it was before the invention of bankruptcy directors, where federal bankruptcy judges were the only impartial actor in most large Chapter 11 cases. In such a scenario, debtors will be free to hire whomever they want to help them navigate financial distress, but the court will regard these bankruptcy directors as ordinary professionals retained by the debtor: it should weigh their position against creditors’, allow creditors to conduct their own investigation and sue, and not approve settlements merely because the bankruptcy directors endorse them.

Beyond bankruptcy law and policy, our analysis has implications also for corporate law. Much of the literature on director independence in corporate law has focused on past and present director ties to the corporation, to management, or to the controlling shareholder. We explore another powerful source of bias: the lure of future engagements and the lawyers advising them.

Soon after the release of a draft of our article, it was featured in the Wall Street Journal, the Financial Times, and Bloomberg, among other publications. It also inspired a robust debate among bankruptcy lawyers. Responding to the controversy, Senator Elizabeth Warren proposed federal legislation that would give exclusive power to the official committee of unsecured creditors to prosecute and settle claims against insiders and to demand a court hearing to scrutinize director conflicts.

Senator Warren’s proposal is consistent with our findings and has similar goals to our proposal, but we urge judges not to wait for Congress to act—they can easily implement our proposal using the tools they already have.

Moreover, while Senator Warren’s proposal has the benefit of simplicity and, if adopted, will ensure consistent application by different judges, our proposal has two advantages. First, it lets the debtor firm appoint experts of its choice to navigate the bankruptcy process and receive judicial deference as long as these appointees are acceptable to creditors. Second, by requiring that bankruptcy directors be acceptable to creditors, our proposal ensures that all board actions in bankruptcy, not just decisions regarding claims against insiders, advance creditor interests. This is important as we find that bankruptcy directors are associated with lower creditor returns even when not investigating claims against insiders.

The complete paper is available for download here.

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