Trend Spotting — Are Courts Becoming Less Friendly to Distress Investors?

When the Bankruptcy Code was enacted in 1978, it embodied a bias in favor of reorganization of going concerns wherever possible. This has been the singular distinction between the “American style” of restructurings and the approach used in most other commercial countries. The very concept of “debtor-in-possession” suggests a belief in the chance of renewal which is absent from the “receivership style” of insolvency prevalent outside the United States. This policy predisposition toward recovery has been a powerful stimulus for the involvement of financial investors in the bankruptcy process, which in turn has attracted liquidity that has itself fostered the reorganization of troubled businesses. The very possibility of a corporate turnaround has encouraged investors to take risk in buying discounted equity and debt in restructurings, where there would be far less interest in asset trading in liquidations. On the other hand, the bankruptcy process is not about aspirations and dreams. It is a hard-nosed business and legal environment that is dependent on sophisticated financial parties having confidence in the logic of outcomes. The purpose of this article is to explore whether certain recent trends could undermine that confidence.

The subtext underlying reorganization has always been the notion of equity or fairness, which temper the more objectively concrete legal rights and duties. Equitable considerations are woven through the Bankruptcy Code and are within the express jurisdiction of the bankruptcy courts. This means the courts are encouraged to use their judgment to achieve outcomes that conform not only to the letter of the law, but also to the policy behind the law that favors going concerns. However, the courts are ultimately held to the applicable law, and that sometimes precludes a successful reorganization and mandates a liquidation.

This dynamic between legal rights and equitable considerations has been the context in which investors assess opportunities to commit capital in insolvency. Such investors include a variety of different types of parties, such as hedge funds, private equity shops, traders and individuals, who have put their money on the line after problems have arisen. In that respect, these investors differ from the equity owners, traditional bank lenders and suppliers whose commitment usually arose before trouble occurred. However, the practical distinction between “original creditors” and “distress investors” blurs as claims trading occurs, and the later-in-time stakeholders purchase the interests of the earlier equity and debt capital providers. For the most part, the Chapter 11 process has been able to harmonize the objectives of all financial stakeholders, and achieve equitable, pro-economic results. However, in the last 18 months, seemingly in response to the Great Recession, there have been some judicial developments that suggest a shift in the balance between openness to new, distress investment in troubled companies and orientations that may favor other stakeholders. This trend is mirrored by certain aspects of the financial market regulatory reform pending before Congress, such as requiring creditors to retain material positions in the credit risk that the creditors sell, transfer or convey to third parties, including the securitization of asset-backed securities. [1]

Even if the developments are adjustments to perceived excesses, they could cause a reaction with its own negative consequences. The growth in secondary or distress investing has been at least thirty years in the making and is a significant contributor to the the prompt resolution of cases. The bankruptcy arena has been one of contention over issues of position, value and expectations for generations. There have been economic crises before that have flooded the courts with cases. However, this may be the first time a class of investor is the apparent target of critical judicial sentiment.

We will use some recent cases for “trend spotting” and then analyze the potential consequences of the trend. In each of the cases mentioned, distress investors had acquired majority or substantial ownership of the debt and or equity of the Chapter 11 debtors.

“Transparency”—Developments Regarding Rule 2019

The most recent developments surrounding Federal Rule of Bankruptcy Procedure 2019—both court decisions and the proposed rule change—are the most direct effort to influence the reorganization process.

The recent decision In re Washington Mutual, Inc. [2] (which was followed even more recently in In re Accuride Corporation [3]) applies the disclosure requirements in Rule 2019 to members of an ad hoc group participating in a Chapter 11 case. While there had been previous, conflicting decisions [4] about whether Rule 2019 governed informal groups that did not purport to act in a fiduciary capacity or represent anyone other than members of the group, the customary practice that had developed was simply for the members of the group to identify themselves and the aggregate amount of claims that they held collectively. The Washington Mutual court, however, not only ruled that the members of the ad hoc noteholders group must disclose their individual holdings, the dates they acquired or disposed of such holdings, and the amounts paid or received therefor, but also that “collective action by creditors in a case implies some obligation to the other members of that class.”

As proposed, the revised Rule 2019 [5] broadens the disclosure requirement to apply to (a) every “entity, group, or committee” that represents or consists of more than one creditor and (b) upon a motion of a party in interest or on the Court’s own motion, to any entity that seeks or opposes the granting of any relief. In addition, it would define the “disclosable economic interests” to include a “participation, derivative instrument, or any other right or derivative right that grants the holder an economic interest that is affected by the value, acquisition, or disposition of a claim or interest.” Finally, the revised Rule 2019 would require parties to disclose the date a member acquired each economic interest and, if required by a court, the price paid for such interest. The increased disclosure is meant “to cover any economic interest that could affect the legal and strategic positions a stakeholder takes in a Chapter 9 or Chapter 11 case.”

Granting the premise that transparency is a positive, the recent decisions in Washington Mutual and Accuride targeted only one party—groupings of distress investors who hold debt—and not on the wide variety of other entities who routinely act in a unified fashion. It does seem incongruous to demand constituent disclosure of unions, but is that because it is impractical or because unions are presumptively benign? Are hedge funds a less authentic constituency in Chapter 11? It is firmly established that the price paid for a claim does not affect the amount of the creditor’s claim, or the creditor’s voting power, [6] so the legitimate use of such proprietary information is unclear, but armed with such knowledge, debtors and other parties-in-interest could attempt to extract concessions from creditors who have paid less than full value for their claims.

“Outcome Orientation”—Have Rights Changed?

Outcome orientation is neither unusual, nor new, nor necessarily even inappropriate in Chapter 11. However, a tour of certain decisions invites a question whether some “obvious outcomes” have established a pattern that might not be desirable and which should be avoided, even if the specific individual cases are properly decided themselves.

• In re Louisiana Riverboat Gaming Partnership and Legends Gaming of Louisiana, LLC. [7] The court confirmed the debtors’ plan of reorganization over the objections of the second lien lenders, who claimed that the plan effectively passed the equityrisk onto them. The debtors retained ownership of their hotels and casinos, and general unsecured creditors were paid in full. The first and second lien lenders’ claims were capitalized and paid in full, with interest, over time, but because of restrictions that limited cash payment of interest to the second lien lenders until the first lien debt was repaid in full, most of the interest that the second lien lenders would receive on the second lien debt would be PIK and not in cash. Underlying the court’s holding was its view that the second lien lenders had accepted and “always borne a substantial amount of [ ] risk” of nonpayment pursuant to the terms of the original second lien credit agreement; therefore, the current risk imposed by the plan was not objectionable to the court. The court found that, regardless of what the debtors could otherwise obtain in the market for such second lien financing, the interest rates proposed (based on the Federal Funds Rate plus a risk factor) were sufficient to compensate the second lien lenders. The court seemed to make a judgment regarding the level of risk that was acceptable, from its point of view, for the second lien lenders to bear, in order to accommodate other, more favored, parties-in-interest.
• In re Charter Communications, LLC. [8] The first lien lenders objected to the reinstatement of the prepetition US$8.2 billion credit facility on the grounds that (a) there had been certain prepetition nonmonetary defaults by the borrower that could not be cured, (b) the equity interests received by the noteholders’ group constituted a change of control that would cause a default in the credit agreement and (c) the insolvency of the borrower’s affiliates had accelerated the obligations under the agreement, but were not ipso facto provisions because the defaults were not conditioned on the insolvency of the borrower. The court rejected each of these objections and found that, especially in the current financial markets, reinstating the first lien debt on the existing, favorable terms (that were materially better than those which could be presently achieved in the market) was not only extremely beneficial to the debtors, but appropriate. The opinion confirming the plan of reorganization not only allowed the debtors to reinstate more than US$8.2 billion in first lien debt over the lenders’ objections, but also found that any impaired accepting class at any of the 131 separate legal entities in those cases may be used to satisfy the requirement of section 1129(a)(10) to allow the debtors to cram down a plan on dissenting, impaired noteholders (holding notes issued by Charter Communications, Inc.). The court found that, because the debtors were part of an integrated enterprise managed by Charter Communications, Inc., somehow the protections that would apply if each debtor had been an individual debtor (i.e., not part of an enterprise that filed together and was jointly administered) no longer applied.
• In re Philadelphia Newspapers, LLC [9] and In re Pacific Lumber Company. [10] The courts denied the secured creditors’ rights to credit bid their claims in the sale of substantially all of the debtors’ assets pursuant to a plan of reorganization. Even though section 1129(b)(2)(A)(ii) preserves a secured creditor’s right to credit bid its claim during a sale of debtor’s assets pursuant to a plan of reorganization, the courts held that the debtors could satisfy the indubitable equivalent cram-down prong through a sale of its assets without affording the creditors their rights to credit bid their claims. These decisions may portray courts’ opposition to the so-called “loan-to-own” strategy, but also serve as a warning to secured creditors that courts may be willing to allow debtors to circumvent certain protections in the Bankruptcy Code that protect secured creditors’ rights to acquire their collateral if debtors seek to sell that collateral and cannot provide the creditors with the full value of their claims.
• In re Chrysler, LLC. [11] The court approved the sale of substantially all the assets of the “Old Chrysler” to a newly created shell company for approximately US$2 billion in cash. That US$2 billion was then paid to first lien creditors in exchange for US$6.9 billion in senior priority debt, while tens of millions of dollars in value was provided to junior unsecured creditors, in violation of the absolute priority rule, to satisfy retiree and auto supplier obligations. Chrysler was able to use a process of sale pursuant to section 363 that the District Court for the Southern District of New York, in a prior case, had cautioned against in similar circumstances because it could “allow a powerful creditor and a debtor anxious to achieve some value for its favored creditors to run roughshod over disfavored creditors rights.” [12]

We can draw from each of these cases an understandable desire to reorganize the debtor as a going concern, because of a belief in the “greater good.” Thus, the courts all found what appeared to them to be credible legal fulcrums for their rulings. It may certainly be true as a matter of policy and macroeconomics that these results did accomplish more than any alternative, but taken as a whole, the message suggests that outcomes and not legal rights should be the investors’ guideposts, which is quite a relativistic and unpredictable index and not encouraging to financial investors.

“Anti-Wall Street Feelings”

Outright anger at the financial community may be a widespread sentiment these days, but it is a rather awkward basis for court decisions. In the Chapter 11 case of In re Yellowstone Mountain Club, LLC , [13] the court equitably subordinated [14] the US$232 million claim of the senior secured lender to the claims of unsecured creditors—thus moving the secured creditor from the first-in-line for recovery to almost the last-in-line—because the court found that the secured lender had engaged in “overreaching and predatory lending practices.” The court found that the very nature of the financial product offered to the debtor, and the way the creditor marketed the product, “were so far overreaching and self-serving that they shocked the conscience of the court.” Of the US$375 million that the lender extended to the debtor, approximately US$340 million was permitted to be used for purposes “unrelated” to the company itself, US$209 million of which was distributed to the principal of Yellowstone Mountain Club, LLC in return for an unsecured note. The lender marketed the “new loan product referred to as a syndicated term loan” as “something akin to a ‘home equity loan,’” which essentially let the developers of luxury resorts take their profit upfront while mortgaging the resort project to the hilt. In return, the lender took what the court stated was a disproportionate US$7.5 million fee and syndicated the entire credit rather than retaining any of the risk. The US$375 million of credit drastically increased the debtor’s leverage by nearly seven times at a time when the company was losing a substantial amount of money.

The Yellowstone court found that this “naked greed” was so egregious as to warrant the extraordinary remedy of equitably subordinating the claims of a non-insider. There was no claim of collusion or that the deal was on anything less than arm’s-length terms, but simply that the product was, by its nature, objectionable. This appeared to be a policy judgment by the court that, unlike in the Hollywood movie “Wall Street”, greed is not only bad but actionable. Yet one must question why financing structures that for years have allowed exit or monetization strategies for incumbent owners ought to be subject to any legal tests other than the well-known rules against fraudulent transfers.

Possible Takeaways

These trends reflect an apparent growing judicial discomfort with a business—distress investing—that can reasonably be said to have modernized the entire bankruptcy process and to have encouraged the salutary policy of favoring reorganization of going concerns. What is to be done? For the time being, distress investors should probably accept that the national climate is hostile to nonreorganization outcomes and, thus, investment decisions and legal strategies should be adjusted accordingly. For the long term, it may be necessary to recalibrate risk decisions adding a greater unknown factor for decisions in bankruptcy, at least until the judicial and legislative environment is more predictable. The ground rules seem to be changing and the investors need to change their playbooks.

Endnotes

[1] See Wall Street Reform and Consumer Protection Act, H.R. 4173 (the Wall Street Reform Act). While the House was considering the Wall Street Reform Act, Senator Dodd was working on his own regulatory reform proposal. Senator Dodd initially sought to gain bipartisan support for this proposal by working with leading Republicans on the Senate Banking Committee, but ultimately proposed a partisan bill that has the backing of the Obama administration.
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[2] In re Washington Mutual, Inc., 419 B.R. 271 (Bankr. D. Del. 2009).
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[3] In re Accuride Corp., Case No. 09-13449 (BLS) (Bankr. D. Del. Jan. 22, 2010). The hearing regarding the applicability of Rule 2019 was held on January 20, 2010, but no opinion has yet been filed.
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[4] In re Northwest Airlines Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007); In re Northwest Airlines Corp., 363 B.R. 704 (Bankr. S.D.N.Y. 2007); In re Scotia Dev., LLC, Case No. 07-20027, Order (Bankr. S.D. Tex. Apr. 18, 2007) (Scotia Docket No. 659). But see In re Premier Int’l Holdings, Inc. (Bankr. D. Del. Jan. 20, 2010) (specifically disagreeing with the Washington Mutual decision and finding that Rule 2019 did not apply to a group of creditors).
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[5] A copy of the proposed amendments to Rule 2019 is available at http://www.uscourts.gov/rules/. The revised Rule 2019 may also apply to an agent bank that has filed a proof of claim on behalf of a syndicate of lenders and may require the agent to disclose the amount, price and acquisition date of its claims as well as the claims of each lender in the syndicate. There is also a provision for court-ordered disclosure by individual creditors, to be made “when a court believes that knowledge of the party’s economic stake in the debtor will assist it in evaluating the party’s arguments.”
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[6] Fairfield Exec. Assocs. v. Hyperion Capital Credit Partners, L.P. (In re Fairfield Exec. Assocs.), 161 B.R. 595, 602 (D.N.J. 1993) (citing In re Pittsburgh Rys. Co., 159 F.2d 630, 632-33 (3d Cir. 1946)).
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[7] In re Louisiana Riverboat Gaming P’ship and Legends Gaming of Louisiana, LLC, Case No. 08-10824, Plan Confirmation Hr’g Tr., June 7, 2009.
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[8] JPMorgan Chase Bank, N.A. v. Charter Commc’n Operating, LLC (In re Charter Commc’n, LLC), 419 B.R. 221 (Bankr. S.D.N.Y. 2009).
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[9] In re Philadelphia Newspapers, LLC, 2010 WL 1006647 (3d Cir. Mar. 22, 2010). (go back)

[10] Bank of New York Trust Co., N.A. v. Official Unsecured Creditors’ Comm. (In re Pacific Lumber Co.), 584 F.3d 229 (5th Cir. 2009).
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[11] In re Chrysler, LLC, 405 B.R. 84 (Bankr. S.D.N.Y. 2009); see also generally In re Old CarCo, LLC, No. 09-50002 (Bankr. S.D.N.Y.); Indiana State Police Pension Trust v. Chrysler, LLC (In re Chrysler, LLC), 576 F.3d 108, 112 (2d Cir. 2009) (affirming the sale on direct appeal).
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[12] In re WestPoint Stevens, Inc., 333 B.R. 30, 49 – 50 (S.D.N.Y. 2005).
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[13] Credit Suisse v. Official Comm. of Unsecured Creditors (In re Yellowstone Mountain Club, LLC), Case No. 08-61570, Adv. Proc. No. 09-00014 (Bankr. D. Mont. May 13, 2009) (Partial & Interim Order).
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[14] Pursuant to section 510(c) of the Bankruptcy Code, the court has discretion to equitably subordinate allowed claims to other allowed claims if it finds egregious conduct on the part of the creditor to be subordinated.
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