Co-authored by Doron P. Kenter.
“Aside from their inconsistency with empirical data, proposals to “reform” the Bankruptcy Code must overcome a more basic reality: The current Code works exceedingly well.”
– LSTA Response
Today, the Loan Syndications and Trading Association issued its Response to the Final and Recommendations the American Bankruptcy Institute Commission to Study the Reform of Chapter 11. As the principal advocate for the corporate loan market, the LSTA’s views carry serious weight with many constituencies in the distressed arena. The Weil Bankruptcy Blog received an advance draft of the LSTA Response; our initial review follows. (Our coverage of the ABI Commission Report is available here).
The LSTA’s Key Objections to the ABI Commission Report
Certain key themes permeate the LSTA Response, which include:
- a challenge to a key narrative underpinning the ABI Commission Report – namely that the Bankruptcy Code has been rendered outdated as a result of the evolution of financial markets and the increased use of secured credit. The LSTA Response argues that no reliable empirical evidence supports the view that increased secured creditor control has undermined the Bankruptcy Code’s effectiveness; in the absence of such empirical evidence, there is no justification for extensive reform.
- a belief that the ABI Commission’s proposed reforms would make the chapter 11 process more complex and expensive, and would have actual negative consequences if implemented. Specifically, the LSTA Response argues that the reforms will increase the costs of secured credit, while reducing the availability thereof. It also contends that chapter 11 cases will last longer and will be more complicated and expensive, thereby reducing recoveries to all creditors.
- an argument that the ABI Commission Report, by proposing to scale back chapter 11’s existing protections for secured creditors, undermines one of the conceptual foundations of the Bankruptcy Code – namely, that of maximizing the value of enterprises and the distribution of that value in accordance with nonbankruptcy priorities.
- an acknowledgment that the leveraged loan market and DIP market will not disappear if the ABI Commission Report’s recommendations to amend the Bankruptcy Code are adopted. On the other hand, the LSTA Response contends that those changes will have material adverse effects on those markets.
The LSTA Response to the Report’s Proposals
The LSTA Response’s specific objections to the ABI Commission Report are as follows:
Under the Bankruptcy Code, secured creditors are generally entitled to be adequately protected against a decline in value of their collateral so long as the debtor retains the right to continue to use that collateral during a bankruptcy case. The ABI Commission Report generally proposes that secured creditors receive adequate protection based on the (lower) foreclosure value of their collateral. (The current approach generally entitles secured creditors to adequate protection based on the use of that collateral in a going-concern business.)
The LSTA Response objects to this proposal on two grounds: first, cutting back secured creditors’ rights to adequate protection will put greater control of the chapter 11 process in a debtor’s hands (and by extension, the debtor’s interests may differ from those of the estate as a whole); second, such an approach ignores practical reality: lenders do not lend based on foreclosure value – secured lenders are generally entitled to the entire value of their claim, whether that value comes from the collateral itself or from the value generated from it, and not limited to the foreclosure value of the collateral. (On the other hand, note that foreclosure under state law would only yield the foreclosure value of any affected collateral.)
Recognition of Security Interests in Proceeds of Collateral (Section 552)
Section 552(a) of the Bankruptcy Code generally cuts off security interests in property acquired by the debtor after the petition date, while section 552(b) provides a general exception to this rule that protects a secured creditor’s security interest in proceeds of collateral.
The “equities of the case” exception to section 552(a) allows a bankruptcy court to limit a secured creditor’s security interest in postpetition proceeds of collateral to the extent such proceeds flow from the use of unencumbered cash to improve the collateral underlying the secured creditor’s claim.
The ABI Commission Report proposes to modify the equities of the case exception by eliminating certain requirements on the debtor and by taking away the debtor’s right to waive this exception (for example, at the insistence of secured lenders).
The LSTA Response views this proposal as a mechanism for increasing debtors’ ability to use the proceeds of secured creditors’ collateral to fund their reorganization efforts and to allow more value to be distributed to junior claims. The LSTA Response argued that, by eliminating the requirement that a debtor document improvements on collateral, a significant proportion of the increase in collateral value will ultimately flow to junior creditors, rather than the secured creditors who are the intended beneficiaries of the collateral.
The LSTA Response further argues that the ABI Commission Report provides no compelling reason for depriving a debtor of a bargaining chip (regarding the waiver of the equities of the case exception), which the debtor could otherwise exchange for other benefits that it judges to be of greater value.
Surcharge of Collateral (Section 506)
Section 506(c) provides debtors with a means to recover from collateral the reasonable, necessary costs and expenses of preserving, or disposing of, the collateral, to the extent of any benefit to the holder of a claim secured by the collateral. In the context of DIP financings or cash collateral agreements, debtors often waive the right to surcharge collateral. The ABI Commission Report proposes a similar ban on such waivers, so as to eliminate secured creditors’ rights to insist that debtors grant such a waiver in their favor. As with the “equities of the case” waiver, the LSTA objects to the proposed ban on 506(c) waivers as an unsupported restriction on debtors’ bargaining chips to be used at their discretion.
Section 363 Sales
Section 363 of the Bankruptcy Code governs sales of substantially all of a debtor’s assets. The ABI Commission Report made two recommendations with respect to section 363 sales:
- A general 60-day moratorium on section 363 sales of substantially all of a debtor’s assets; and
- The addition to section 363 of some (but not all) of section 1129’s requirements for plan confirmation.
The LSTA Response to these recommendations is that, to the extent there are legitimate concerns with the speed of a section 363 sale process, they can be addressed under current law. For instance, there is a real concern that the estate that remains after a quick 363 sale will be administratively insolvent, and the LSTA Response agrees that secured creditors should not push the administrative costs of a bankruptcy sale on to other creditors who will be left to foot the bill after a debtor’s assets are sold. However, the LSTA Response argues that courts already have the power to decline to approve a sale that will leave behind an administratively insolvent estate, or to otherwise take steps to mitigate the risk of such a result.
The LSTA Response also challenges the ABI Commission’s finding that sales are occurring too quickly to allow for robust auctions or for the proper exploration of restructuring alternatives, thereby preventing realization of the full value of businesses to the detriment of more junior creditors. The LSTA Response points to a study finding that fewer than 30% of cases have section 363 sales of any kind, and that there is no empirical data supporting a connection between section 363 sales and secured creditors’ control of the chapter 11 process.
In addition to the section 552 and 506(c) prohibitions outlined above, the ABI Commission Report proposed the following DIP financing related limitations:
- Banning roll-ups (which convert prepetition secured loans made by a DIP lender into postpetition obligations) unless substantial new financing on better terms than otherwise available in the market is received from that lender;
- Banning liens on avoidance actions or their proceeds;
- Banning milestones that occur within 60 days of the petition date; and
- Rendering unenforceable any intercreditor provisions that prohibit junior creditors from providing DIP financing, so long as senior creditors are given the right to match and senior liens are not primed.
The LSTA Response views the control provisions outlined above as critical in compensating lenders for both the uncertainty associated with the bankruptcy process and for the risk associated with a debtor’s particular circumstances. Removing any one of these controls would inevitably force lenders to seek additional protections in other areas. The LSTA Response therefore argues that eliminating certain controls would simply increase the cost of credit and curtail lending to borrowers most in need of it.
Redemption Option Value
The ABI Commission Report has proposed an exception to the absolute priority rule, allowing junior creditors to receive value in some circumstances even if senior creditors are not paid in full. The LSTA Response opposes such a fundamental overhaul of the Bankruptcy Code’s payment waterfall, largely because it considers the proposal to be highly impractical, requiring bankruptcy courts to engage in complex and costly valuation proceedings that are not currently required.
Voting and Classification
The ABI Commission Report has also proposed an overhaul of certain voting thresholds and classifications under the Bankruptcy Code: (i) removing the requirement that an impaired class accept a chapter 11 plan in order for it to be confirmed (ii) adopting a “one-creditor/one-vote” approach for creditors holding multiple claims in the same class; and (iii) restrictions on the waiver of voting rights in intercreditor agreements.
The LSTA Response argues that these proposals do not improve on the current law and would introduce additional (and unnecessary) complexity in a system that already works well.
Small and Medium-Sized Enterprises
The ABI Commission Report has proposed an alternative restructuring approach for nonpublic companies with less than $10 million in assets or liabilities (i.e., small and medium-sized enterprises, or “SMEs”). The most fundamental proposed change to those cases would eliminate the absolute priority rule applicable in chapter 11, and would allow prepetition equity holders to retain some equity ownership in the reorganized company, even if creditors have not been paid in full. In addition, the court would have the discretion to appoint a neutral financial advisor to assist the debtor and/or to direct the appointment of a committee of unsecured creditors (which would otherwise not be necessary). Lastly, the deadlines to file a plan and solicit acceptances thereof would be determined on a case by case basis, rather than on a fixed timetable in all cases.
In its report, the ABI Commission reasoned that radical change was needed for SMEs’ chapter 11 cases because the existing chapter 11 regime is too expensive, complicated, and time-consuming, leading to SMEs in particular to delay filing for chapter 11 relief until it is too late to restructure, forcing a foreclosure or liquidation.
The LSTA Response opposes this proposal, arguing that business corporations need not benefit from the same “fresh start” policy that the Bankruptcy Code affords to individuals. Instead, The LSTA Response proposes less drastic measures for SMEs, such as applying the existing provisions of chapter 12 (small farming business) to SMEs.
The LSTA Response agrees with the ABI Commission Report’s recommendation that secured creditors retain their right to credit-bid in sales of their collateral, specifically clarifying that the potential chilling effect of a credit bid alone should not constitute cause to deny credit bids, side-stepping the uncertainty generated by cases such as Fisker Automotive Holdings and Free Lance-Star. The LSTA Response reiterates that it is essential that secured creditors be permitted to assign a higher value to property via a credit bid (as opposed to a lower, cash-based bid by a third party), and that this principle is central to secured creditors’ basic bargain to be paid in full or receive the collateral securing the debtor’s obligations.
Cramdown Interest Rates
The ABI Commission Report whole-heartedly supports a market rate for cramdown interest. In the wake of decisions like Momentive, the LSTA Response unsurprisingly agrees with the ABI Commission Report, relying on the theory that cramdown paper should be sold at par value, in order to ensure that secured creditors receive the equivalent of their claim in cash, as is required by the Bankruptcy Code.
The ABI Commission Report proposes codifying the “new-value corollary,” the doctrine under which prepetition equity-holders may retain some equity interest in a reorganized debtor to the extent that they contribute new capital to the reorganized business. The LSTA Response agrees with the ABI Commission Report’s proposal that a prepetition equity holder be able to retain an equity interest where it contributes new money or money’s worth in an amount reasonably proportionate to the equity received or retained by equity holders, subject to a reasonable market test. The LSTA Response’s only caveat to its agreement is that it would require such new value to be at least equal to the equity retained or received by the old owner (to ensure that the absolute priority rule is being respected), as opposed to the ABI Commission Report’s recommendation that new value must simply be reasonably proportionate to the equity retained or received by the old owner.
The LSTA Response notes that many of the proposed reforms in the ABI Commission Report are premised on the so-called “perception that secured creditors now exercise greater control over chapter 11 proceedings than they once did, to the potential detriment of the debtor and unsecured creditors.” This control by secured lenders (largely as a result of the issuance of the increasing amount of secured debt) has, according to the ABI Commission Report, shifted the balance between “preserving a debtor’s need to rehabilitate” and maximizing value for creditors. Perhaps because chapter 11 debtors (and unsophisticated unsecured creditors) do not have their own lobbying groups, we posit that the ABI Commission Report found it necessary to return some degree of control in this area to debtors.
On the other hand, the LSTA Response does not take issue with the ABI Commission Report’s proposed reforms that would benefit secured creditors. For example, the LSTA Response endorses the ABI Commission Report’s recommendation that secured creditors should be entitled to a market rate of interest on their claims under a cram-down chapter 11 plan (which is currently the subject of some debate in different courts). The LSTA Response similarly supports secured creditors’ rights to credit-bid their debt, even where permitting such bids could chill other bidders’ interest in the assets.
The LSTA Response is thoughtful, well-researched, and forceful, and its most compelling arguments turn on the importance of certainty and uniformity in bankruptcy courts, in the Bankruptcy Code itself, and in creating the best incentives for doing business outside of bankruptcy, which is itself often informed by the backdrop of potential distress, default, and chapter 11.
Ultimately, credit markets adjust to developments in the law and in practice, just as they adapt to ever changing market forces. As Congress considers whether and how to reform chapter 11, the functioning of credit markets is one among many important considerations for all stakeholders to consider. It should be noted that the LSTA Response represents the views of one particular constituency, and does not purport to be a neutral, third party response to the ABI Commission Report. But regardless of one’s views on the matter, the merits of critical thought and serious analysis of the ongoing debate regarding chapter 11 reform are clear, and the LSTA Response adds serious, critical analysis of the ABI Commission Report to this discussion.