Viewpoints

Proposed Changes to U.S. Bankruptcy Code Could Create Opportunities in Distressed Credit

​​If adopted, the American Bankruptcy Institute’s (ABI) proposed revisions to the U.S. Bankruptcy Code could profoundly affect restructuring processes and creditors’ rights. ​

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In December, the American Bankruptcy Institute (ABI) published a report proposing revisions to the United States Bankruptcy Code – changes that, if adopted, would affect restructuring processes, creditors’ rights, valuation determinations and the allocations of recoveries to creditors. Market participants, including distressed credit investors, have been assessing the possible consequences if the ABI proposals are adopted. Many have expressed concerns over proposals that could modify today’s straightforward insolvency process based on the “absolute priority” rule – the idea that secured and senior creditors must be paid in full before junior creditors receive any recovery. On the other hand, distressed investors who understand the nuances of bankruptcy may find the changes enhance rather than diminish opportunities.

Background and overview
The American Bankruptcy Institute is a nonpartisan group established in 1982 to advise Congress. The ABI’s proposals aim to balance the objectives of effective reorganization of debtors and the maximization of asset values for all creditors and stakeholders. While Congressional debate on the ABI report will commence in 2015, implementation is likely several years away. On balance, the ABI’s recommendations seem to favor unsecured creditors and other stakeholders over secured creditors.

Proposals that could potentially disadvantage senior creditors
The ABI recommendations could limit some rights of senior creditors to be paid in full before junior creditors or make “loan to own” strategies more difficult.

Re-evaluate the need for adequate protection payments. Courts award “adequate protection” to secured creditors in the form of payments or additional collateral when there is a risk that the creditors’ original collateral will lose value during bankruptcy. The ABI’s proposal could make it more difficult for secured creditors to obtain “adequate protection” payments or collateral by setting the starting value for evaluating that risk at the foreclosure value of their collateral, as opposed to the “going concern” value of their collateral that most courts use today – i.e., the generally higher value such collateral has when it is part of an ongoing business.

Limit the ability to roll-up debt into debtor-in-possession (DIP) financing. DIP financing – the loans provided to companies in bankruptcy so that they can continue to operate – can be attractive because these loans are senior to all pre-petition debts and are generally over-collateralized. Often, pre-bankruptcy creditors will offer DIP financing themselves, and then convince a court to allow them to “roll-up” their pre-petition loans by converting them into a component of the new, attractive DIP financing. Such roll-ups allow pre-bankruptcy lenders to defend their positions, increase available collateral and sometimes leapfrog ahead of other creditors. The ABI’s proposal would limit roll-up capabilities.

Approval of sales via a 363 process. “363 sales” are sales of debtors’ assets during the bankruptcy. Sometimes secured lenders “credit bid” in the sale, meaning that rather than bidding and paying in cash, they offer to buy the assets in exchange for the value owed to them under their pre-bankruptcy debt. The ABI proposes that 363 sales be judged by the same high standards as plans of reorganization, limiting the ability of distressed buyers or secured lenders who credit bid to obtain ownership of assets or of a debtor, while leaving little or no recovery left for junior creditors.

Absolute priority rule and the concept of redemption option value. The Bankruptcy Code generally embodies the principle of absolute priority – the tenet that senior creditors must be fully paid before junior creditors or shareholders receive anything. Among its most radical proposals, the ABI proposes that reorganizations that impair senior lenders could be approved over lender objections to the extent that such plans grant junior lenders “redemption option value,” meaning a payment equal to the “option value” in a company’s value attributable to market cycles, temporary market dislocation, etc. Such value would be calculated based on option pricing models.

Codification of the new value corollary. Under this corollary, junior creditors and stakeholders sometimes argue for the right to contribute “new value” to a bankrupt entity in order to buy a stake in the upside. Impaired senior creditors often object to what they see as a sale of value at a lowball price before they are paid in full. The ABI would allow such “new value” contributions by junior creditors so long as there is an open bidding process for the contribution.

Assignment of voting rights in intercreditor agreements. Intercreditor agreements are structured between different groups of creditors (senior and junior creditors, bondholders and bank lenders) such that they obligate each group to take or refrain from taking certain actions. Under the ABI proposal, intercreditor agreements would no longer grant senior creditors the right to vote junior creditor positions in a bankruptcy.

Proposals that could potentially disadvantage junior creditors
The ABI recommendations could limit junior creditors’ ability to delay reorganization or employ other veto strategies to receive more than they otherwise would.

Elimination of the need for an impaired accepting class to approve a plan of reorganization. As currently written, the Bankruptcy Code generally requires that at least one class of creditors that is getting less than a full recovery vote to approve a plan of reorganization. The requirement allows a more junior class of creditors to seek to obtain more value from senior creditors than that to which it might otherwise be entitled by simply refusing to vote in favor, thereby delaying reorganization. The ABI proposal could end this strategy.

Eliminate the “chilling effect” argument against credit bids. Junior creditors would no longer be permitted to argue for the rejection of credit bids by senior creditors based on the proposition that credit bids deter potential third party bidders.

Redemption option value for junior creditors. Under this proposal, junior creditors who reject the “redemption option value” offered and delay reorganization would receive nothing.

Eliminate the ability to force senior creditors to take new debt at below market rates. Junior creditors have used a 2004 United States Supreme Court ruling known as “Till” to win approval of reorganization plans that don’t pay senior creditors fully, but instead give them new debt at sub-market rates. The ABI plan would foreclose that strategy.

Other ABI proposals
These recommendations are designed to close loopholes.

Elimination of some “safe harbors” for leveraged buyouts. This proposal would allow an estate to attempt to claw back moneys paid to former shareholders through a buyout that later sent a company into bankruptcy. Buyouts of public companies might be protected.

Narrowing of defenses against fraud. The current rule, which forbids a criminal from suing his co-conspirator, has been used to block bankrupt companies from suing executives or third parties such as accountants who participated in or abetted fraud, even via negligence (e.g., Refco, Madoff). Narrowing the defense may make it easier for estates to win recoveries for creditors who suffered from corporate fraud that resulted in bankruptcy.

Empower an “estate neutral” to advise on disagreements. This would expand the role sometimes played by court-appointed examiners, and give the court significant leeway in determining whether the appointment is in the “best interest of the estate.” The increased court discretion could create a new realm for legal maneuvering within the reorganization process.

Creation of regimes for small and medium-sized enterprises (SMEs). Some experts believe the expense and complexity of the current regime discourage small businesses from filing for bankruptcy until it is too late to save them. It is hoped that streamlined and simplified structures will allow smaller companies to file earlier and use the process so that businesses can be saved.

Implications for investors
The ABI proposals seem to mark an effort to modify the positions of different creditor classes in bankruptcy, a move that could disadvantage both senior and junior creditors depending on the particular case. The proposals (other than rejection of the ruling in Till) also seem to mark a step away from the belief in the market as the arbiter of value and toward the belief that regulation can counteract market cycles.

Investors who favor a straightforward insolvency process – in which secured and senior lenders are paid out strictly according to rank and where firms are protected from litigation – have commenced their responses with comments and will lobby to inhibit adoption of the ABI proposals. On the other hand, distressed investors who understand the nuances of bankruptcy may find the changes have the potential to increase – rather than decrease – opportunities to accumulate positions that may produce attractive, non-correlated returns over a multiyear horizon. Several changes could reward distressed investors’ abilities to recognize value that can only be realized by strategically purchasing positions in distressed capital structures and then navigating the complexities of the bankruptcy process. Examples include the potential to profit from analyzing and assigning value to pre-petition collateral underpinning secured claims, and from estimating the probability of adequate protection payments. Distressed investors may also find opportunities to appraise and invest in the “option value” that could be awarded to more junior claims.

Distressed investing has always required the ability to match granular, value-based investment approaches with keen credit analysis and an understanding of bankruptcy in all its complexity. The latest proposals, if enacted, will likely spawn a new set of strategies that will favor investors comfortable with the intricacies of insolvency and the scenarios it presents.

The Author

Sai S. Devabhaktuni

Head of Corporate Distressed Portfolio Management

Ethan Schwartz

Portfolio Manager, Distressed Credit

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Disclosures

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