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How Distressed Debt Investors Decrease Debtor Leverage and the Efficacy of Business Reorganization

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How Distressed Debt Investors Decrease Debtor Leverage and the Efficacy of Business Reorganization THOMAS GALLEYSFINAL 2/16/2011 12:05 PM TIPPING THE SCALES IN CHAPTER 11: HOW DISTRESSED DEBT INVESTORS DECREASE DEBTOR LEVERAGE AND THE EFFICACY OF BUSINESS REORGANIZATION INTRODUCTION Congress drafted chapter 11 of the Bankruptcy Code to provide a forum where creditors and business debtors enter the reorganization process with the common interest of maximizing returns to all creditors through the debtor’s rehabilitation,1 while preserving the going-concern value2 of the debtor.3 Contravening this purpose, chapter 11 also allows nontraditional creditors4 to buy claims5 at a steep discount once a business files for bankruptcy and to demand full payment of these claims.6 These nontraditional creditors are known as distressed debt investors7 or vulture funds.8 For the purposes of this Comment, “DDI” will be used to describe all parties that invest in distressed 1 Chaim J. Fortgang & Thomas Moers Mayer, Trading Claims and Taking Control of Corporations in Chapter 11, 12 CARDOZO L. REV. 1, 12–13 (1990) [hereinafter Fortgang & Mayer, Trading Claims]. 2 “Going concern value” is defined as the positive difference between the debtor’s liquidation value and value of the business in continued operation. See H.R. REP. NO. 95-595, at 223 (1977) (“[G]oing-concern value . is usually higher than the liquidation value of the business, because assets in operation can usually earn more than assets sold for scrap.”). 3 Id. at 220 (“The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors . It is more economically efficient to reorganize than to liquidate . .”). 4 The term “traditional creditor” refers to institutional lenders envisioned by the drafters of chapter 11. Traditional creditors have relationships with the debtor long before the debtor files for bankruptcy and provide capital in expectation of a long-term relationship with the debtor and the successful operation of the debtor’s business. Non-traditional creditors are those creditors that have no prior relationship with the debtor and invest during bankruptcy to obtain a short-term return on their initial investment as well as on investments at other levels of the debtor. See Harvey R. Miller, Chapter 11 Reorganization Cases and the Delaware Myth, 55 VAND. L. REV. 1987, 2014 (2002). 5 Claims are debts accumulated by the debtor, such as trade debts, bank debts, tort claims, and other obligations that sophisticated investors treat like securities and trade for consideration. Daniel Sullivan, Big Boys and Chinese Walls, 75 U. CHI. L. REV. 533, 533 (2004). 6 Frederick Tung, Confirmation and Claims Trading, 90 NW. U. L. REV. 1684, 1699 (1996); see also Michelle M. Harner, Trends in Distressed Debt Investing: An Empirical Study of Investors’ Objectives, 16 AM. BANKR. INST. L. REV. 69, 76 (2008) (“The concept of ‘relationship lending,’ where a bank would work with a troubled company to develop a mutually-agreeable restructuring plan to foster repeat business with the company, is now the rare exception rather than the rule.”). 7 Hereinafter “DDI.” 8 Vulture Fund, INVESTOPEDIA, http://www.investopedia.com/terms/v/vulturefund.asp, (last visited Sept. 27, 2010) (“[T]hese funds are like circling vultures patiently waiting to pick over the remains of a rapidly weakening company. The goal is high returns at bargain prices.”). THOMAS GALLEYSFINAL 2/16/2011 12:05 PM 214 EMORY BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 27 debt, while “vulture fund” will refer to a DDI that either seeks short-term returns through distressed debt investing, or attempts to take control of corporations when they exit chapter 11.9 Often, vulture funds have no interest in a successful reorganization,10 and they use their leverage to obtain short-term returns on investments at the expense of the debtor and other creditors.11 DDIs are not bad or malicious; however, like all participants in chapter 11 cases, DDIs are rational actors that attempt to maximize profits. Problematically, there is no individual entity present in a chapter 11 proceeding that represents the preservation of going- concern value or the rehabilitation of the debtor. It is easy to see why traditional creditors have interests inapposite to preserving going-concern value: they want their money.12 The individuals that comprise the debtor’s management may theoretically represent the preservation of going-concern value and the interests of the debtor; however, these individuals are impermanent and have concerns external to the debtor, such as personal well- being and continued employment.13 Instead, the rules of the game—the provisions of chapter 11—are present to protect going-concern value and promote rehabilitation. The rules are far from perfect. Congress enacted the basic structure of chapter 11 in the Bankruptcy Reform Act of 1978,14 which took effect on January 1, 1979, before claims-trading was a popular investment strategy.15 DDIs are currently able to pursue strategies that the drafters of 9 See, e.g., Michelle M. Harner, The Corporate Governance and Public Policy Implications of Activist Distressed Debt Investing, 77 FORDHAM L. REV. 703, 716–17 n.55 (2008). 10 Chapter 22: Are Vulture Investors to Blame?, 38 Bankr. Ct. Dec. (LRP) No. 4, at A1 (Aug. 21, 2001) (“[Vulture investors] are looking to buy at 40 and sell at 50. They’re only interested in their particular piece of paper. They couldn’t care less about the constructive process of developing a reasonable plan.”). 11 See Miller, supra note 4, at 2014; see also Steven Andersen, Distressed Debt; New Players, Global Sophistication Make Restructuring More Complex, INSIDE COUNSEL, May 2008, at 12 (“Nontraditional lenders often like the fact that debt is in default. If they do their homework right, they can buy-in at a discount and gain huge returns, but their primary concern is not necessarily that the borrower pay off the loan.”). 12 Indeed, a foundational premise of bankruptcy law, given creditors’ propensities to pursue their claims aggressively, is the need for a common collection procedure to prevent the individual state remedies available to creditors from being a detriment to creditors as a whole. Thomas H. Jackson, Of Liquidation, Continuation, and Delay: An Analysis of Bankruptcy Policy and Nonbankruptcy Rules, 60 AM. BANKR. L.J. 399, 399 (1986). 13 See Henry Hu & Jay Lawrence Westbrook, Abolition of the Corporate Duty to Creditors, 107 COLUM. L. REV. 1321, 1377 (2007). 14 Hereinafter “the ‘78 Act.” 15 Harner, supra note 9, at 710; Fortgang & Mayer, Trading Claims, supra note 1, at 13; see also Chaim J. Fortgang & Thomas Moers Mayer, Developments in Trading Claims: Participations and Disputed Claims, 15 CARDOZO L. REV. 733, 733 (1993). THOMAS GALLEYSFINAL 2/16/2011 12:05 PM 2010] TIPPING THE SCALES IN CHAPTER 11 215 chapter 1116 did not contemplate and that contravene the policy choices made in creating the system.17 Specifically, claim flipping18 and betting against the success of reorganization19 are popular strategies used by vulture funds that tend to exacerbate the difficulties of complex business reorganizations. Furthermore, vulture fund involvement decreases a debtor’s leverage in negotiations by increasing confusion, thereby delaying productive negotiations.20 These delays diminish the value of the estate and prevent a debtor from investing in negotiations because the identities of creditors are not constant.21 Finally, vulture funds that actively seek control of the debtor through the reorganization process create disincentives for a debtor’s management to file a proactive plan for reorganization.22 The culminating effect of nontraditional creditor involvement is to decrease the debtor’s ability to preserve going-concern value, which is contrary to the purpose of business reorganization.23 While distressed debt trading is undoubtedly big business—estimates place the market in the hundreds of billions of dollars24—its consequences for the 16 See Jonathan C. Lipson, The Shadow Bankruptcy System, 89 B.U. L. REV. 1609, 1614–15 (2009) (arguing that chapter 11 creates a “shadow bankruptcy” system where “[s]ophisticated and aggressive private investors exploit interstices in [c]hapter 11, and between [c]hapter 11 and other laws—in particular federal securities laws—that might check their behavior”). 17 These policy choices include the premise that rehabilitation may benefit creditors more than a piecemeal liquidation of the debtor’s assets. See Fla. Dep’t of Revenue v. Piccadilly Cafeterias, Inc., 554 U.S. 33, 50 (2008) (noting that chapter 11 has “twin objectives of ‘preserving going concerns and maximizing property available to satisfy creditors” (quoting Bank of Am. Nat’l. Trust and Sav. Ass’n. v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 453 (1999))); H.R. REP. NO. 95-595, at 220 (1977) (“The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors . It is more economically efficient to reorganize than to liquidate . .”). Reorganization may also preserve jobs and tax bases in the communities where the debtor operates while preventing the general upheaval caused by liquidation. 7 COLLIER ON BANKRUPTCY ¶ 1100.01 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2010). 18 Purchasing and selling claims for a profit before plan confirmation. See infra text accompanying notes 120–26. 19 See infra text accompanying notes 127–45. 20 See infra text accompanying notes 163–71. 21 See infra text accompanying notes 163–71. 22 See infra text accompanying notes 212–31. 23 See H.R. REP. NO. 95-595, at 220 (1977). 24 Adam J. Levitin, Finding Nemo: Rediscovering the Virtues of Negotiability in the Wake of Enron, 2007 COLUM. BUS. L. REV. 83, 86 (2007); Tung, supra note 6, at 1685 (“The size of the [distressed debt] market was estimated to run as high as $300 billion.”); see also Robert D.
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