1 Bankruptcy Process for Sale Kenneth Ayotte Jared A. Ellias1
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Bankruptcy Process for Sale Kenneth Ayotte Jared A. Ellias1 April 7, 2020 Abstract The investors that fund Chapter 11 reorganizations usually look to acquire some level of control over the bankruptcy process through the contract associated with the debtor-in-possession loan. In this paper, we study a large sample of DIP loan contracts and show that the average level of control that creditors take over managers has significantly increased over the past three decades, with today’s DIP loan agreements routinely dictating the very outcome of the restructuring process. For their part, managers have incentives to sell their control of Chapter 11 if they can benefit personally through side payments. We call this transaction a “bankruptcy process sale.” We propose a model that identifies two situations where creditors may inefficiently buy control of the bankruptcy process: (1) when a creditor leverages the debtor’s liquidity shortage to lock in a preferred outcome at the outset of the case (“plan protection”); and (2) when a creditor steers the case to protect its claim against litigation (“entitlement protection.”) Both incentives can lead to outcomes that are not value-maximizing for the firm’s investors as whole. Using a new dataset that uses the text of 1.5 million court documents to identify process sales, we offer evidence consistent with the predictions of the model. 1 U.C. Berkeley School of Law and U.C. Hastings Law School, respectively. We would like to thank Christopher Hench and the U.C. Berkeley Data Lab for extraordinary help in gathering our text data, and Jonathan Gottlieb, Aartika Maniktala, Nir Maoz, and Daniel Rua for excellent research assistance. The authors also thank Brooke Gotberg, Ed Morrison, Rainer Haselmann and Tobias Trager and seminar audiences at the Annual Meeting of the Canadian Law & Economics Association, the Goethe University House of Finance and the BYU Winter Deals conference for their helpful feedback. 1 When large firms file for Chapter 11 bankruptcy, existing managers retain broad control over the bankruptcy process. In the early years of the bankruptcy code, managers were thought to use this control to favor shareholders.2 By design, this period of control would last until the confirmation of a Chapter 11 reorganization plan, when the bankruptcy judge would find that the rights of creditors had been protected and control would then shift to the firm’s new owners.3 Roughly twenty years ago, scholars began to notice that creditors had found a way to acquire control at an earlier point in the bankruptcy case. Chapter 11 firms usually require so-called debtor-in-possession financing to reorganize and this financing is typically arranged immediately after filing for bankruptcy, which is often months before any Chapter 11 plan is on the table. Existing senior creditors typically provide this financing, and they began to add language to the financing contract that had the effect of forcing management to give up some amount of control immediately after filing for Chapter 11 in exchange for needed capital.4 Many scholars and practitioners worried that this change in bankruptcy practice might undermine the bankruptcy system, as the bargaining power of senior creditors could distort bankruptcy outcomes.5 In this Article, we use new evidence – a sample of DIP loan agreements spanning three decades and the text from all court filings in 278 large Chapter 11 cases – to show that in the modern era, management often agrees to financing conditions that are so onerous that the debtor- 2 In the early years of the modern bankruptcy code, managers were thought to use their control to favor shareholders over creditors. See Lynn M. LoPucki The Debtor in Full Control-Systems Failure Under Chapter 11 of the Bankuptcy Code? 57 Am. Bankr. L.J. 99 (1983), Lawrence A. Weiss and Karen H. Wruck, Information Problems, Conflicts of Interest, and Asset Stripping: Chapter 11’s Failure in the Case of Eastern Airlines, 48 J Fin Econ 55 (1998). 3 While the period of incumbent management control is designed to allow for management to guide the firm to a Chapter 11 plan, that is not always the case. The initial period of incumbent management control lasts for 120 days, but can be extended by the bankruptcy judge if management requests an extension. See generally 11 U.S.C. § 1121. In 2005, Congress limited this period of exclusive control to 18 months after the petition date. See 11 U.S.C. § 1121(d)(2)(A). The new statute did provide creditors and shareholders with the power to terminate management’s period of exclusive control of the case, which is referred to as “exclusivity.” See 11 U.S.C. § 1121(d)(1). 4 David A. Skeel Jr, Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 U Pa L Rev 917, 919 (2003); Elizabeth Warren and Jay L. Westbrook, Secured Party in Possession, 22 Am Bankr Inst J 12, 12 (Sept 2003); Barry E. Adler, Vedran Capkun, and Lawrence A. Weiss, Value Destruction in the New Era of Chapter 11. 29(2) J L, Econ, & Org 461 (2013). Douglas G. Baird and Robert K. Rasmussen, The End of Bankruptcy, 55 Stan L Rev 751, 784 (2002). 5 Skeel, supra note 2; Kenneth M. Ayotte and Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 J Legal Analysis 511, 514 (2009) (finding that bankruptcy sales are more likely and traditional reorganization less likely with debtors that have oversecured secured creditors); Ellias 2014; Mark Jenkins and David C. Smith, Creditor Conflict and the Efficiency of Corporate Reorganization (unpublished manuscript, May 2014) online at https://ssrn.com/abstract=2463700. More recently, scholars have begun to describe a new practice whereby management cedes control over the bankruptcy through a “restructuring support agreement” or other contract in which management pledges to implement a particular transaction. See generally Douglas G. Baird, Bankruptcy’s Quiet Revolution, 91 Am. Bankr. L.J. 593 (2017). 2 in-possession loans amounts to a de facto transfer of total control to the senior creditors.6 Our sample of DIP agreements show that the story of DIP financing over the past twenty five years is a story of lenders acquiring increasingly greater levels of control over management. This transfer of control – which we describe as a “bankruptcy process sale” 7 – is qualitatively different, we argue, from the account of debtor-in-possession financing previously offered in the literature, which centered on senior creditors forcing faster bankruptcies. As we show below, the average DIP loan contract today amounts to a total sale of control of the bankruptcy process to the DIP lenders, leaving management in an almost ministerial role of implementing a specific transaction. Troublingly, managers may be tempted by moral hazard to sell control to the buyer who offers the largest side-payment, who may be not be the efficient buyer. This practice – the sale of total control of the bankruptcy process at the outset of a Chapter 11 case – deserves closer scrutiny as it may undermine the statutory structure of Chapter 11.8 Bankruptcy law exists to solve problems caused by creditor coordination failures. To solve these problems, the Bankruptcy Code stays individual creditor remedies, and centralizes control in the debtor’s managers, who have a fiduciary duty to the creditor body as a whole. Management is expected to exercise that control under the watchful eye of the bankruptcy judge and creditors 6 For an example of a court overruling a “sub rosa” DIP Loan, see In re Belk Properties, LLC, 421 B.R. 221 (Bankr. N.D. Miss. 2009) (“the purpose of the Meadowbrook post-petition financing proposal still violates the holding of Braniff because it achieves the same effect as a sub rosa Chapter 11 plan of reorganization.”) 7 In bankruptcy courts, creditors appear to refer to these loans derisively as “sub rosa plans,” a bankruptcy term of art implying that the bankruptcy financing effectively determines the outcome of the bankruptcy case and the distribution of the estate’s value from the start. For example, an objection to the DIP loan in the Propex case: “Second, the proposed financing facility is a sub rosa plan, which cannot be approved by this Court. Having all of the hallmarks of a sub rosa plan, the proposed financing facility (i) dictates the terms of the Debtors’ reorganization in that it forces the immediate liquidation of the Debtors’ assets, (ii) significantly alters all creditors’ rights with respect to the Debtors’ assets in that, once the proposed financing facility is approved, creditors and parties in interest have no meaningful opportunity to oppose the sale of the Debtors’ assets without jeopardizing the Debtors’ postpetition financing and (iii) requires that the Debtors liquidate all of their assets immediately, leaving nothing left to reorganize. Since the proposed financing facility constitutes an improper sub rosa plan, the relief requested in the Motion must be denied.” 8 To be sure, that distressed companies transfer control rights to creditors is well-known, and there are benefits to such control shifts from shareholders to creditors when they occur outside of bankruptcy. See, e.g. Phillippe Aghion and Patrick Bolton, An Incomplete Contracts Approach to Financial Contracting. 59 Rev. Econ. Stud. 473 (1992); Mathias Dewatripont and Jean Tirole, A Theory of Debt and Equity: Diversity of Securities and Manager- Shareholder Congruence. 109 Q. J. Econ. 1027 (1994); Greg Nini, David C. Smith and Amir Sufi, Creditor Control Rights, Corporate Governance and Firm Value. 25(6) Rev. Fin. Stud. 1713 (June 2012). There is mixed empirical evidence suggesting that creditor control leads to outcomes consistent with efficiency inside bankruptcy; for results more consistent with the efficiency side, see Stuart C.