A Primer on Bankruptcy Law and Trends in Corporate Reorganization Ken Ayotte

1. A Primer on Bankruptcy Law and Trends in Corporate Reorganization Ken Ayotte Northwestern University School of Law Ken Ayotte

2. Outline • Historical origins of corporate reorganization • What are the goals of Chapter 11? • Major features of the bankruptcy code • Recent trends and developments Ken Ayotte

3. Early corporate reorganization: railroads • The major building blocks of corporate bankruptcy law today come from railroad reorganizations in the late 1800s. • Characteristics of railroads: • Large amounts of capital required up front • Financed by bond issues, dispersed investor base • “Mortgage bonds” secured by cars and track • Though heavily indebted, RR worth more as going-concern than liquidated (who wants to pull up track from the ground?) • But hard to get all parties around the table to agree to a workout: small creditors may hold out. • What do we do? For a detailed discussion see David A. Skeel, Debt’s Dominion Ken Ayotte

4. Solution: “equity receiverships” • Investment banks who underwrote the bonds (J.P. Morgan) forms a committee • Bondholders “deposit” their bonds with the committee who acts on their behalf • Petition a court to stop all collection activities while a “foreclosure sale” takes place • Management continues to run the railroad in the interim At the “foreclosure sale”: • Investment bank sets up a new entity to bid, which is usually the only bidder at the sale • “Credit bids” with the deposited securities and some new cash Ken Ayotte

5. Later additions to the process At the end of the process: • The new entity owns the railroad, and sets up a new, less-levered capital structure with old bondholders as new equity • Cash from foreclosure sale is paid to holdout creditors, old entity extinguished Later developments: • Suppliers to the railroad were given priority claims to encourage them to continue supplying during the foreclosure process • Courts added “upset prices”: minimum floor price that holdouts must receive (to prevent bondholders from getting a windfall at the expense of holdouts) Most of the features of this informal process are codified today in the bankruptcy code! Ken Ayotte

6. Types of bankruptcy Three chapters in the U.S. bankruptcy code that are most commonly used in business context: • Chapter 7: Liquidation • Management is replaced by a trustee who sells the assets • Chapter 13: Adjustment of debts • Available only to individuals, but sole proprietorships can use it to restructure small business debts. May be cheaper than Ch 11. • Chapter 11: Reorganization • Most relevant chapter for corporate debtors if survival is possible. • Liquidation can occur in Ch 11, or case can be converted to Ch 7 later in the process. Ken Ayotte

7. What are the goals of Chapter 11? The “law and economics” perspective on Chapter 11: Two goals (sometimes in conflict): 1. To maximize the value of the estate - May involve keeping the firm as a going-concern, or may involve liquidating it 2. To pay creditors according to their contractual priorities Basic priority ranking: secured first (up to value of collateral), then unsecured, then equity The problem: It’s hard to know what a firm is objectively worth A party’s priority ranking distorts their incentive to maximize the value of the estate. Secured creditors may have a fire-sale bias, while junior creditors/equity have a continuation bias Ken Ayotte

8. When is Chapter 11 useful? • The railroad case is instructive because it describes a situation where a Chapter 11 filing is most useful: • The business may be worth more as a going-concern than liquidated • Creditors are dispersed: difficult to coordinate and possibility of a “race to the courthouse” to grab assets • The firm needs: • Time/ breathing space (to sort out its affairs, decide what to do with the firm and who gets what, find potential buyers) • Cash (to continue operations while decisions are made) • Restructuring (shedding assets and unprofitable operations) • Reduction in debt burden (so that the firm can operate profitably going forward, if it chooses to reorganize) Ken Ayotte

9. Time and breathing space:the automatic stay • The automatic stay (§362) • Puts an effective shield around the property of the debtor’s estate • Requires creditors (and other parties) to stop any collection efforts • Remains in effect until the conclusion of the case • Creditors may ask the court for relief from the stay in some circumstances • Example: secured creditor can ask for stay to be lifted if interest in property is not adequately protected (§361, 362) Ken Ayotte

10. New cash:Debtor-in-possession financing • Debtor in possession financing (§364) • Allows new money to come into the firm at a higher priority than the firm could offer a lender outside of bankruptcy • Usually, DIP loan is secured by any free assets, or by a second-lien on asset where a first-lien creditor is “oversecured” • Code allows secured creditors to be primed (§364(d)), though not common without lender consent • Overrides any contractual terms (like negative pledge clauses in bonds) that attempt to prevent firm from granting security to new lender Ken Ayotte

11. Restructuring:Sale of assets “free and clear” • Selling assets “free and clear of liens” (§363) • Outside of bankruptcy, a lien follows the asset to the buyer • Subjects potential buyers to costly investigations, due diligence, etc. to know what they are getting • Bankruptcy allows for buyers to purchase assets “free and clear”—lienholder consent not always required • In today’s environment, common for the entire going concern to be sold via a §363 sale Ken Ayotte

12. Restructuring:Assumption and assignment/rejection • Assumption/assignment and rejection of leases and other “executory contracts” (§365) • Debtor decides whether to assume or reject its leases (sometimes subject to time limitations) • If it assumes, firm must cure defaults and continue paying according to its lease contract • If it rejects, lessor can seize the leased asset • Also gets damages for breach, but the claim is unsecured! • If it assumes, it can assign the lease to a third-party, even if an anti-assignment clause in the lease contract • Warning: many exceptions and complications here Ken Ayotte

13. Reducing debt burden:confirming a plan of reorganization • Basic requirements of confirming a consensual plan of reorganization (§1129(a)): • Creditors grouped into classes, must be “substantially similar” • Classes vote: for creditors, 2/3 in value and ½ in number for a class to approve (just 2/3 in value for equity) • All “impaired” classes must approve • Debtor has exclusive rights to propose a plan for the first 120 days of the case. • Prior to 2005 act, exclusivity period could be extended at judge’s discretion indefinitely, now limited to 18 months Ken Ayotte

14. Cramdown • Alternatively, a party can propose a cramdown (§1129(b)): • Done when consensual plan is not attainable—does not require approval by all impaired classes • Judge can confirm plan only if it satisfies the absolute priority rule: • For each class, either paid in full, or • No lower class of claims (or interests) receives any value • In addition, in any plan of reorganization, any creditor is entitled to receive at least as much as in a liquidation (the “best interest of creditors” test) Ken Ayotte

15. Recent developments in Chapter 11 • The rise of secured creditor control • Chrysler and the 363 sale • Asset securitization and “bankruptcy remoteness” • GGP bankruptcy Ken Ayotte

16. Secured creditor control • In the early days of the code (1970s/ early 1980s), common view was that Chapter 11 was too “debtor-friendly” • Managers forum shop to “debtor-friendly” judges who would extend exclusivity period indefinitely • Used Chapter 11 to extract concessions from creditors • Too many reorganizations of companies that should have liquidated, low creditor recoveries • Example: Eastern Airlines Ken Ayotte

17. The changes: creditor control • While the bankruptcy code has not changed much, creditors (particularly, secured bank creditors) have learned how to protect themselves • Evidence on creditor control from large bankruptcies in 2001: • CEO turnover: 70% of CEOs in place two years prior to filing are out by the filing date • “Deviations from absolute priority” toward equity are rare (only about 6% of cases) • Sales of the business (either piece-meal or going concern) much more common than traditional reorganization (about 2/3 are sales) See Ayotte and Morrison, “Creditor Control and Conflict in Chapter 11. Working paper available on www.ssrn.com Ken Ayotte

18. More evidence on creditor control • Why have these changes occurred? • Senior secured creditors take control over the firm’s access to cash through secured lines of credit • Most pre-bankruptcy secured credit facilities are secured by “all assets”. Lack of free assets makes alternative sources of credit hard to find • Covenants in loan contracts, threats to cut off funding exert direct influence over firm behavior • Line item budgets • Require hiring of turnaround consultants • Require firm to be sold within a fixed time period Ken Ayotte

19. Chrysler and the 363 sale • Chrysler not able to resolve distress outside of bankruptcy due to holdout senior creditors • Plan to resolve Chrysler’s distress through a 363 sale in bankruptcy: • $2B in cash goes to senior creditors in exchange for most assets of Chrysler • “New Chrysler” jointly owned by US and Canadian Govts, Fiat, and VEBA (trust for retiree benefits) • What are the key legal issues? • 1. Is the sale a “sub rosa” plan of reorganization? • 2. Can Chrysler be sold “free and clear” of liens when the sale price is less than the face value of the secured debt? • 3. Should the judge have approved the bidding procedures? Ken Ayotte

20. Asset securitization • Securitization is a process by which assets are sold from an originator (operating firm) to an SPV which issues claims to investors • Bankruptcy implications: create a true sale of assets (instead of a secured loan) so that investors avoid the automatic stay • Used in many distressed/highly leveraged deals to obtain lower cost of funding • Creating “true sale” is not bullet-proof: LTV Steel example Ken Ayotte

21. Assets $ SPV Securities $ Investors Securitization Transaction Structure: “Bankruptcy Remoteness” Borrowers (Receivables) $ Originator Bankruptcy-Remoteness from originator: -True Sale - Non-consolidation “Bankruptcy-Proofness” of SPV “Structured financings are based on one central, core principle: a defined group of assets can be structurally isolated, and thus…[is] independent from the bankruptcy risks of the originator” Committee on Bankruptcy and Corporate Reorganizations of the Association of the Bar of the City of New York

22. General Growth Properties:What happened? • GGP is a publicly traded REIT that owns shopping centers, commercial office properties, planned communities • As is common, most individual properties owned by separate SPVs • SPVs were structured to be bankruptcy remote • Separate boards with “independent” directors • But when GGP filed for Chapter 11, 166 of its SPV subsidiaries filed along with it • The parent replaced the independent directors! Key lesson: “Bankruptcy remote” structures are never bullet-proof! Ken Ayotte