The American Bankruptcy Institute Commission to Study the Reform of Chapter 11 released its Final Report and Recommendations on December 8, 2014.1 The ABI organized the Commission in 2011 to study and address the evolution of products and participants in the financial markets, many of which have outgrown the current statutory framework enacted nearly 40 years ago.
Two categories of recommendations are most significant for secured creditors in large Chapter 11 cases: the rebalancing of pre-petition secured creditors’ rights and DIP financing. Whether or not any recommendations are enacted into law, the report will continue to generate vigorous debate and will likely heavily influence the thinking of practitioners, judges, lenders and investors in future Chapter 11 cases.
A perceived shift in power to secured creditors since the enactment of the current Bankruptcy Code is a principal theme of the report. With rebalance in mind, the Commission advocates for many changes that appear to shift power away from secured creditors, while attempting to preserve their rights to the benefit of their pre-petition bargain. The recommendations are intended to form a coherent and analytically consistent set of rights and remedies for secured creditors throughout a Chapter 11 case.
New/clarified standards to value secured creditors’ collateral for purposes of adequate protection, and distribution at plan confirmation or sale are proposed to balance the secured creditor’s right to its pre-petition bargain against a debtor’s interest in flexibility, and access to liquidity early in the case.
The report specifically recommends that collateral be valued at its foreclosure value for adequate protection purposes, but at the higher reorganization value for distribution purposes. This approach is consistent with §506(a) of the Bankruptcy Code, which states that value “shall be determined in light of the purpose of the valuation and of the proposed disposition or use of [the] property.” If the debtor were unable to provide adequate protection, the secured creditor would be entitled to a lifting of the automatic stay. If the stay were lifted, the secured creditor typically could do nothing more than pursue its right to a state law foreclosure sale of its collateral, and accept the discount that often comes with that process. However, for purposes of final distributions in the Chapter 11 case, the report recommends that the secured creditor should receive the full going concern (reorganization) value of its collateral.2 According to the findings, this bifurcated approach should allow the debtor greater flexibility to finance itself during the early stages of the case, while protecting the secured creditor’s ultimate right to reap the benefits of the reorganization at the end.
Redemption Option Value
The Committee recommends a new source of junior creditor recoveries called “Redemption Option Value.” Under the proposal, the class of creditors immediately junior to the class that would otherwise receive the residual value of the reorganized firm would be entitled to receive the value of a hypothetical option to purchase the entire firm at a future date, at a strike price equal to the senior class’ or classes’ full entitlement and at a given volatility.3
A court would be able to confirm a plan (or approve a sale of all, or substantially all, assets) that does not strictly observe the absolute priority rule over the objection of an impaired senior class only if the deviation from the absolute priority rule were limited to the distribution to the junior class of the Redemption Option Value. Similarly, a court would be able to cram down a plan rejected by a junior class only if the junior class receives at least the Redemption Option Value attributable to the plan or sale, if any, and, in the case of a plan, if the court determines that the reorganization value in the plan was not proposed in bad faith.
Although the proposal appears to be a significant deviation from the absolute priority rule, even where a junior creditor class or classes is entitled to a distribution on account of the Redemption Option Value, the senior class or classes will still receive the preponderance of the residual value of the reorganized company.4 Further, if the senior class is significantly impaired, there is only a small likelihood that the junior class would receive any Redemption Option Value. The largest Redemption Option Values would occur in short cases concerning businesses in highly volatile markets, addressing the concern that today’s fast-paced bankruptcies sometimes force junior creditors to accept a significant “bankruptcy discount” by tying recovery to a snapshot in time, while not allowing enough time between filing and confirmation for business cycles or idiosyncratic industry events to run their course.
The Commission acknowledged the significant deviation from current practice that this proposal represents. While the report outlines the broad contours of the Redemption Option Value proposal, the Commission also recognized that, even if adopted, Congress would be faced with significant implementation issues.
Cramdown Interest Rates
Section 1129(b) allows confirmation of a plan over the objection of an impaired class of secured creditors if the plan provides a deferred payment stream to such creditors with a present value equal to the allowed amount of the relevant secured claim, sometimes referred to as “cramdown.” Though the provision appears straightforward, the discount rate used to calculate the present value of those deferred payments — so-called “takeback paper” — has been a matter of great controversy, especially recently.
In 2004, in Till v. SCS Credit Corporation, the Supreme Court mandated the use of the “formula” approach, in which the risk-free rate is increased by a discretionary 100 to 300 basis points, to determine the discount rate in Chapter 13 individual debtor cases. In Momentive, a recent Southern District of New York bankruptcy case, the bankruptcy court applied the holding of Till to a Chapter 11 case. Secured creditors argued the court should use a market rate of interest, suggested by a footnote in Till as more sensible in the Chapter 11 context, and that the use of the prime rate undercompensated them, especially in comparison to identical-priority exit credit facilities the debtor had already negotiated. The bankruptcy court, nevertheless, concluded the market rate was not appropriate because secured creditors receiving takeback paper under a cramdown plan were not entitled to compensation for “transaction costs and overall profits.”
The report recommends overriding the use of the formula approach in Chapter 11 cases, and use of a market rate of interest to determine the interest rate of secured creditor takeback paper. Where a market rate is not available, it advises using a risk-adjusted rate that reflects the actual risk posed by extension of credit to the debtor.
The Commission’s recommendations regarding DIP financing would likely shift the balance of power in favor of Chapter 11 debtors. Although the Commission recognized that today’s robust market for post-petition financing is an asset to the successful reorganization of businesses, it appears to believe the cost has resulted in a significant reduction in flexibility for debtors and other stakeholders.
Intercreditor agreements often contain prohibitions on junior secured creditors offering DIP financing without the consent of senior secured creditors. The report recommends limiting the effect of these provisions in bankruptcy to allow junior secured creditors to offer competing DIP financing notwithstanding intercreditor agreements barring such offers. As with many of its findings, the report here clearly reflects a compromise among the commissioners, including two important conditions: (1) no junior creditor’s post-petition credit facility will be permitted to prime the senior secured creditors’ pre-petition liens, absent their consent; and (2) if the bankruptcy court approves such a facility, the senior secured creditors will have the right to provide DIP financing on the same terms in lieu of the junior secured creditors. If these two safeguards are included, the report further recommends barring senior secured creditors from suing any junior secured creditors that offer competing financing for breach of the intercreditor agreement.
This proposal may result in generally lower costs and better terms for DIP financing, as debtors benefit from the increased pool of potential lenders. However, troubled companies’ pre-petition financing may become more expensive, as lenders price in the increased uncertainty. The proposal also carries what might be called implementation risks, as Congress may be wary of interfering with the contractual relations of unrelated non-debtor entities. Concerns also exist about how the recommendation would work in practice, as senior lenders willing to meet (or beat) junior lender economic terms may struggle with whether it is possible for them to either step into the junior lenders’ papers and accompanying noneconomic terms, or agree on new final documentation in a workable timeframe.
Interim DIP Orders
Interim orders addressing many important issues are typically approved soon after the commencement of a case, often at the first-day hearing. These orders are subject to modification by a final order, but rarely vary significantly from interim orders, and parties are often reluctant to challenge them in a meaningful way. The report recommends prohibiting “extraordinary financing provisions” in interim orders, including: (1) milestones, benchmarks and other provisions that require debtors to perform certain significant tasks or satisfy certain material conditions; (2) concessions regarding the validity or extent of lenders’ pre-petition liens; (3) “roll-up” provisions, by which pre-petition debt is refinanced through post-petition facilities; (4) waiver of debtors’ rights to surcharge lender collateral pursuant to §506(c); and (5) waiver of debtors’ rights to challenge the attachment of lenders’ liens to proceeds of lenders’ collateral under §552(b)’s “equities of the case” exception.
The Commission’s suggestion is intended to create breathing room for the debtor and other stakeholders at the beginning of a Chapter 11 case. The common practice of splitting approval of DIP financing into interim orders and final orders has, to some degree, limited the opportunity for debtors and other stakeholders to consider and challenge certain conditions often found in the documentation and enabling orders for DIP financing. However, these extraordinary financing provisions are often integral to DIP financing packages, and limiting the bankruptcy court’s discretion to approve these provisions in interim orders, may cut some debtors off from post-petition financing during the period when it is most critical to their survival.
60-Day Milestones Moratorium
The report also recommends a 60-day moratorium, running from the petition date, on milestones likely to materially affect the debtor’s operations or conduct of the case, which can be highly effective at guiding the outcome of bankruptcy cases. Prohibited milestones would include deadlines to conduct an auction, close a material sale, or file a disclosure statement and Chapter 11 plan. This moratorium would be cumulative to the prohibition on such provisions in interim DIP orders, setting an inside barrier of 60 days on such conditions, even where final orders were entered more quickly. Less-material milestones, such as reporting requirements, customary loan covenants and compliance with a budget would still be permissible within the 60-day window unless they would achieve the same effect as a prohibited milestone.
The Commission considered changes to rules governing provisions that roll up pre-petition debt held by pre-petition lenders into post-petition credit facilities, or that require a debtor to pay off its pre-petition debt with the proceeds of its post-petition credit facility. Under the Commission’s proposal, roll-up provisions remain permissible only if: the post-petition facility is either provided by a new lender or repays the pre-petition facility in cash, extends substantial new credit to the debtor and provides more financing on better terms than alternative facilities offered to the debtor; and the court finds that the proposed post-petition financing is in the best interests of the estate. It seems likely that, if adopted, these new requirements would provide parties with further significant opportunities to challenge DIP orders, and would potentially create significant delays in the entry of final DIP orders.
Chapter 5 Avoidance Actions
The report recommends excluding the proceeds of Chapter 5 avoidance actions (preference and fraudulent conveyance claims) from the types of property on which debtors may grant liens as part of DIP financings. Such proceeds would continue to be available in the event of a shortfall in the lender’s adequate protection liens under §507(b) of the Bankruptcy Code, but they could no longer be offered as part of the collateral package to prospective post-petition lenders or pledged as adequate protection for the benefit of a pre-petition secured creditor.
This recommendation, if adopted, would improve the prospects for unsecured creditors in cases where Chapter 5 avoidance action proceeds prove to be a key source of recovery. However, the recommendation would also foreclose the strategy of pledging legally marginal avoidance actions to avoid becoming an attractive nuisance during the Chapter 11 case. The cost of increased motion practice and litigation of marginal claims, often against ongoing suppliers and customers, might significantly reduce the net benefit to general unsecured creditors and reduce recoveries overall.
Given recent developments in cases such as Momentive and others, it is clear that, whether or not any of the report’s recommendations are adopted, significant pressure will be placed on secured lenders in Chapter 11 cases. Recent case law reflects judges’ reactions to many of the same issues and changes in commercial practice that motivated the recommendations in the Commission’s report.
Since it appears an ad hoc rebalancing of secured creditors’ rights is being conducted through the courts in any event, the report’s candid evaluation of those rights, and its recommendations — whether one agrees with them or not — highlight the arguments on both sides of the issues and frame the debate. We expect the report will be the starting point in a long and vigorous conversation regarding the reform of Chapter 11. Time will tell whether any of the recommendations, or alternatives later proposed, will be enacted into law.
Damian S. Schaible is a partner in the Insolvency and Restructuring group, and Kevin J. Coco is an associate in the Insolvency and Restructuring group, both at Davis Polk & Wardwell LLP in New York.
1. The full report is available at http://www.commission.abi.org/ target=”_blank”>click here.
2. The right to going concern value in connection with ultimate distributions in the case is subject to the entitlement of junior classes to any Redemption Option Value, as more fully discussed below.
3. For ease of discussion in this section, “junior class” refers to the class or classes of creditors junior to the class or classes that would otherwise receive the residual value of the reorganized firm, and “senior class” refers to the class or classes that would receive the residual value of the reorganized firm. Often, the senior class would be the fulcrum class of creditors, but not always.
4. The report states that the Commission recognized that certain issues require further development, including how the Redemption Option Value would be applied when the residual interests in the firm are allocated among several senior classes or when the senior class or classes do not receive the entire residual value of the firm.