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Vol 14, Num 5 l August 2015

Business Reorganization An ABI Committee Newsletter - Spnsored by The Wall Street Journal
 

Shuffling the Deck: The Rebalancing of Creditor Rights Proposed by ABI Commission’s Final Report

ABI

Mette H. Kurth
Fox Rothschild, LLP
Los Angeles

One of the themes of the Final Report and Recommendations released by the ABI’s Commission to Study the Reform of Chapter 11 is the shift in the balance of power between a distressed company and its creditors, as well as the introduction of perceived inequities among creditor constituencies. These shifts have diluted the effectiveness of chapter 11 and driven companies to seek alternatives, which can come at the expenses of creditors and other stakeholders.[1] In response, the Commission Report contains many recommendations that would shift the balance of power away from secured creditors.
           
Additional recommendations would also impact the balance of power among senior and junior secured lenders, unsecured creditors and creditors’ committees, debtors, equityholders and other parties. The stated goal behind the recommendations is to better balance the maximization and realization of asset values for all creditors and stakeholders.[2] This article highlights just a few of the more significant ways in which the recommendations, if adopted, would shift power, rights or value among key constituents.

Altering the Contractual Balance of Power Between Senior and Junior Secured Creditors
The Commission scrutinized various contractually negotiated restrictions that senior secured creditors often place on subordinated junior secured creditors. Its recommends that §§ 364 and 510 of the Bankruptcy Code should be amended to make it easier for junior creditors to provide post-petition financing by rendering unenforceable contractual provisions that would otherwise allow senior creditors to recover damages from junior creditors based on their provision of post-petition financing. (The junior creditors, however, would not be permitted to prime perfect security interests of the senior creditors, which would also have the option to match the terms of, and to provide the financing facility in lieu of, the junior creditors.) Contractual assignments or waivers of voting rights in favor of senior creditors under an intercreditor, subordination or similar agreement would also be unenforceable. Subordinated junior creditors would retain the right to vote on a plan and invoke the protections of § 1129(b) of the Bankruptcy Code.

Shifting Value from Secured Creditors to Junior Classes: “Redemption Option Value”
The Commission expressed concern that although a company’s valuation reflects its future potential, a valuation during a trough in business cycles may result in a lower valuation than during an upswing. With bankruptcy cases becoming shorter and allowing little time for business cycles or disruptive events to run their course, this dynamic could favor senior stakeholders and undermine the Bankruptcy Code’s principle of providing a breathing spell from business adversity. In response, the Commission proposed a significant (and theoretical, possibly unworkable) deviation from current practice, a new source of junior creditor recoveries called “redemption option value.”[3] Simply put, a complex mechanism is proposed under which the general priority scheme of chapter 11 may be modified to require an economic transfer of value from impaired senior creditors to out-of-the-money junior creditors or equity holders. This redemption option value could be paid as cash, debt, stock, warrants or other consideration, at the election of the senior class giving up value.

Shifting Power from Secured Creditors: Financing and Cash Collateral Usage
We are all familiar with first-day hearings at which debtors apologetically disclose that they have agreed to numerous disfavored financing and cash collateral provisions such as surcharge waivers, liens on avoidance actions, roll-ups and cross-collateralization. The Commission’s recommendation would tip the balance of power to favor unsecured creditors, which may not be represented or organized into a committee in the early days of a case when many financing and cash collateral decisions are made.

Cross-Collateralization
Cross-collateralizing pre-petition debt with post-petition property would be permissible only in order to provide adequate protection under § 361, and only to the extent that is needed to cover any decrease in the value of the secured creditor’s collateral as of the petition date.

Avoidance Actions
The proceeds of avoidance actions would be excluded from the types of property on which debtors may grant liens as part of debtor-in-possession (DIP) financings (including through superpriority claims), from the collateral packages that are available to prospective post-petition lenders, and from adequate protection for the benefit of pre-petition secured creditors. However, avoidance action proceeds would remain available in the event of a shortfall in the lender’s adequate protection liens under § 507(b).

Roll-Ups
Post-petition financing would only be permitted to contain provisions rolling up pre-petition debt into a post-petition facility or paying down pre-petition debt with proceeds of the post-petition facility if (1) the post-petition facility is 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 (2) the court finds that the proposed financing is in the best interests of the estate.

Milestones
A court should not approve any proposed post-petition financing requiring the debtor to meet significant milestones or benchmarks (such as auction or plan deadlines) within 60 days after case commencement.

Representations Regarding Liens and Claims
A court should not approve extraordinary terms such as representations regarding the validity or extent of the creditor’s liens on the debtor’s property or property of the estate.

Surcharge Waivers
The debtor should not be permitted to waive its ability to surcharge collateral under
§ 506(c) of the Bankruptcy Code.

Eroding Lender Controls: Slowing Down and Scrutinizing Bankruptcy Auctions
The rules regarding bankruptcy auctions would be adjusted so that the debtor is not permitted to sell all or substantially all of its assets within 60 days after commencing a bankruptcy case. This moratorium may tend to shift power toward unsecured creditors, who often seek to delay a sale process while they negotiate carve-outs, investigate liens and credit biddings rights, vet the auction process and procedures, or seek out alternative transactions or additional buyers. In cases of true crisis, however, value could be lost. To address this, the 60-day moratorium could be shortened upon clear and convincing evidence that there is a high likelihood that the value of the debtor’s assets will decrease significantly during this period.
           
Sales of all or substantially all of a debtor’s assets would be subject to additional scrutiny, perhaps also tilting the balance of power away from secured creditors interested in liquidating their collateral and instead toward unsecured creditors seeking to maximize any residual values and other recoveries. For example, such sales would have to comply with applicable provisions of the Bankruptcy Code and be proposed in good faith. Payments made by the debtor or buyer in connection with the sale would be subject to court approval, and sale proceeds would have to be reserved to provide for claims under § 507(a)(2) or (3) and trustee fees. Notice must also be provided regarding release or discharge provisions in the sale order that provides claims protection for the purchaser.
           
Not all of the proposed reforms would erode secured creditor’s rights. For example, the proposed reforms would make it clear that a secured creditor may credit bid up to the amount of its allowed claim relating to the collateral in question — unless the court orders otherwise for cause. The potential chilling effect of a credit bid alone, the Commission stated, is not cause to deny a right to credit bid, although the court should attempt to mitigate any such chilling effects in approving the sale process.

Disenfranchising Unsecured Creditors and Creditors’ Committees….
Although the financing provisions tend to favor of unsecured creditors, the Commission’s proposals would significantly erode an unsecured creditor’s ability to participate in cases by significantly curtailing the formation of officially appointed committees. If unsecured creditors do not have a meaningful ability to participate in a case, it is unclear whether the recommendations regarding financing and auction processes represent a real shift in power.
           
While the appointment of a creditors’ committee would remain the default in larger chapter 11 cases, the court, U.S. Trustee or any party in interest — apparently irrespective of unsecured creditor interest in serving on a committee — would be able to initiate a hearing to determine whether appointing a committee would not be in the best interests of the estate or that unsecured creditors do not need representation. In cases for small or medium enterprises, the new default position would be that a committee will not be appointed unless an unsecured creditor or the U.S. Trustee files a motion with the court requesting the appointment of a committee and the court determines that the appointment is necessary to protect the interests of unsecured creditors.

This represents a high hurdle for creditors in small cases. However, the court sua sponte, U.S. Trustee, debtor or party in interest would be able to request the appointment of an estate neutral — a sort of “bankruptcy coach” paid for by the estate — with an authority to advise the DIP on operational and financial matters, as well as the content and negotiation of its plan. It is unclear how this estate neutral would differ from, or interact with, the debtor’s other professionals who are presumably already paid to provide such advice. Also, neither the court nor the U.S. Trustee would be authorized to constitute an official committee of administrative claimants.

… In Favor of Chapter 11 Trustees and “Estate Neutrals”
The Commission’s recommendations would make it easier for creditors to have a chapter 11 trustee appointed while making that relief significantly more uncertain. The recommendation is to codify the burden of proof related to appointment of a chapter 11 trustee, basing it on the preponderance-of-the-evidence standard, not the stricter clear-and-convincing-evidence standard. However, § 1104(b), which permits creditors to directly elect a chapter 11 trustee, would be deleted. In its place, creditors would have the right to object to the U.S. Trustee’s appointed trustee — but only if they (1) offer particular facts supporting their objection and (2) can establish clear and convincing evidence that the U.S. Trustee did not properly consult with parties in interest. The appointee is not eligible to serve as a trustee under § 321, has not qualified to serve as trustee under § 322, and is not disinterested or has a disqualifying conflict of interest.
           
The Commission recommends replacing examiners with a new, more flexible entity, an “estate neutral.” Unlike § 1104(c), which mandates the appointment of an examiner, courts would be permitted under certain circumstances to order the appointment of an estate neutral if the appointment is in the best interests of the estate or for cause. Parties in interest could object to the appointment of a neutral on the same grounds that are available for objecting to appointment of a trustee.

Clawing Back Leverage Given to Landlords Under BAPCPA
Landlords secured significant protections under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The Commission has recommended changes that would scale back one of these protections, extending the debtor’s time to assume or reject unexpired nonresidential real property leases under § 365(d)(4) of the Bankruptcy Code from 210 days to one year from case commencement in the interest of enhancing prospects for reorganization. In addition, the calculation of post-petition rent would be calculated under the accrual method, allowing a debtor to treat rent accrued before commencing a case as a pre-petition claim.

Conclusion
One of the major themes of the Commission’s Report (the recommended “rebalancing” of pre-petition secured creditors’ rights and DIP financing, and the pressure that this rebalancing would place on secured lenders in Chapter 11 cases) is generating vigorous debate and discussion.[4] However, the myriad of recommendations, taken together, do not represent a simple shift of power from secured creditors to unsecured creditors or even to junior secured creditors or bankrupt companies. Rather, they evidence a reallocation of power among all myriad constituents, many of whom will see both “wins” and “losses” in the pages of the Commission’s Report. For example, unsecured creditors may benefit from provisions that curtail the reach of secured lenders. However, unsecured creditors’ committees, which have traditionally been viewed as necessary to protect unsecured creditor interests and monitor debtor activities,[5] are viewed with skepticism and significantly curtailed under the Commission’s Report. In turn, the committee’s monitoring functions  have not been shifted to other creditors but have been moved to a new creature envisioned by the ABI Commission but with little definition: the estate neutral. Whether this reallocation of power will result in a more vibrant chapter 11 process remains to be seen but one thing is fairly certain: If rational expectations and efficient markets are disrupted because of the uncertainty associated with the new rules and power dynamics, unexploited profit opportunities will exist. There will be winners and losers during the period of adjustment, with the spoils going to those who adapt most quickly to the rule changes.


1. See the Final Report and Recommendations of the ABI Commission to Study the Reform of Chapter 11 (the “Commission Report”) at p. 11. The report is available at commission.abi.org.

2. See Commission Report at p. 3.

3. See also Donald S. Bernstein and James E. Millstein, “ABI Commission: Redemption Option Value Explained,” XXXIV ABI Journal 6, 10-11, 57, June 2015.

4. See, e.g., Damian S. Schaible and Kevin Coco, “ABI Commission Chapter 11 Report — Secured Lender Implications,” ABJ Journal (March 2015).

5. See Commission Report at p. 40.

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