Earlier this month, the Loan Syndications and Trading Association (LSTA) released its The Trouble with with Unneeded Bankruptcy Reform, a response to the ABI Commission Report. Of course, Plan Proponent has been covering the Commission Report since February. It’s only fitting then that, to “prime the pump” after an unplanned but nearly 2 month hiatus, Plan Proponent jump back in with the LSTA Report. (Thanks to a former colleague for pointing it out during the hiatus.)

Overview of the LSTA Report

On Twitter, we joked that the LSTA Report is a “completely nonpartisan” criticism of the Commission Report. After all, the LSTA describes itself as the “leading advocate for the U.S. syndicated loan market since 1995.” In fairness, though, it would be naive to suggest that the LSTA is biased while the Commission is unbiased. In the 80 page Report, prepared with the assistance of a team of lawyers at Wilmer Hale, the LSTA outlines what it perceives are the “flaws and potential harmful effects of the recommendations” made in the Commission Report. Although the LSTA participated early-on in the Commission’s two year Reform Study and even points out that it hosted the Commission’s first field hearing, the LSTA isn’t bashful in setting out how its “views on reform diverged from those of many of the Commissioners.”

Ultimately, the difference in viewpoints boils down to a disagreement about how to balance the interests of secured creditors and unsecured creditors in Chapter 11 (or whether realigning those interests is necessary). The Commission emphasizes its perception that, since 1978, there has been an increase in senior secured creditor control of cases, such that a realignment is necessary. However, the LSTA is skeptical about the Commission’s perceptions and suggests that, “on balance, the changes to creditors’ rights that the Report recommends are likely to do more harm than good to debtors, creditors, and credit markets alike.”

The LSTA Report consists of three major parts. Part I includes a summary of the themes and proposals in the Commission Report that impact secured creditors. Part II examines perceived flaws in the Commission Report, with an emphasis on whether the empirical basis for the Commission Report is flawed or missing and the potential damage from its proposals on bankruptcy efficiency and “broader credit markets.” Part III discusses, one-by-one, those Commission proposals that the LSTA has problems with or comments on.

General Observations in the LSTA Report

The LSTA Report makes three general observations:

  • The bankruptcy system is “working remarkably well.” The perception that the “the system has failed” is “not supported by reliable empirical evidence.”
  • The Commission Report “breaks from” the principle of “maximization of value for all stakeholders” by altering “distributional mechanisms in order to achieve results that it believes are fairer” while also departing from “non-bankruptcy entitlements” and “non-bankruptcy rights and priorities.”
  • Many of the Commission proposals would “operate to reduce the likely recoveries by secured lenders in the event of default.” Even if markets could adjust, the adjustments would “necessarily” make secured credit more expensive” (and “potentially unavailable to the non-investment-grade borrowers”).

Specific Observations in the LSTA Report

The LSTA makes four specific observations:

  • With respect to adequate protection, limiting adequate protection to the “amount a secured creditor would receive for its collateral in a hypothetical state-law foreclosure proceeding” will “essentially require secured reditors to fund a debtor’s efforts at reorganization.” The result: waste; inefficiency; and prolonged, more expensive cases.
  • A 60-day moratorium on 363 sales (which isn’t grounded on empirical evidence) is “likely to harm bankruptcy process” by reducing flexibility in addressing “melting ice cube” situations. Similarly, proposals to limit DIP loan terms will limit the ability of debtors to negotiate lower interest rates and will increase the cost of credit for debtors.
  • Essentially, the Commission’s “redemption option value” proposal (which also lacks an empirical justification) requires senior creditors to pay junior creditors, “even when the senior creditors have not been paid in full.” Additionally, the proposal “would add enormous complexity (and therefore cost) to the bankruptcy process, with little or no clear benefit.”
  • Chapter 11 might be too complex and expensive for small and medium-sized enterprises but the SME proposal sweeps too broadly” and will likely “add complexity rather than reducing it.” A narrower solution might come through the Commission’s credit-bidding, cramdown interest rate, and new value corollary proposals.

(The redemption option value stuff is rather complex. At a minimum, the LSTA Report might serve to illuminate the concept!)

LSTA’s Views on Voting and Classification Proposals

The LSTA concludes that the Commission Report’s “voting and classification” proposals are driven by “a fear that the various rights, checks, and balances the Code builds into the voting process, rather than fostering consensus, in fact serve to permit, or even facilitate, ‘gamesmanship’ or other self-serving and counterproductive behavior by debtors, creditors, or other interest-holders.” Although the LSTA agrees that there is some merit for concern, it believes that the “Commission’s proposals are not an improvement over current law.” For example, suggests the LSTA, the “impaired accepting class” requirement still serves a “useful” (even if an “imperfect”) role in ensuring plan fairness. Further, a “one creditor, one vote” standard would “introduce additional complexity and line-drawing into a system that works well enough as it is,” says the LSTA. Finally, the LSTA believes that creditors should be free to assign or waive votes, with the existing vote designation rules providing a sufficient check against the “most egregious strategic behavior.”

Our Take

The LSTA Report wears its policy bent on its sleeve. After all, its author is literally a trade group for secured creditors. Nevertheless, the LSTA Report is a serious piece of work. It’s also an inevitable piece of work. Wilmer Hale’s well-earned fee is a drop in the bucket of the fees that the credit markets will incur in challenging any serious reform effort.

Both sides of the debate (must) agree that the goals of Chapter 11 are to (1) maximize the value of the estate and (2) pay creditors according to their statutory priorities. However, they disagree about the extent to which intervention is necessary to meet those goals. On the one hand, I think that portions of the Commission Report (ROV?) have too much of a Robin Hood quality about them. On the other hand, I think that the LSTA Report (i) understates the extent to which the Code has a “substantive vision of a ‘fair’ distribution” of value and (ii) overstates the “minimalist” nature of bankruptcy law–it’s not just state-law-with-a-stay. Bankruptcy law is interventionist by definition.

Nevertheless, the Commission Report needed this continuing attention. We know the Commission is listening.