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.

(Can the Commission’s SME proposal better-adapt Chapter 11 for Main Street?)

(Yes, Bark Marketing needs to update for the upcoming season. Go Dawgs!)

This is the final post in Plan Proponent’s series on the plan confirmation-related recommendations in the ABI Commission Report. We wrapped-up our coverage of the Exiting the Case piece in our last post. In this (long overdue) “bonus” post, we’ll focus on the Commission’s confirmation-related recommendations in Section VII of the Report dealing with Small and Medium-Sized Enterprise (SME) Cases.

Background

As Prof. Michelle Harner, the Reporter for the ABI Commission Report, pointed out in a Credit Slips post back in January, even though “most of the media and caselaw coverage discusses only the megacases” (i.e., 2 to 3% of all Chapter 11 debtors) “approximately 90% of all chapter 11 debtors have less than $10 million in assets or liabilities, less than $10 million in annual revenues, and 50 or fewer employees.”  Additionally, Prof. Harner points to an empirical survey (ABI log-in required) conducted by Professor Dalié Jiménez  and relied on by the Commission where “over half of the respondents disagreed with the statement that ‘[t]he Code provides sufficient tools for small and midsized debtors.’”

On the one hand, the Commission recognizes that concerns about small companies in bankruptcy are not new. After all, Congress added the small business provisions with the 1994 and 2005 amendments. Under those provisions, a “small business” debtor (very generally, a debtor with total debts that do not exceed $2,490,925) can “fast track” its Chapter 11 case. Particularly relevant to this blog, under Section 1121(e), small business debtors (i) have the exclusive right to file a plan during the first 180 days (as opposed to 120 days for other debtors); (ii) can extend the 180 day period if they demonstrate “by a preponderance of the evidence that it is more likely than not that the court will confirm a plan within a reasonable period of time” and they obtain the extension order before the existing deadline expires; and (iii) must file a plan (and disclosure statement, if required) no later than 300 days after the petition date.

Under Section 1125(f), the court may (i) determine that a separate disclosure statement is not necessary; (ii) approve a disclosure statement submitted on standard forms; (iii) conditionally approve a disclosure statement subject to final approval; and (iv) combine the hearing on the disclosure statement with the hearing on plan confirmation. And under Section 1129(e), a small business plan must be confirmed within 45 days after the plan is filed unless the court orders otherwise.

On the other hand, the Commission’s evaluation of those provisions suggested that the fast track approach can be “challenging and counterproductive” for small business debtors and is still challenging even after the 2005 amendments. To be sure, the 2005 amendments were a response to the criticism that small business debtors benefited from the initial delay and protection that comes with Chapter 11, but were merely prolonging their “imminent demise” in Chapter 11. Additionally, witnesses and commentators suggested to the Commission that small and medium-market debtors are relying on state and federal insolvency remedies more and more (e.g., receiverships, assignments for the benefit of creditors, etc.)–remedies that the Commission views as “subpar.” As the Commission points out, the general testimony was that, other than facilitating 363 sales and liquidations, Chapter 11 is “not working for small and middle-market debtors.”

Therefore, with the above statistics and considerations in mind, the Commission set out to make Chapter 11 work for small and medium-sized debtors by doing 3 things: “(i) simplifying the process; (ii) reducing costs and barriers; and (iii) providing tools to facilitate effective reorganizations for viable companies.”

Recommendations

Definition of an SME

The reasoning behind the Commission’s identification of the cut-off for qualifying as a “small or medium-sized enterprise” (SME) is beyond the scope of this post, but spelled-out in the Report. Generally though, an SME would be a “business debtor” who is (i) not public and (2) has less than $10 million in assets or liabilities, subject to the following:

• The SME proposal excludes individual debtors;
• An SME’s jointly-administered debtor affiliates must also satisfy the “not public” test;
• The assets/liabilities test is a consolidated test that includes debtor and non-debtor affiliates;
• The debtor must file a good faith balance sheet as of the petition date;
• The debtor’s SME designation is subject to objection from the court, the UST, or parties-in-interest;
• Non-public business debtors make seek SME status if (i) they file a timely motion; (ii) they have between $10 million and $50 million in assets or liabilities; and (iii) the court makes an evidentiary finding that SME status would be in the best interests of the estate for that debtor;
• Debtors that are “single asset real estate debtors” can’t be an SME; and
• The existing small business debtor provisions would be deleted from the Code.

 The Commission believes that its SME definition would capture 85-90% of Chapter 11 filings.

Plan Filing Timeline

Focusing on the need to avoid prolonging cases unnecessarily while also avoiding artificial deadlines, the Commission recommends that:

• The 300 day filing and 45 day confirmation deadlines be deleted;
• Instead, SMEs should file a plan filing/solicitation timeline within 60 days after the petition date;
• Relying on that filing and Section 105(d)(2)(B), the court should enter a timeline order; and
• SME should be subject to, and court’s timeline order should be consistent with, the Section 1121.

[Note: The Commission doesn’t explicitly state that the 300/45 day rules go away, but it does recommend deleting all of the small business case provisions from the Code.]

Plan Content and Confirmation

The Commission acknowledges that there are different opinions about why Chapter 11 is difficult for small debtors. Some complain about the deadlines. Others suggest that the plan process and confirmation standards are almost impossible for small business debtors to satisfy. Still, others submit that reorganizing small debtors is just not feasible, generally.

In response, the Commission recommends the following:

• SME plans should provide for payment of all admin and priority claims per Section 1129(a)(9);
• Bifurcation of undersecured claims into secured claims and unsecured deficiencies consistent with Section 506;
• Section 1111(b) elections (and related confirmation provisions, e.g. Section 1129(a)(7)(B)) won’t apply to SMEs;
• Secured creditor distributions would continue to be governed by consent or by Section 1129(b)(2)(A);
• Unsecured creditor distributions are trickier. See below.

An SME plan would have up to 3 options for paying unsecureds.

First, unsecured claims could be paid as provided in the plan as long as each class of unsecured creditors consents. Second, unsecured claims could be paid via Section 1129(b)(2)(B) (i.e., cramdown) subject to the Commission’s “New Value Corollary” recommendation.

Finally, if all else fails, unsecured claims could be paid via an “SME Equity Retention Plan.” Basically, an Equity Retention Plan (ERP) is a device that would permit pre-petition equity interest holders to retain their ownership interests in the debtor even if the plan fails to satisfy the absolute priority rule. An ERP must:

• Require the equity interests to remain involved in the debtor’s operations at a level comparable to their pre-petition involvement.
• Provide that unsecured creditors receive the debtor’s excess cash flows for the first 3 full years following the plan effective date.
• Include (as a part of the disclosure statement) a budget that (i) summarizes how the excess cash flow calculation would be made and (ii) forecasts excess cash flow over the 3 years.
• Provide unsecured creditors with 100% of a class of preferred stock (or the like) whereby they (i) have pro rata voting rights for certain extraordinary transactions (only) and (ii) are entitled to 85% of the reorganized debtor’s distributions when the preferred interests mature in the 4th year.
• Extraordinary transactions: (i) anything related to changes in insider compensation, dividends, and the like; (ii) a sale of all or substantially all of the debtor’s assets, a dissolution, or a merger; or (iii) any organizational document changes that would change the rights of the preferred interests.
• Therefore, equity gets 100% of the common stock (subject to the extraordinary transaction voting rights of the preferred), but, in the 4th year, the preferred holders see their interests mature into an 85% common stock interest unless the debtor redeems them out in cash before maturity.
• The redemption price would equal the face amount of the unsecured creditor’s unsecured claim (less payments received under the plan prior to redemption).

Our Thoughts

Most of our cases, even on a consolidated basis, would fall within the SME guidelines. And as much as I’d like to report that we cramdown on the merits on a routine basis, I can only think of 1 case in the last 5 years that I crammed-down over the objection of a creditor. (The result was, if I do say so myself, an excellent opinion on Till from Judge Drake). If they’re reading, then perhaps my colleagues will correct me with additional examples. However, even they would agree that most good Chapter 11 cases, especially those that would be in the SME range, are hard-fought battles that settle at the 11th hour. The reason: It’s extremely difficult under the current Bankruptcy Code for an SME-sized debtor to cramdown.

A major contributor–if not THE contributor–to that difficulty is the absolute priority rule and its tendency to alienate equity. Therefore, we really like the ERP option. First, we even employed a version of an ERP in an ultimately-consensual (non-SME-sized) case that we had last year. Second, the ERP would give our mostly-closely-held clients a confirmation recipe that wouldn’t require consent, as long they’re confident they’d be able to perform their way out of an unsecured creditor takeover of the company within 3 years.

Unfortunately, though, we like the SME proposal so much that we’re also pretty sure that it will remain just that–a proposal.  It would just be too much of a boon for debtors to go very far. And on that note, we conclude our 7 months of coverage of the ABI Commission Report!

(by Elizabeth Carden of the ABI)

(by Dave’s iPhone)

The American Bankruptcy Institute held its 20th Annual Southeast Bankruptcy Workshop on Amelia Island last week. At the conference, we heard Prof. Michelle Harner, the Reporter for the ABI Commission Report, talk about the Commission’s recommendations regarding “structured dismissals.” That’s fitting because that is the focus of this post in Plan Proponent’s series on the plan confirmation-related recommendations in the ABI Commission Report (and, in particular, its Exiting the Case piece). In this post, we’ll wrap-up the Exiting the Case piece by covering Section G of the Report regarding “Orders Resolving Chapter 11 Cases.”

Background

The Commission primarily focuses on “structured dismissals” as an alternative to the traditional means of exiting a case (confirmation orders, dismissal orders, and conversion orders). As the Commission explains, a structured dismissal is a “hybrid dismissal and confirmation order in that it typically dismisses the case while, among other things, approving certain distributions to creditors, granting certain third party-releases, enjoining certain conduct by creditors, and not necessarily vacating orders or unwinding transactions undertaken during the case.” They’re usually the result of settlement negotiations between the debtor and key parties in the case.

The Commission notes that structured dismissals are controversial depending on their terms (the “bells and whistles”). The Commission points to common features with structured dismissals:

• Substantially all of the debtor’s assets have been sold under Section 363.
• The debtor’s estate is reduced to cash that’s to be distributed.
• Secured creditors are undersecured and the case is administratively insolvent.
• A court-approved settlement is in place that resolves major case issues and includes third-party releases.
• The settlement provides for distributions to the secured creditor.
• There is an alternative claims-allowance process.
• Some of the sale proceeds are to be “gifted” to lower priority creditors who would likely not be entitled to those proceeds under a plan.
• The court retains jurisdiction and all prior orders survive the dismissal.