ACIC 2015 SPRING INVESTMENT FORUM CURRENT ISSUES IN BANKRUPTCY PRACTICE VIEWED THROUGH THE LENS OF THE ABI COMMISSION'S RECOMMENDATIONS FOR THE REFORM OF CHAPTER 11 APRIL 30, 2015 Moderator: Fred S. Hodara, Akin Gump Strauss Hauer & Feld LLP Panelists: Renée Dailey, Bracewell & Guiliani LLP Stefanie Birbrower Greer, The Prudential Insurance Co. of America Damian S. Schaible, Davis Polk & Wardwell LLP AMERICAN BANKRUPTCY INSTITUTE (ABI) COMMISSION TO STUDY THE REFORM OF CHAPTER 11  Commission is comprised of 23 leading insolvency and restructuring practitioners • Informed not only by their individual experiences but also by 13 advisory committees focused on various study topics, including, among others:       Financing issues Asset sales in chapter 11 Procedural and structural issues under plans Financial contracts, derivatives, and safe harbors Administrative claims and other pressures on liquidity Executory contracts and unexpired leases • Held 17 public field hearings in 11 U.S. cities • Organized and hosted an academic symposium with University of Illinois College of Law on the role of secured credit in business bankruptcies 1 ABI COMMISSION TO STUDY THE REFORM OF CHAPTER 11  Purpose of the Commission • To evaluate the U.S. business reorganization laws • To increase transparency • To reduce costs • To propose reforms “that will better balance the goals of effectuating the effective reorganization of business debtors—with the attendant preservation and expansion of jobs—and the maximization and realization of asset values for all creditors and stakeholders” 2 ABI COMMISSION TO STUDY THE REFORM OF CHAPTER 11  Final Report and Recommendations (“Report”) • Two year effort culminating in a 400-page report published on December 8, 2014 • Report contains far-reaching recommendations, some of which are novel and/or controversial  Generated significant debate in the restructuring and investment communities, which is a stated goal of the Commission • Recommendations arguably favor the debtor overall 3 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS  Many recommendations are focused on the role and impact of creditors in large chapter 11 cases  Some of the Commission’s recommendations would be beneficial to creditors  A number of recommendations would constrain creditors’ rights, if implemented as suggested in the Report 4 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS  Key Categories of the Recommendations • • • • • Valuation Confirmation Postpetition Financing Asset Sales Safe Harbors IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS  Modifying Creditors’ Rights to Reorganization Value • Key aspects of the current state of the law:  The Absolute Priority Rule requires that creditors and equity holders get paid in a certain order of priority; namely secured, unsecured, subordinated, equity  The “fulcrum security” is the security/debt instrument where value breaks, meaning that that creditor class is not paid in full and junior classes receive no value  Junior non-consenting creditors can be crammed down as long as the Absolute Priority Rule is followed  Distributions to creditors in accordance with the Absolute Priority Rule requires a determination of value  Courts have had different approaches to valuation both in terms of methodology and timing considerations  Timing of valuation, i.e., in a down cycle, can result in junior creditors and interest-holders receiving no value (similar in sale of assets context)  Valuation is a frequently litigated concept in bankruptcy 6 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS: MODIFYING CREDITORS’ RIGHTS TO REORGANIZATION VALUE (CONTINUED)  The Report clarifies the way in which secured creditors’ collateral is valued and applied in chapter 11  The stated goal of the recommendations is to strike a balance between the prepetition bargain of a secured creditor and a debtor’s ability to obtain postpetition financing to reorganize Current Law  Adequate Protection ABI Report Recommendations  Adequate Protection • Section 361 of the Bankruptcy Code affords secured creditors adequate protection to the extent of any diminution in the value of their collateral • Amount of adequate protection necessary to protect secured creditor is determined using the “foreclosure value” of the collateral • Valuation standard is undefined and subject to judicial prerogative • Foreclosure value is not liquidation value • In a foreclosure sale where the secured creditor is credit bidding, secured creditor must use the net cash value that it would realize upon a hypothetical, commercially reasonable foreclosure sale, not the face amount of the debt • Arguably facilitates priming financing and discourages sales 7 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS: MODIFYING CREDITORS’ RIGHTS TO REORGANIZATION VALUE (CONTINUED) Current Law  Valuation for Plan Distribution Purposes • Secured creditors receive “secured claim” to the extent of the value of their collateral • Valuation standard is undefined and subject to judicial prerogative  Junior Creditor Distribution • In accordance with the “absolute priority rule,” junior classes will not receive a distribution under a plan if senior classes are not paid in full ABI Report Recommendations  Valuation for Plan Distribution Purposes • Secured creditors’ claims should be valued at the “reorganization value” of their collateral ▫ Measured based on a debtor’s proposed method of exiting bankruptcy (enterprise value or net sale price)  Junior Creditor Distribution • “Redemption Option Value” ▫ Commission proposes to add option value for the “immediately junior class” that is out of the money, provided the senior class receives the preponderance of the residual value of the reorganized company under a plan - The theory is that if, after emergence, a company has upside during the measurement period, it should go to the junior creditors - Commissioners’ goal is to provide an incentive to creditors to want rehabilitation of the debtor 8 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS: MODIFYING CREDITORS’ RIGHTS TO REORGANIZATION VALUE (CONTINUED) Current Law  Surcharge on Collateral • No mandatory surcharge on collateral under section 506(c) of the Bankruptcy Code ABI Report Recommendations  Surcharge on Collateral • No mandatory surcharge on secured creditors’ collateral under section 506(c) of the Bankruptcy Code ▫ But, the Report proposes that debtors should not be permitted to waive their rights under sections 506(c) and 552(b)  Cramdown Interest Rate  Cramdown Interest Rate • A non-consenting class of creditors can be “crammed down” or forced to accept a chapter 11 plan if, among other things, the class receives the value of their interest in the collateral (if secured) or the allowed amount of their unsecured claim • Recommends using market rate of interest where available • Courts have used different methodologies to determine value and appropriate interest rates of debt instruments issued under a plan: • Rejects “prime plus” formula mandated by the Supreme Court in Till and adopted by the SDNY bankruptcy court in Momentive ▫ ▫ ▫ ▫ • If not available, the Report recommends using a riskadjusted rate, which would be determined using the traditional factors involved in pricing a loan Formula Coerced loan Cost of funds Presumptive contract rate 9 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS  Confirmation Issues • Several recommendations are designed to eliminate creditors’ hold-up value, gamesmanship and/or reduce costly litigation Current Law  Impaired Accepting Class • Debtor is required to have at least one impaired accepting class in order to “cramdown” the plan on a rejecting class ABI Report Recommendations  Impaired Accepting Class • Elimination of requirement under section 1129(a)(10) of the Bankruptcy Code to have an impaired accepting class in all chapter 11 cases • Not required for cramdown  Gifting • “Gifting,” where a senior creditor may seek to share a portion of its distribution with junior stakeholders to facilitate a consensual or speedy reorganization, is permissible in certain courts, even though it may violate the absolute priority rule  Assignment or Waiver of Voting Rights • Courts split on enforceability of contractual assignments or waivers of voting rights in favor of senior creditors  Gifting • No “gifting” allowed ▫ Report views the class-skipping transfers that are designed to eliminate obstacles to confirmation as violative of the absolute priority rule  Assignment or Waiver of Voting Rights • Contractual assignments or waivers of voting rights in favor of senior creditors will not be enforced • More nuanced voting provisions requiring that a creditor vote or refrain from voting in a certain manner may still be enforceable 10 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS: CONFIRMATION ISSUES (CONTINUED) Current Law  Numerosity Requirements for Voting ABI Report Recommendations  Numerosity Requirements for Voting • Section 1126(c) of the Bankruptcy Code requires “at least two-thirds in amount and more than one-half in number” for a class to vote to accept a plan • “One creditor, one vote” ▫ Could have significant impact on large institutions and investors with multiple affiliates or funds under common management, which would be treated as one creditor for voting purposes • Number of votes can be based on number of “claims” a creditor holds  Exculpation and Third-Party Releases  Exculpation and Third Party Releases • Chapter 11 plans frequently contain exculpation and release provisions for non-debtor parties • Courts are split on scope and standards for inclusion in chapter 11 plans  “New Value” Exception • “New value” exception to the absolute priority rule permits equity holders to get a distribution under a plan if they provide consideration, even where senior claimants are not paid in full • Courts are split on recognizing the exception • Codified exculpation and release standards permit inclusion in chapter 11 plans  “New Value” Exception • Report proposes codification of the exception • Goal is to provide a wider range of available funding sources for chapter 11 plans ▫ Prepetition equity holders may be the most likely source of funding for a plan 11 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS  Postpetition Financing Issues • Commission believes prepetition secured lenders have increasingly exercised greater (too much) control over the DIP financing process and, consequently, the course of the chapter 11 cases • The recommendations are intended to increase debtors’ (and other stakeholders’) flexibility and leverage in obtaining postpetition financing Current Law  Intercreditor Agreements • Intercreditor agreements frequently contain contractual prohibitions on junior lenders offering DIP financing • Court treatment of such provisions is inconsistent ABI Report Recommendations  Intercreditor Agreements • Courts may modify intercreditor agreements restricting junior creditors’ ability to provide DIP financing ▫ Report recommends that junior creditors subject to intercreditor restrictions be permitted to offer competing DIP financing, provided senior secured creditors are not primed without consent and senior creditors get the chance to match the terms of the junior creditors’ proposed facility 12 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS: POSTPETITION FINANCING ISSUES (CONTINUED) Current Law  Mandatory Valuation Disclosure • No requirement to disclose valuation information • Debtor’s required financial disclosure includes petition schedules, schedules of assets and liabilities, statements of financial affairs and monthly operating reports  “Extraordinary Financing Provisions” • “Extraordinary financing provisions” such as milestones, roll-ups and representations as to validity of liens are often included in both interim and final financing orders  Milestones • DIP financing agreements often contain “milestones” or deadlines by which a debtor must accomplish a task, such as filing a plan, obtaining approval of a disclosure statement, etc., all in an effort to control and expedite a bankruptcy case • Milestones may be the subject of disagreement between the DIP lender and other creditor constituencies, but the Bankruptcy Code does not contain any restriction on short-term milestones ABI Report Recommendations  Mandatory Valuation Disclosure • Debtors must file a “valuation information package” or “VIP” in connection with financing or sale motions filed within the first 60 days of the case • VIP is available to any creditor requesting it for a “proper purpose,” subject to redactions unless the court orders otherwise and confidentiality requirements  “Extraordinary Financing Provisions” • No “extraordinary financing provisions” may be approved as part of interim financing orders  Milestones • Moratorium on milestones for material acts for 60 days after filing ▫ Material sale of the debtor’s assets or filing of a disclosure statement and chapter 11 plan ▫ Need “clear and convincing” evidence to overcome this bar ▫ Other milestones are permissible if they do not have the same effect as a prohibited milestone 13 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS: POSTPETITION FINANCING ISSUES (CONTINUED) Current Law  Avoidance Action Proceeds • Proceeds from fraudulent transfer and preference actions brought by the debtor after the filing of a bankruptcy case are property of the estate • Such proceeds are frequently part of the collateral package pledged to DIP lenders  Roll-Ups • A DIP lender frequently conditions the extension of postpetition credit on the “rolling up” of its prepetition debt into the postpetition facility so that its prepetition secured debt is effectively paid ABI Report Recommendations  Avoidance Action Proceeds • Chapter 5 avoidance action proceeds cannot serve as DIP collateral ▫ This rule could improve recovery prospects for unsecured creditors  Roll-Ups • “Roll-up” provisions remain permissible under certain conditions, if the court finds that the proposed financing is in the best interests of the estate 14 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS  Asset Sales – Sale of All or Substantially All Assets • 11 U.S.C. § 363 governs a debtor’s ability to use, sell or lease property outside the ordinary course of business while in bankruptcy • New “Section 363x” will address sales of all or substantially all of a debtor’s assets outside of a plan Current Law  Standard of Review ABI Report Recommendations  Standard of Review • Sales of all or substantially all of debtor’s assets may be conducted through section 363 of the Bankruptcy Code • New section 363x for sales of all or substantially all of debtor’s assets • Quick sales may sidestep creditor protections contained in section 1129 of the Bankruptcy Code • Incorporates plan-like protections into the sale process ▫ Augments notice requirements with respect to release and discharge protections afforded to the purchaser in the order approving the sale • Commissioners believe the current climate of quick sales undermines important bankruptcy policy and circumvents the full disclosure and voting requirements applied to a chapter 11 plan, which arguably leads to less robust auctions and lower recoveries  Timing • Sales of all or substantially all of debtor’s assets may be conducted at any time during a chapter 11 case  Timing • 60-day moratorium on section 363x sales at the beginning of a case with exception for “melting ice cube” situations 15 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS  Asset Sales – General Provisions Current Law  Standard of Review ABI Report Recommendations  Standard of Review • Debtor’s business judgment • “Enhanced” business judgment • Deferential to debtor’s board and management • More rigorous review ▫ May create delay and add cost as parties challenge debtors’ decision-making processes  Sale Free and Clear of Interests • Section 363(f) of the Bankruptcy Code allows debtors to sell assets free and clear of “interests,” but “interests” is not defined  Credit Bidding • Historically the right of a secured creditor to credit bid the amount of its debt in an asset sale auction has been unfettered, but there has been a recent trend toward greater scrutiny and potential constraints  Finality of Sale Orders • Certain courts permit sale orders to be overturned if a new or continued sale process would gain a higher bid  Sale Free and Clear of Interests • “Interests” would include litigation claims, discrimination claims and most successor liability claims • “Interests” would exclude land use restrictions, environmental liabilities that run with the land and successor liability under federal labor law  Credit Bidding • Consistent with historical practice, the potential chilling effect of a credit bid would not be considered “cause” to limit a secured creditor’s right to credit bid  Finality of Sale Orders • The potential increase in value from a new or continued sale process would not, without more, constitute the “extraordinary circumstances” required for the court to reconsider a section 363 sale 16 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS  Safe Harbors for Financial Contracts • “Safe harbor” provisions permit non-debtor counterparties to close out and liquidate collateral for certain types of financial contracts, without regard to certain bankruptcy protections like the automatic stay or the invalidation of bankruptcy default clauses in executory contracts • Special protection is afforded to financial contracts due to the unique nature of the public financial markets • Commission agrees with critics who have argued that safe harbors are now too broad and hamper reorganizations without a corresponding benefit to any public financial market 17 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS: SAFE HARBORS FOR FINANCIAL CONTRACTS (CONTINUED) Current Law  Private LBOs and Section 546(e) • Shareholder payments in LBOs of private companies are sometimes covered by safe harbors ABI Report Recommendations  Private LBOs and Section 546(e) • Report recommends clarification of section 546(e) to carve out purely private leveraged buyout transactions (LBOs) ▫ No more safe harbor protection in avoidance actions against beneficial owners of privately issued securities in connection with prepetition transactions that used some or all of the debtor’s assets to facilitate the relevant transaction ▫ By contrast, financial institutions acting as conduits for shareholders in private LBOs would be expressly exempted from avoidance actions under the safe harbor ▫ Commission did not address whether, if estate declines to bring avoidance action, counterparties to qualifying financial contracts are protected by the safe harbor against suits by non-debtors to the same extent they are protected from similar suits by debtors or chapter 11 trustees  Walkaway Clauses • Not addressed in Bankruptcy Code • Enforceability determined under state law  Walkaway Clauses • Definition of “walkaway clauses” should correspond to definitions in Federal Deposit Insurance Act and similar laws 18 IMPORTANT RECOMMENDATIONS AFFECTING LENDERS AND INVESTORS: SAFE HARBORS FOR FINANCIAL CONTRACTS (CONTINUED) Current Law  Repo Safe Harbors • Definitions of “repurchase agreements” and “securities contracts” were made broader by Bankruptcy Code amendments in 2005  Ordinary Supply Contracts • Due to broad definitions, contracts between nonfinancial businesses for goods in the ordinary course are sometimes covered by financial contract safe harbors ABI Report Recommendations  Repo Safe Harbors • Revise treatment of repurchase agreements to preBAPCPA reforms (or amend safe harbor provision to exclude repurchase agreements that are, in substance, committed financing arrangements for mortgage loan portfolios)  Ordinary Supply Contracts • Ensure “ordinary supply contracts” (entered into in the ordinary course of business between nonfinancial sector firms) do not benefit from safe harbors 19 IMPACT OF THE ABI REPORT  The Report highlights key issues of importance to institutional investors that lack consistent treatment across the various jurisdictions and are often the subject of litigation.  It remains to be seen whether any of the Report’s recommendations will be introduced into legislation before Congress or if Congress will make bankruptcy reform a high priority in the coming year.  But, lawyers and judges are already taking the proposals into consideration in their practices, pleadings and courtrooms.  Investors may want to factor the lack of settled precedent or potential modifications relating to such issues into their risk analysis and documentation. 20