Chapter 11 of the U.S. Bankruptcy Code strives to rehabilitate distressed companies and maximize creditors’ recoveries. After its enactment in 1978, the Code served those purposes well, saving companies such as Federated Department Stores, Laidlaw International, Texaco, and multiple U.S. airlines. In the process of those reorganizations, secured and unsecured creditors received distributions on their claims, employees retained their jobs, and revenue streams continued for local, state, and federal governments.
Nevertheless, today’s financial landscape is very different. The testimony from almost three years of public hearings before the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 suggests that the Code no longer works effectively for many distressed companies. In fact, the testimony, research, and survey evidence suggest that companies—particularly small and middle market companies—are pursuing alternative insolvency schemes (e.g., assignments for the benefit of creditors or receiverships) rather than filing a chapter 11 case.
The Commission addressed these and other issues critical to effective business rehabilitations in its Final Report and Recommendations, released on December 8, 2014. Specifically, the recommendations strive to (i) reduce barriers to commencing a chapter 11 case, including the costs associated with the process and challenges to liquidity early in a case; (ii) streamline the administration of a case by resolving circuit splits on key litigation issues and ambiguities in current practice under the Code; and (iii) facilitate more effective exit strategies for debtors and their stakeholders.
The Commission’s recommendations are the product of two years of intense research and study, and almost another full year of additional research and deliberations. The Commissioners critically analyzed and debated all issues, focusing not on what was best for debtors or for a particular creditor group, but rather, on what was best for the system as a whole. The recommendations represent considered compromises that reflect a balanced approach to corporate rehabilitations.
The Commission recommends, for example, using the foreclosure value of a secured creditor’s collateral early in the case for adequate protection purposes and then the reorganization value of the collateral, which would include any “going concern surplus” associated with the collateral, for purposes of distributions later in the case. The Commission extensively evaluated, among other things, a secured creditor’s state law entitlements, the scope of security interests under state law, the potential Constitutional issues, and the value arguably created in a debtor’s assets through the chapter 11 process. This last factor includes items such as avoided costs (e.g., leases and other future expenses avoidable in bankruptcy) and the availability of a “national foreclosure scheme” under section 363 of the Bankruptcy Code. In this context, the Commissioners of course considered and recognized the challenge of balancing the competing creditor interests.
Accordingly, the Commissioners developed the foreclosure versus reorganization value principles so as to appropriately protect the interests of secured creditors, yet provide debtors with an opportunity to reorganize through a plan or a value-maximizing sale. One of these protections is the proposed definition of “foreclosure value,” which does not mean liquidation or forced sale value. Rather, the Commissioners intend it to be a fact-based determination grounded in the rights of the secured creditor under state law at the time of the chapter 11 filing. If the secured creditor can demonstrate that its contractual rights and applicable state law would have allowed it to foreclose on and then sell the debtor’s assembled assets and workforce, it may have a strong argument that the foreclosure value is equal to or higher than the reorganization value, hence requiring adequate protection. Likewise, if the court initially determines that the foreclosure value is lower than the debtor’s reorganization value and does not require adequate protection, a subsequent decision by the court granting relief from the automatic stay for lack of adequate protection would allow the secured creditor to use the section 363 sale process to liquidate its collateral—a remedy currently not available to secured creditors. (For a more detailed description of the foreclosure value concept, see Part IV.B of the Report.)
The reorganization value principle is coupled further with a concept labeled by the Report as “redemption option value.” This concept is intended to mitigate valuation fluctuations caused by the timing of a valuation-realization event in chapter 11. For example, if a section 363 sale is approved or a plan is confirmed during a downturn in the economy or a crisis in the debtor’s industry, the Commission does not believe that stakeholders should be penalized by temporary lulls in valuation. Rather, the Commission—after much deliberation and debate—determined that a better mechanism would consider the value of the company over a three-year period, starting at the petition date, and would allow stakeholders to capture the full value of the company during that period. Accordingly, in very basic terms, if the value of the debtor under the redemption option value formula set forth in the Report is adequate to pay the secured creditor in full (including any deficiency claim and interest), the immediately junior class of creditors may then be entitled to a distribution on the plan confirmation or sale order date. The redemption option value concept is nuanced and requires further development for more complex cases, but its simple objectives are to provide a full return to classes “in the money” on the value-realization date, and also to “double-check” whether any value might remain for the first class that appears to be “out of the money” on that date. (For a more detailed description of the redemption option value concept, see Part VI.C of the Report.)
The finance concepts and compromises discussed above attempt to allocate the debtor’s assets in a fair and responsible manner that respects rights under state law to the greatest extent possible. They also establish baselines against which parties can more efficiently negotiate consensual resolutions. Although the balance struck does not necessarily result in a “winner take all” scheme, it often presents an effective resolution to a collective action problem.
Not all parties involved in chapter 11 cases may appreciate the balance achieved in the Report. Some may argue that using foreclosure value undervalues the secured creditor’s collateral. The Commission recognized this potential concern and worked to mitigate it by developing a definition of “foreclosure value” that assesses the secured creditor’s collateral based on its state law rights as of the petition date in any bankruptcy. Moreover, the secured creditor’s primary remedy immediately prior to the petition date is foreclosure. The bankruptcy petition delays the secured creditor’s realization of the collateral’s value in such a foreclosure, but does nothing more. Requiring adequate protection of a value in excess of foreclosure value merely because the exercise of that remedy is delayed would overvalue the secured party’s interest at the outset of the case.
Others may argue that the redemption option value concept is simply a surcharge in disguise on the senior class. Several witnesses testifying before the Commission argued in favor of a fixed charge (e.g., five percent) on the senior class’s recovery that would be allocated to junior classes in all cases. The Commission rejected a surcharge concept, and redemption option value differs from a surcharge in several key respects. For example, the right to redemption value is not arbitrarily allocated or required in all instances. The value must be supported by the court-determined reorganization value of the company, and would be based on, among other factors, the duration of the chapter 11 case. If the case consumes most of the three-year valuation period and the secured creditor is partially out of the money, the redemption option value would be nominal or non-existent. It is not intended as a gift or a reallocation of value; rather, as with many of the Commission’s proposals, it strives to encourage value-maximizing conduct and to allocate fairly that resulting value among stakeholders.
The redemption option value concept recognizes and, where supported by the evidence, places a value on the contingent interest in the residual held by a junior class (retaining that upside for the junior class, instead of allowing the more senior classes to allocate it amongst themselves). Indeed, this principle is the “other side of the coin” to the protections historically offered to secured parties under sections 363(k) (credit bid rights) and 1111(b) (the ability to elect to be treated as fully secured), both of which were designed to protect the secured party from being “crammed down” when its collateral had a lower market valuation, by allowing it to capture upside reorganization value when and if such value was realized. Redemption option value accomplishes similar protection for junior claims. In addition, all of these finance concepts seek to enhance debtors’ rehabilitation efforts, whether through a plan or a sale.
Overall, the Commission’s recommendations offer innovative changes to the Code that would provide debtors, creditors, and the courts with more effective and flexible tools to achieve the original dual goals of the Code—rehabilitation of debtors and maximization of value for creditors. Analyzing the Report through a single lens—whether from the perspective of a debtor, secured creditor, bondholder, trade creditor, landlord, or employee group—predictably and understandably skews and limits the proposed recommendations. The Commission adopted a holistic approach to its study and recommendations, and it believes that the proposed reform package would strengthen the overall system, providing more tools for successful outcomes for debtors and creditors alike.
This post comes to us from Michelle M. Harner, Professor at the University of Maryland Francis King Carey School of Law and Reporter, ABI Commission to Study the Reform of Chapter 11.