July 13, 2021 - by Elliot Ganz. Recently, we reviewed two important law review articles focused on the breakdown of norms in restructuring and bankruptcy practice. Because the bankruptcy code and bankruptcy practice are so critical to the syndicated loan market, these breakdowns contribute to the breakdown in norms we are currently experiencing. Last time we reviewed the problems identified in those articles and below we briefly review the authors’ policy proposals.
In “The Rise of Bankruptcy Directors”, Jared Ellias, Ehud Kamar and Kobi Katiel demonstrate that many distressed companies, especially those controlled by private equity sponsors, prepare for bankruptcy by appointing bankruptcy experts to their boards of directors and give them the power to make key bankruptcy decisions. These supposedly independent directors (who are usually appointed repeatedly) often seek to wrest control from creditors of self-dealing claims against shareholders. In a second paper, “Purdue’s Poison Pill: The Breakdown of Chapter 11’s Checks and Balances”, Adam Levitin argues that the procedural checks and balances of bankruptcy are breaking down because of three interconnected trends: increasingly coercive tactics, the inability to appeal bankruptcy court decisions, and the ability of debtors to hand-pick the presiding bankruptcy judge.
I. The Rise of Bankruptcy Directors. The authors argue that judges should defer to the business judgment of what they call “bankruptcy directors” (nominally independent directors appointed by the debtor) only after they verify that the directors are truly neutral. Further, they argue that such directors cannot be neutral if shareholders alone select them. Thus, they propose that bankruptcy directors be treated as independent only if they win creditor support at the beginning of the case. They posit that such a requirement will not discourage the use of bankruptcy directors or erode the benefits they can bring.
The authors agree that, theoretically, neutral experts could be valuable in assisting courts in navigating contentious proceedings and helping to smooth the path to settlement, counteracting the problems with leaving a self-interested board in control. In theory, they could provide some of the benefits of a court-appointed trustee without the judge having to appoint one. In practice, however, bankruptcy directors are not neutral. Debtors appoint directors on the advice of counsel and they are “naturally predisposed to favor those who choose them for this lucrative assignment.” Indeed, the dependence on future engagements strengthens their desire to be helpful to the debtor and its lawyers. This can result in cheap settlements of claims against shareholders and restructurings that allow shareholders to retain more equity. In short, say the authors, “shareholders’ control of the appointment of bankruptcy directors undermines their independence.” Moreover, these shortcomings become worse when the shareholders and their lawyers are repeat players in the bankruptcy process and tend to pick from among a small group of bankruptcy directors. The authors argue that, given these conflicts, bankruptcy judges should treat these directors no differently from any other professional hired by a debtor in Chapter 11.
What can be done? The authors argue that courts and distressed firms must involve creditors in the selection of bankruptcy directors. Specifically, they propose that judges hold a hearing early in a case in which a debtor presents directors it has appointed or plans to appoint. If the creditors support the appointments, the court will treat the bankruptcy directors as neutral actors. If they do not, the court will regard the directors as partisan on issues where creditors disagree. Thus, for example, a court should not conclude that a proposed settlement is fair only because non-approved bankruptcy directors approve it.
While we are somewhat skeptical that creditors would willingly bless the appointment of bankruptcy directors chosen by debtors, courts recognizing that such directors are not independent would certainly help level the playing field.
II. The Breakdown of Chapter 11’s Checks and Balances. Adam Levitin’s prescription for fixing chapter 11 begins with an admiration for a system that “works incredibly well in many regards” and for bankruptcy judges of the highest quality and integrity. He then veers to a set of systemic features that lead to an “inevitably compromised chapter 11 system that tilts toward debtors and their allied partners”. The system works because, despite being structurally coercive, “it is a procedural mechanism that carefully balances debtor and creditor rights.” He asserts that random case assignment and appellate review are essential elements of these checks and balances and that they are compromised “when forum shopping and lack of effective appellate review enable debtors to pick judges and evade review of overreaching maneuvers.” Levitin believes that fixing even one of these elements can largely ameliorate the negative effects of the other two.
Levitin believes that the easiest fix is to jettison complex case assignment rules and intra-district division case assignment rules that concentrate so many cases in the hands of a very small handful of judges. While these changes would go a long way to addressing the forum shopping problem (and would not require Congressional action), Levitin also calls for the legislative reform of district venue shopping (while recognizing that past legislative efforts to reform venue rules have fallen flat).
Levitin then pivots to the problem with appeals, arguing that perhaps even more important than venue reform is the need to ensure that appeals can be taken more easily and quickly. Noting that the need for speed is paramount, he looks to the world of mergers and acquisitions where the Delaware Chancery Court has developed a workable solution. That court will enjoin a challenged M&A transaction, quickly hear the case, and render an opinion a few days later. That process is possible because the court is comprised of experienced jurists who are experts in Delaware corporate law. Levitin believes that “bankruptcy needs an equivalent specialized court that can hear appeals rapidly”, specifically, a Federal Court of Bankruptcy Appeals. This court would operate with more abbreviated procedural deadline and would “be more likely to take a holistic view of the operation of the Bankruptcy Code…” It would also provide more uniformity of bankruptcy law rather than the patchwork that results from the current system of disparate district and appellate courts hearing appeals. Short of standing up a Federal Bankruptcy Court of Appeals, Levitin pushes for expedited appellate review (without the need for expensive bonds) for orders such as DIP loans, asset sales and plan confirmations. The chapter 11 system will only hold up, he concludes, if courts are able to push back when necessary against the ever more aggressive tactics that have become a hallmark of current bankruptcy practice.
The two articles highlighted here and in previous posts raise important issues that directly impact the syndicated loan market and offer concrete proposals that should be seriously studied and considered.
