The dice are being loaded in corporate collapses. No longer is fairness central to how debt and financing issues are worked through in bankruptcy. Instead, an egregious process occurs where the strongest party enforces its interests. And the courts seem loth to intervene.
That at least is the situation in the US, and at least in the view of University of California Associate Professor of Law Jared Ellias, and Robert Stark, a New York partner at law firm Brown Rudnick. The pair have authored a hard-hitting forthcoming California Law Review article called Bankruptcy Hardball.
The authors trace this change from a mindset of fiduciary duty and fairness to a negotiated toughness to a pair of Delaware court decisions, the senior one reached on the eve of the financial crisis, when perhaps too many thought that straitened financial times might not be seen again. The cases were Gheewalla in the Delaware Supreme Court [N. Am. Catholic Educ. Programming Found. v Gheewalla, 930 A.2d 92 (Del. 2007)], reinforced by Quadrant Structured Products in the Delaware Chancery Court [Quadrant Structured Prod. Co. v Vertin, 102 A.3d 155].
One of the main conceptual bases for these decisions was that creditors did not need protection as they were large enough and influential enough to look after themselves. One thing that most of the world did not recognise before the financial crisis was the extent to which corporate debt had been sliced and diced and sold on to multiple investors — a process which could be seen to argue precisely against this conceptual basis. Nonetheless, the courts decided that no judicial protection was needed. Director business judgment was to be left largely unfettered. This set the context for bankruptcy hardball:
“While courts thought they were reducing the costs of contracting by not requiring creditors to attempt to anticipate all potential scenarios where their interests could diverge from shareholders, academic contract theorists became increasingly convinced that equitable doctrines aimed to achieve fairness – like contract law doctrines that would void otherwise enforceable contracts – were largely unnecessary.”
The consequence is that, “Without fiduciary duty, creditor protection rests on the idea that creditors are sufficiently protected through contract law, with fraudulent transfer law and bankruptcy law hovering in the background”. And this is proving a weak basis for fair restructurings and court decisions. The authors identify a series of examples where hardball decisions have been taken that run counter to fairness and prior understandings of the just allocation of residual value between the shareholders and various creditors. At PetSmart, Forest Oil, Cumulus Media, Colt Holdings, General Growth Properties, American Safety Razor and Lyondell, the authors highlight a series of case studies where the outcomes are unfair and contrary to where good public policy might lead.
In an associated blogpost, the authors summarise these outcomes bluntly:
“the current level of chaos and rent-seeking is unprecedented. It is now routine for distressed firms to engage in tactics that harm some creditors for the benefit of other stakeholders, often in violation of contractual promises and basic principles of corporate finance.”
And the result is not a narrow impact on a small number of investors who ought to be able to protect themselves — or at least should be able to cope with the outcome. In the article, the authors argue that the overall consequences of the new approach are severe, and invite excessive aggression in the structuring of the financing of companies, potentially creating more business failures and defaults:
“The slow moving trains of justice here have broader consequences than denying justice to one particular plaintiff or another. It emboldens the entire private equity industry to extract excessive dividends from portfolio firms, knowing that it might take more than a decade to litigate the fraudulent transfer action, by which time every employee currently at the private equity firm will be gone.”
This may not seem to matter to those of us in the UK, where we believe there will be constraints on the actions of debt-holders and where the switch of directors’ duties in insolvency from an enlightened shareholder model to seeking to minimise the losses of creditors (the consequence of, among other things, s214 of the Insolvency Act), seem to offer significant defences.
But there are cautions from this switch in the US nonetheless. We have seen the UK’s insolvency regime being abused — the number of phoenix companies, put into insolvency and almost immediately revived, continues to increase. This takes advantage of their suppliers and other creditors — which almost always lists the taxpayer at the top of the list as VAT and payroll taxes are rarely paid up to date. This increase continues despite successive governments saying this is an issue that they are keen to address. The case of Comet, covered energetically by Tabby Kinder of the FT, is but a particularly egregious, and apparently abusive, example. According to her reporting, the taxpayer was left with a £50 million bill while the investors profited by £100 million less than a year after buying the collapsed company for just £2.
“The private equity firms stitched up a structure that guaranteed a huge profit from insolvency, which went unchallenged by the administrators,” an anonymous source told Tabby.
So we should not be complacent. We should also not be complacent because we consistently hear from UK governments that they are keen to replicate the US Chapter 11 bankruptcy regime — believing that this would help instil a more entrepreneurial culture and less of a sense of embarrassment about business failure. In any move in this direction we need to ensure that the protections of fair dealing we assume to be in place are indeed retained, and that we do not import the negative behaviours and approach that now are reported as prevalent in the US. All too often we adopt the cultural approach of US business almost by accident; some might argue that the Comet case is evidence that we already are. Fairness would argue that in this area we need to guard against the tendency.
In the quantitative eased world of almost free debt, we face unprecedented levels of leverage across the financial system. With this having been accompanied by a race to the bottom in terms of covenants on debt, many of the usual protections that debt-holders might have expected to enjoy are not in place. There is a real danger that court protection will not be there either. The result is unlikely to be pretty, and it seems very unlikely on recent evidence to be fair.
I am grateful to a dear former colleague for bringing Bankruptcy Hardball to my attention.
Bankruptcy Hardball, Jared Ellias, Robert Stark, 2019
forthcoming in 108 California Law Review
Associated OBLB blogpost, Jared Ellias, Robert Stark, Oxford Business Law Blog, 2019
Hailey’s Comet: how Deloitte helped funds win a distressed bet, Tabby Kinder, Financial Times, February 2020