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Sunday, August 29, 2010

Company Law - Death & Reconstrction of Secured Credit

Chapter 1
The Bankruptcy Reform Act of 1978 (the Code) posed palpable threats to secured creditors. It was drafted by a commission that was at least as concerned with the rights of debtors as with the rights of creditors. It was modified and adopted by a Congress that might have been the most liberal since World War II and signed into law by President Carter at the apogee of the left's power, two years before the Reagan election that marked the rise of the right and the beginning of the left's decline. The power of the left was exerted most forcefully on behalf of consumer debtors who are not the subject of this paper.
In matters of commercial debt and in contests between secured commercial creditors and unsecured commercial creditors, the distance between the congressional poles was much less than it was in the consumer's case. But even in commercial cases one could expect politics to intrude. In a large commercial bankruptcy many of the unsecured creditors would regard the left as their patron. For example union members whose interests appear as present unsecured creditors and as potential future employees of a business in reorganization, might look to the Democrats in Congress to protect their rights in a reorganization against the competing secured claims of banks and other financial institutions.
Because of the composition of the Congressional right and of the academic right, the influence of the right was even weaker in 1978 and in the preceding five years of the Commission's work than might otherwise appear. Newt Gingrich was first elected to Congress in 1978 and was no part of the action that led to the Code's passage in that year; Richard Posner first came to fame by publishing “Economic Analysis of Law” in 1978. Few free market law and economic scholars were around to make the cruel argument that society would prosper if the free market were allowed to kill off weak and inefficient companies. That the dismissed workers of a dead company might be better off in the long run as a result of that death (or that a competitor's workers would be) was hardly considered. The incantation, “reorganization, yes, liquidation, no” echoed through the Commissions meetings and in the halls of Congress. Firms should be given every chance to save their goodwill; no one seems to have thought much of the firms with badwill that could be liquidated for a greater sum than they would command as going concerns, nor did anyone seem to believe that a large percentage of firms that would use chapter 11 might possess badwill, not good. So even in 1978 and certainly in the years during the Commission's work, the right was a pale and moderate version of its later self, and many of the arguments one might hear from the law and economic crowd today were but whispers then.
And the pros from the bankruptcy bar that were most deeply involved in the drafting and lobbying process also probably held the view that reorganization was to be favored and liquidation avoided. Most influential was a group of bankruptcy lawyers, academics, and judges that made up the National Bankruptcy Conference (NBC) who, as Professor David A. Skeel, Jr. succinctly put it, “sought to transform bankruptcy from a mildly unsavory, often archaic practice to a more useful, attractive, and reputable response to financial distress. 'Perfecting' the bankruptcy laws had been the National Bankruptcy Conference's main mission since the 1930s, and the 1970s reforms were very much in this spirit.”
As I have suggested elsewhere the bankruptcy lawyer members of the NBC would be natural beneficiaries of a flourishing reorganization practice. Their private interests did not lie in measures that might allow a determined secured creditor to abort a reorganization when it appeared that a firm should be liquidated. Reorganization was their game, and, for some, I suspect that reorganizations under the Code could not be too long or too complex.
It is likely, as Professor Markell has suggested in his criticism of a draft of this paper, that part of the secured creditors' difficulties arose from the fact that secured creditors asked for the wrong things in the negotiation of the Code. For example, secured creditors apparently argued hard for 1111(b)(2), a provision that they would gladly throw overboard now. Perhaps the secured creditors' negotiators can be forgiven for not anticipating the developments in public chapter 11 cases that I describe in Parts II through VI infra.
For these political reasons it is no surprise to see consumer debtors make great gains in the Code, to see non-consumer creditors such as union employees gain ground against more affluent institutional creditors, and to see the petit bourgeoisie--the trade creditors--do better than the institutional secured and unsecured creditors. One would also expect to see the power of the commercial debtor strengthened--so to insure that reorganization, not liquidation, results in any close case.
Many writing at the time of the Code's enactment and during its early years emphasized the dangers that bankruptcy--as represented by the Code--presented to secured creditors. In a 1984 article Professors Baird and Jackson explain that junior parties who do not bear the true cost of their decisions will try to keep the firm together and that judges who have concluded (or assumed) that reorganization is the only goal of chapter 11 will assist these parties, all to the injury of the seniors. Professor Eisenberg makes a similar point by noting that the quest for “going concern value” should, but often will not, take account of the price of that quest which will be charged to the secured creditors' bill. Others expressed similar concerns about the stay, adequate protection and the debtor's enhanced rights to use and dispose of collateral. Some of these authors explicitly address the enlargement of the dangers from the Code; others do so only implicitly.
Even a mildly neurotic secured creditor could see many threats in the new law. In the new chapter 11 the power of the courts, of the debtor and of any trustee against a secured creditor were larger than the powers of those persons under the dominant form of reorganization before 1978. Under chapter XI of the Act of 1898 (the Act) neither the debtor, nor a trustee nor, generally, the court could affect the rights of a secured creditor. While a court could issue a stay and so prevent repossession, it lacked the power to deal with a secured creditor's rights in a plan of reorganization. If the collateral was an important asset, in theory at least, the secured creditor could refuse to give up its interest and so forestall a reorganization. While a clever court and debtor might conspire to make it worthwhile for a secured creditor to agree to a reorganization, they could not force it.
In every case under the new chapter 11, the courts and the debtor in possession had all of the rights and more than a court and trustee would have had under chapter X of the Act. Under the Act, large companies were supposed to go into chapter X and smaller ones into chapter XI. For reasons too complicated to deal with here, few went into chapter X and many that should have been in chapter X used chapter XI. So the Code's largest threat was that the bankruptcy judges and the DIP would have the right to mess with the collateral in every reorganization where, formerly, that right was available only infrequently and at the cost of suffering the inefficiencies and aggravations of chapter X.
It must also have been threatening for the Code to spell out the rights of the DIP in such detail. Even if these rights had existed in old chapter X, many were buried in cases, rules or practices. In the Code they were put out front, in the black letter so that even the slowest DIP lawyer could find and assert them. Consider some of these rights.
First is the automatic stay of section 362. On filing of the petition, a creditor is automatically stayed from doing anything that might look, feel or smell like the collection of a debt. The secured creditor could not repossess. Even if he had repossessed, he could not sell. That a secured creditor could get “adequate protection” was cold comfort, for what was “adequate” was at the discretion of the judge, and the judge might find that a mortgage on a rusting plant was adequate protection for the impairment of a security interest in some A+ accounts receivable. Moreover the court might not find a need to protect the creditor's entire position or might conclude that the collateral was not decreasing in value (as the creditor claimed) and thus no protection would be needed.
It was not always so clear that the stay, which was frequently imposed under chapter XI, could stop a foreclosure proceeding that had begun before the bankruptcy was filed. Section 362 clearly stopped foreclosures in their tracks, and after Whiting Pools did so even with respect to personal property that had been repossessed before the filing.
Second was the expansive right in section 363 for the DIP to use and even sell collateral. Kmart can sell and United Airlines can fly the creditors' collateral. Here too the court could limit such use, but courts that saw a mandate to foster reorganizations and to avoid liquidations would not favor the secured creditors' arguments. Under 363, use and sale in the ordinary course do not require a court's or the creditor's approval, but such approval surely would have been necessary under chapter XI and likely so under chapter X.
Third was section 506(b) that appeared to cut off interest liability of the debtor except to the extent that the value of the collateral exceeded the amount of the debt. That meant that if the debtor airline owed $500 million secured by aircraft worth $499 million, there was no obligation during the reorganization proceeding to pay or accrue interest on the debt. If a reorganization proceeding could be expected to last three or four years when interest rates were at 10 percent, it meant that the creditor stood to lose the right and opportunity to earn $50 million of interest each year. In making its interest calculation, every secured creditor had to consider the risk that it might have to extend an interest free loan for a undetermined period.
The right of the DIP to control the reorganization was apparently insured by section 1121's grant of a 120 day exclusivity period. Of course, creditors feared that judges would extend the exclusivity period as they had the power to do so. During that period the DIP could make its own plan, negotiate with various creditors and conceivably get a plan approved that disfavored one or more creditors while that creditor was barred from even proposing an alternative plan.
Finally the Code explicitly granted the power to “cramdown” a plan over the objection of a secured creditor provided the plan met the requirements of section 1129, particularly that it promised the secured creditor a stream of payments with a present value equal to the value of the collateral. A secured creditor did not have to be paranoid to fear that a judge might find that its collateral was worth less than the creditor thought or apply too high a discount rate--so limiting the secured creditor to a stream of payments with a smaller value than the creditor believed its collateral had.
The Code inflicted many other small cuts on the secured creditor. It expanded the bankruptcy court's jurisdiction to allow the debtor to bring a recalcitrant secured creditor into that court, a forum thought more favorable to the debtor than some remote state or federal court might be. Preference law was strengthened by adding a reach of one year for insiders, by the omission of the reasonable cause to believe requirement, and by the addition of a presumption of insolvency during the 90 days before the petition was filed. And section 364(d)'s authority for post-petition priming credit must have frightened secured creditors who did not wish to be DIP lenders.
Some of the secured creditors' fears about the Code were soon borne out. First the cases affirmed that the bankruptcy court's new jurisdiction reached well beyond the boundaries that had existed. A court's jurisdiction over particular property under the Act of 1898 depended in many cases on the debtor's possession of that property. Shortly after the Code became effective, a series of lower court cases held that goods that had been repossessed prior to the filing were nevertheless part of the estate, subject to the stay, and liable to be turned over to the debtor. This line of cases was capped by a 1983 Supreme Court decision, Whiting Pools, where the Court held that even the supreme creditor, the Internal Revenue Service, had to turn back assets that it had taken from the debtor before it filed. By reaching back to acts done before the filing these cases diminished a secured creditor's incentive to hasten toward a repossession, for the expense and effort of such a repossession or partial foreclosure would be for naught if the debtor filed shortly after the assets were taken from the debtor's possession.
Second the cases shortly found that “adequate protection” did not quite maintain the status quo ante. Assume an uncommonly vigilant secured creditor who not only insisted that his debtor hold collateral equal to 120% of the debt but, mirabile dictu, also enforced that requirement by diligent monitoring and by refusing to extend additional credit unless the ratio was maintained. In 1978 that creditor might have believed that section 361(3)'s promise to preserve the “indubitable equivalent” of his interest “in such property” would mean that his ratio of collateral to debt would be maintained during the bankruptcy. Those hopes were ended by Judge Maybe's decision in In re Alyucan .
Alyucan and cases following it concluded that only that part of the collateral equal to the amount of the debt was entitled to adequate protection. To add insult to injury the Court found that the “equity cushion,” here the 20%, could itself be regarded as adequate protection for the 100%. Our vigilant creditor was punished for his vigilance by being forced to devour his own collateral. On the other hand his brother--a prodigal son who had allowed his collateral to shrink to the amount of the debt--was entitled to new security as adequate protection.
A third disappointment for secured creditors arose from bankruptcy courts' early practice in routinely extending the “exclusivity” period during which only the debtor could propose a plan of reorganization. Under section 1121 only the debtor can file a plan for the first 120 days of a chapter 11 case. For that period a debtor need not fear a competing plan from secured or unsecured creditors and has an accordingly reduced incentive either to hasten its plan to a vote or to bargain with its creditors over a plan. In Manville the court extended exclusivity 5 times and in Ames Group 9 times. These decisions seemed to portend that chapter 11 would take the wretched course of railroad reorganizations where railroads lingered in bankruptcy for decades. Long delays are hurtful to secured creditors not only because they increase the risk that collateral will decline in value or be dissipated, but also because they constitute an interest free unilateral extension of an existing loan.
That most secured and all unsecured loans would be interest free during the bankruptcy was confirmed by the Supreme Court in the 1988 case Timbers of Inwood. A secured creditor could make a powerful argument that the “indubitable equivalent” of its interest in its collateral included the opportunity to liquidate the collateral and invest the proceeds elsewhere-- or alternatively that it receive interest during the bankruptcy. This right to liquidate, so the argument goes, was an opportunity that was part of the secured creditor's bargain and so should be recognized as part of the secured creditor's “interest.” Against this argument was the statement in section 506 that explicitly granted interest to secured creditors to the extent that the value of their collateral exceeded the amount of the debt. Did that rule also contain an implication that one whose collateral did not exceed the amount of the debt was not entitled to interest? In Timbers the Court found that implication in section 506 and rejected the counter argument from section 361.
That secured creditors could expect no interest during the pendency of a chapter 11 proceeding magnified their concern over courts' willingness repeatedly to extend the exclusivity period. Note too that the debtor's escape from interest liability on its secured debt enabled a debtor to devote its cash flow to other needs and diminished its incentive to get out of chapter 11. Why should one venture into a world where one's competitors were paying 8 or 10 percent for their money when interest free money could be enjoyed behind the bankruptcy court's shield?
A fifth threat that the early cases confirmed arose from the bankruptcy court's discretion to shape adequate protection to its fancy. While section 362 and 363 promised adequate protection to the secured creditor and section 361 assured a version of Judge Hand's elegant “indubitable equivalence,” in reality every bankruptcy judge had wide discretion in determining the length and breadth of adequate protection. The forms specified in section 361 are only examples and other forms of adequate protection could be as long or as short as the judge's imagination. For example a secured creditor who held a security interest in high quality accounts receivable at the start of the case might fear that the DIP would use the proceeds of his receivables and substitute a mortgage on a rusty factory of “equal value.” While security in the former might be much more valuable than security in the latter, convincing a hostile judge of that (or overturning a contrary finding on appeal) would be hard. To prove that a stream payment or some other asset has a greater or smaller value than some other apparently comparable asset might require expert testimony and, in a big case, days of hearings with no certainty of success in front of a judge who might be hell bent on seeing a confirmed reorganization.
Finally courts' unwillingness to permit sales, early in the chapter 11 proceeding, of all or most of the assets of chapter 11 debtors seemed to close a door that offered an escape from a long chapter 11 proceeding. Shortly after it filed in May of 1982, Braniff Airlines had agreed to discontinue operations and to sell most of its assets to PSA, a west coast airline. The employees and unsecured creditors objected to a sale that would have foreclosed the possibility of a reorganization. Those objecting argued that such a sale deprived them of the protections built into section 1129 and into the rules on voting and negotiation that apply to plan approval. The Court refused to allow an early sale under 363 in the hope of a successful reorganization. In the end Braniff failed to reorganize and the secured creditors doubtless suffered losses from depreciation of their collateral as well as the loss of the time value of their money from the delay.
The thesis of this paper is that the predictions from the Code and the early interpretations of the Code have proved wrong. I believe that chapter 11s of public companies now form a market that facilitates dealings among secured and unsecured creditors, debtors, employees and others. In that market, the secured creditor has achieved a power and status (as this is written in 2004) that at least equals his status prior to the Code and, perhaps, exceeds it. In this paper I consider only secured creditors in chapter 11 cases of public companies.
Secured creditors have achieved this resurrection by clever use of the provisions of the Code and, more importantly, by using their economic power to get agreements from debtors and debtors in possession that mitigate the sting of injurious provisions of the Code. Part of the sting of these provisions has been removed by changes in bankruptcy judges' attitudes and by creditors' guiding debtors to courts where judges might be sympathetic to the secured creditors' arguments and to the enforcement of agreements between debtors or DIP's and their secured creditors.
I divide the discussion into four major subjects:
I. Change in judicial attitude concerning the time that a debtor should be allowed to linger in bankruptcy.
II. Securitization and other security substitutes that remove assets from bankruptcy's reach.
III. Early liquidation under section 363.
IV. Elevation and protection of secured creditors' claims by agreement with the debtor.

Chapter 2
The time a debtor lingers in bankruptcy matters. Lawyers charge by the hour, investment bankers charge by the month and assorted other professionals also charge by time, not by event. So, longer bankruptcies mean larger bills. But that is not the principal cost of lingering. The principal cost for the secured creditor--and for every other person that will receive a payment at the conclusion of the case--is the lost opportunity to put that payment to use. Outside of bankruptcy a secured creditor can foreclose, turn the collateral into cash and invest that cash. Inside bankruptcy and, absent a bargain of the kind described in Part VI, interest payments for pre-petition debt are suspended in almost all cases; consequently the creditor's bargained benefit is lost.
For some, prolonging bankruptcy is good. Of course, lawyers and others who charge by unit of time have an interest in prolonging the case; the same is true of employees of the debtor. Where liquidation will leave nothing for the shareholders, or, in more desperate cases, even for the unsecured creditors, they too lose nothing and may gain by prolonging. The shareholders--and less likely the unsecureds--share Mr. Micawber's hope that “something will turn up,” the hope that the market for the debtor's product will turn, that the recession will end, or that the debtor's competitors will stumble. In most cases these hopes are as vain as Mr. Micawber's were. By hypothesis in these cases the debtor's trajectory is downward; those who have put the firm into this precarious position are usually still in the cockpit and the bankruptcy itself is increasing the dive angle. Still this hope of future payment, however unrealistic, is preferable to the present certainty of no recovery that liquidation brings.
This is the conflict that the Code and the courts must resolve. The shareholders, employees and perhaps the unsecureds want the bankruptcy prolonged in the hope that they can capture some latent upside and the secureds want liquidation so they can cash out and move on. In life the arguments will not be as honest and crude as I have suggested. Those out of the money will not ask for extensions by expressing hope that something will turn up, rather they will argue that the value of the company is large enough to leave something for them. They will argue about the going concern value of the debtor and will scold the secureds for their selfish wish to destroy that value. The employees, fully aligned with shareholders for this purpose, need only stand in the wings with tears in their eyes to make their interest known. The lawyers and others with an interest in prolonging may covertly delay court proceedings but they dare not voice their private interests.
These conflicts between the secureds on the one hand and shareholders, et al. on the other, can be joined in several ways. The most obvious is over the debtor's request for an extension of the exclusivity period, the period within which only the debtor can propose a plan of reorganization. The period is 120 days and the court has the power to extend it repeatedly. The conflict might also be fought out over a secured's request for the stay to be lifted or for adequate protection.
In the large cases that followed on the heels of the Code, judges often spoke and acted as though the purpose of chapter 11 were to produce reorganizations and avoid liquidations at all costs. This attitude led to multiple extensions of the exclusivity period in early cases.
But then two things challenged conventional judicial attitudes. First there was a burst of academic writing. Professor Michelle White and others demonstrated the evils of prolonging the life of a dying firm. This writing demonstrated that prolonging bankruptcy could hurt not only secured creditors but also unsecured creditors and competing firms. And this cost was not offset by significant rewards for employees. For example Eastern Airlines flew for two years in bankruptcy. When it liquidated, its secured creditors were not paid in full, its unsecureds went hungry, and its employees lost their jobs. To the extent that its continued operation was subsidized by the bankruptcy process (no interest payments for 22 months), it injured its competitors who had to pay their interest bills.
Professor White lists a number of “subsidies” that are given to reorganizing firms in bankruptcy, such as an interest-free bankruptcy reorganization period, and the right selectively to cancel unprofitable projects. White followed these writings a few years later by showing that both efficient and inefficient firms were likely to file for bankruptcy, and suggested that the process needed to be reformed to improve efficiency in chapter 11.
Also the courts began to take hits in the popular press. A 1993 Wall Street Journal article criticized courts for turning bankruptcies into “marathons.” The article suggested that preserving dying companies did little to benefit the industry but forced competitors to suffer by having to compete with debt-reduced, reorganized dogs--often in crowded markets. Some bankruptcy practitioners even joined in these complaints.
A third event may have played a role here too. By the late '80's professional DIP lenders had evolved and those lenders and their lawyers had figured out that some courts were more favorable to their interests than others. As I explain more fully below, these DIP lenders directed their debtor clients to courts that would be more receptive to a creditor's request to life the stay or to present a competing plan. Also, as I show below, the DIP lenders learned to take a stronger grip on the debtor than they had done previously. This may have had a direct impact on the length of cases even if the judges had not changed.
The upshot of this is shown by the charts in the footnotes. Note that the average length of large bankruptcies of 1007 days in 1980 has shrunk to 402 days by 2000. Even when one controls for pre-packaged and pre-negotiated bankruptcies, the average length in days has fallen from 1007 in 1980 to 469 in 2000. The length of time has also dropped even if one excludes the cases that were filed away from the debtor's home (i.e., in a forum presumably favorable to the debtor); the average length of cases filed in the place of the debtor's headquarters has fallen from 926 in 1980 to 423 in 2000.

Chapter 3

A. Securitization
A principal limitation on the bankruptcy court's jurisdiction is the definition of “Property of the Estate” in section 541. In general if something is property of the estate, the court and the DIP have power to mess with it; if not, they don't. If a lender can somehow transfer its collateral to a third party, such as a trust or a “special purpose vehicle,” the property will be beyond the reach of the DIP and of the court in any bankruptcy of the debtor. This means that the creditor will not be subject to the stay with respect to the collateral, the DIP will not be able to use or sell it under section 363 as it could if the collateral were inventory or equipment subject to a security interest, and it means that interest (or the economic substitute for interest) continues to be paid. Finally of course this property and any claims to it are unaffected by any plan of reorganization.
An ancient practice called “factoring” fits this model. A “factor” is one who buys a seller's accounts receivable for a discount and without recourse. The factor thus buys the entire upside (if the accounts pay more than his discounted price, he gains) and bears the risk of default by the account debtors (if many default, he bears that loss). Factoring is the economic equivalent of a secured, non-recourse loan under which the creditor has agreed to look to the accounts as its sole recovery.
Beginning in 1948, factoring graduated to the big leagues where it was given a new name, “securitization.” Securitization first developed in the home mortgage market. In that market Fannie Mae struck upon the idea of bundling packages of mortgage loans, putting them in a trust or other entity and then selling interests in the pool of mortgages. This transaction gave Fannie Mae cash for its mortgages so enabling it to make new mortgage loans. Separating the loans from Fannie Mae meant that the pool of mortgages carried a credit rating unrelated to Fannie Mae's business and freed the investors from any need to monitor Fannie Mae or to determine its creditworthiness. It seems unlikely that fear of bankruptcy of the lenders, Fannie Mae, et al., stimulated those early securitizations (for the Freddies', Fannies', and Ginnies' liabilities are thought to carry the implicit guarantee of the federal government) but moving them off the balance sheet of Fannie Mae, et al. simplified the credit evaluation.
Soon securitization spread to other markets where bankruptcy of the original lender was conceivable. Beginning in 1985, consumer lenders, weak and strong, and many others started securitizing. In some of these cases bankruptcy of the original lender, no longer Ginnie or Freddie protected by the government's wing, was a possibility. When so, investors would be willing to pay to be free of that risk. Therefore in those cases, the seller of the accounts would enjoy a lower effective interest rate (a smaller discount) than they would have to pay on a conventional direct secured loan against the same accounts. Professor Lupica describes this growth of securitization as follows:
[C]lever investment bankers realized in the mid-1980s that the same financial innovation could be applied to non-real estate related receivables. Once discovered, the securitization market grew quickly, and currently, it is the fastest growing segment of the capital markets. More than 2.5 trillion of asset-backed securities are outstanding, and over the past fifteen years, the market has grown at a rate of thirty percent per year. Industry experts have observed that virtually any asset income stream can be securitized, and recent years have seen a volume of $150 billion in issuances. An estimated $700 million in public asset-backed securities are now issued in an average business day.
It is indisputable that for many debtors securitization is a cheaper way of acquiring capital than secured borrowing is. What part of that savings is attributable to avoidance of the trustee's reach in bankruptcy is not clear, but surely some part of the savings comes from bankruptcy “remoteness.” Whether the process is efficient, whether, as Prof Schwarcz argues, it is truly an alchemy, is also subject to dispute. Despite all the arguments that one sees about freedom from the debtors' “exposure to external events, business downturns, interest rate fluctuations, [and] management decisions,” it seems plausible to me that avoidance of the debtor's trustee is the only virtue in many cases. Apart from the bankruptcy risk, I see no reason why a fully secured creditor should charge a higher interest rate than a securitization investor would demand. Absent bankruptcy, full security protects from bad business decisions, external events, claims of other creditors of the debtor's business, etc.
Let me explain the “bankruptcy risk.” Compare a secured creditor who lends $10 million and takes a security interest in debtor's $12 million of receivables with a group of investors who buys notes from a trust that holds the debtor's $12 million worth of receivables. Experience tells us that the investors will demand a lower effective interest rate than the bank will charge.
It is indisputable that the debtor's interest in the receivables in which it has given a security interest is part of the bankruptcy estate under section 541. Even though the debtor has given a perfected security interest, the debtor retains title. In the second case most commentators and virtually every practitioner of securitization believe that the “sale” of the receivables to the trust has removed them from the bankruptcy estate as that estate is defined in section 541.
When the debtor enters bankruptcy, the trustee or DIP has rights over the receivables in the former but not the latter case. The most threatening of those rights is the right to use property of the estate under section 363. For example the DIP might propose to take one month's payments from the receivables to pay for operating expenses and offer to give the bank a mortgage on its unmortgaged plant as adequate protection. As I suggest above, the bank might find this collateral not adequate because it is illiquid or because it believes that the value of the plant is much less than the value of the receivables. Because the securitized receivables are sold, and not within the estate, the DIP has no such power over them.
At this writing it is not absolutely clear that the law will continue to treat these two transactions differently. Some argue that the sale to the trust or special purpose vehicle is no more than the grant of a security interest and therefore that the sold account is still within the estate.
In section 541 the drafters of the Code were generally content to follow the state law on ownership in defining property of the bankruptcy estate. With few exceptions that was “all legal or equitable interests of the debtor in property” as defined by the applicable state law. There is no indication that the Commission or the legislative drafters foresaw the rise of securitization; in any case there was no attempt to deal with it in section 541.
Had the drafters of the Code looked for state law on the nature of a securitizer's rights in property they would have found it in Article 9 of the Uniform Commercial Code (UCC). Earlier the drafters of Article 9 in turn could have taken either of two positions on the rights of a factor/securitizer. First they might have treated a factor/securitizer as a secured creditor for all purposes. They might have disregarded the form and simply ruled as a matter of state law that title to a “sold” account was not sold but remained the property of the seller and that the factor/securitizer held only a security interest that could be perfected by filing.
Alternatively the drafters could have recognized the “sale” as valid but ruled that the “buyer” had to file a financing statement or be subordinated to the rights of the seller's creditors.
By specifically referring to “sale of accounts” in section 9-102(1)(b) and by treating the buyer's interest as a security interest in 1-201(37) and subordinating unperfected security interests to the rights of lien creditors in 9-301, the drafters apparently chose the latter alternative. That alternative was less radical than a complete statutory reconfiguration of the transaction. So the law as adopted did not say that a “sale of an account” was merely the “grant of a security interest” for all purposes, rather by applying Article 9 to certain “sales,” it appeared to recognize those transactions as sales for certain undisclosed purposes but to require that the buyer perfect if he wishes to enjoy priority over certain creditors of the seller.
The magnitude of securitization--new public and private issue volume in the ABS market set a record in 2002 of $420 billion --makes this process the most significant anti-bankruptcy device for secured creditors. The dollar amount of receivables that are securitized must swamp the dollar amount in which secured creditors take conventional security interests. It seems unlikely that securitization can be stretched to be a substitute for security in inventory but the creditors tried to do so in LTV Steel and it is conceivable that others will succeed. Judge Bodoh was particularly offended that the creditors in LTV thought that they could convey the inventory of raw steel to a third party (who was to hold it ready for production), make finished products of the steel on the day before LTV filed and yet claim that the steel was not part of LTV's estate. Were effective securitizations of inventory possible, Article 9 would become obsolete for large firms.

B. Leases
Leases and deals that are documented as leases but are in fact secured loans are well known. Here I ignore the kinds of leases--often with inexpensive purchase options--that are treated as security agreements under section 1- 201(37) of the UCC in UK. I consider only deals that would be regarded as true leases, not subject to Article 9 but rather to Article 2A.
Even though this latter group is classified as leases and not as security agreements, they can be a secured lending substitute. For example a trucking company might lease a new truck for ten years. If these leases had no option to buy, they would not be treated as a security agreement under section 1- 201(37) but would enable the trucking company to have assured long-term use of the asset in return for installment payments. Economically, if not legally, such a lease is a substitute for a loan secured by the asset.
The rights of lessors, covered in exquisite detail in section 365, differ widely from the rights of a secured creditor in bankruptcy. First the debtor must either assume the lease or reject it within a reasonable period after the filling. To assume a lease, the DIP must bring the lease payments up to date or give adequate assurance (not to be confused with the weaker adequate protection) that he will promptly do so. After he affirms, the DIP must pay according to the lease terms. Failure to pay on a lease that the lessee has assumed would be a basis for lessor's cancellation, and amounts not paid after an assumption earn administrative expense priority. Most important, the debtor has no right to tender mere adequate protection nor does he have the right in reorganization to keep the asset on payment of an amount equal to its value. In short the cramdown under section 1129 that may be forced on every secured creditor (making it settle its secured claim for the value of the collateral) cannot be imposed on a lessor.
Leases are not perfect or pervasive substitutes for security. They are not suitable for inventory and they carry a debtor's option to cancel. Under section 365 a debtor who chooses not to assume may reject a lease, return the asset to the lessor and suffer only an unsecured claim equal to the damage caused to the lessor by the rejection.
This means that leases are preferable to security agreements for certain only where the leased goods will retain value to the debtor/lessee that is greater than the present cost of the lease payments. Consider a hypothetical airline that leases both 777's and 727's. The former are new large two engine aircraft with low operating costs per seat/mile; the latter are smaller, older three engine gas pigs. When the airline declares bankruptcy, it will want to keep the 777's and get rid of the 727's, and the market will share the debtor's opinion--777's resale market will be high and the 727's, low. In a proposed renegotiation of the 777 leases, the lessor will have the upper hand; in a renegotiation of the 727 leases, vice versa.
So in some cases leases side-step many of the barriers that chapter 11 places in front of secured creditors. If the asset is suitable for lease, and if there is a reasonable likelihood that the asset will retain sufficient value to make a reorganizing lessee assume the lease, the lease is likely to preserve the lessor's analog to interest, likely to avoid issues of unsatisfactory adequate protection and, under the terms of section 365, be impervious to any other tricks of the DIP.

Chapter 4
By hypothesis most public firms that file in chapter 11 need money. They have used up their available capital in operating losses, unexpected tort or contract liability, or have made improvident investments. Because of their financial plight they are excluded from the public borrowing markets. To survive they must usually turn to a “DIP lender;” the DIP lender might be the firm's existing secured creditor or it might be a new lender who may partner with the existing lender. Section 364 is a roadmap for secured and unsecured lending to a DIP. It authorizes not only unsecured credit that will be treated as an administrative expense (and so paid ahead of the unsecured creditors) but also secured credit. In every case post petition lending of this kind will bear interest at the rate agreed and both principal and interest will have administrative priority--superior to the priority of the debtor's pre petition unsecured creditors.
Beginning in the early 90's secured creditors realized that by agreeing to become the DIP lender they might make money on any new loans and, more to the point for us, might avoid many of the traps that the Code and the cases put before pre-petition secured creditors. Now facing bankruptcy, the debtor had become a pigeon. The debtor, who earlier might have played one potential creditor against another to get the best terms, had lost its bargaining position. The imminence of bankruptcy will have scared off other lenders and the debtor might face liquidation if it had to go into chapter 11 without new money. Such a debtor would be amenable to terms in a loan agreement that would limit its rights. And such a debtor would cheerfully accept terms that strengthen the DIP lender's hand against trade and other unsecured creditors, for there the debtor truly would be spending another's money.
But not every court will let the DIP lender have his way with the debtor. Some courts might be hesitant to let the debtor trade away the rights of absent unsecureds even to a powerful DIP lender whose loan might be critical to the debtors' life. Understand that granting priority to a large new loan carries the possibility that pre-petition unsecured creditors, who might receive a payment in a prompt liquidation, might get nothing in a later liquidation or reorganization where the DIP lender had to be paid first. Too, some courts might find that the debtor's grant of rights to the DIP lender (or its disavowal of rights such as the stay's protection) invaded the court's prerogatives.
The solution to these problems was to find a court that appreciated the importance of the DIP lender and respected the debtor's agreements with that lender even when those agreements might step on other toes. But how to find such a court?
Here the debtor, encouraged by his potential DIP lender, turned to the generous venue rules applicable to chapter 11 cases. Under section 1408 a debtor may file in any court where it is “domiciled”, where its “principal place of business” is, or where its “principal assets” are located. Even better, it can file anywhere there is a pending case concerning any “affiliate.” Every subsidiary is an affiliate under section 101(2). These rules explain why one looking for the bankruptcy of Eastern Airlines, headquartered in Miami, finds it under the name of “Ionosphere Clubs” in New York, why Enron, with its headquarters in Houston, was able to file in New York, and why dozens of companies incorporated in Delaware but having no other connection with the state have been able to file there.
It is now common for the debtor and its existing principal secured creditor, if there is one, or the debtor and any other creditor who is willing to do DIP lending to negotiate before the filing. One issue to be discussed with the potential DIP lender is the place of filing. If some or many of the judges in the District where the debtor proposes to file are hostile to terms that the DIP lender wants in its loan agreement, the lender can refuse to lend. Particularly when the secured's major issues have to do mostly with the secured rights vis à vis unsecureds, the debtor may be indifferent about the place of filing. We now observe a large number of filings in Delaware and, more recently, some filings in the Southern District of New York and in Chicago. I believe that this pattern of filing is directly responsive to the DIP and DIP lender's interests. Both the lender and the debtor probably want certainty; for the DIP lender that certainty means assurance that its favorite clauses in the cash collateral order and in the DIP lending agreement will be acceptable to the court. If the District has a couple of hare-brained judges, if its rules and practices are not well spelled out, or if it has rules or decisions on important issues that are anathema to any of the important players (debtor, secured creditor, critical vendor), no bankruptcy of a large public company will darken its door.
Perhaps because the SEC or an SEC nominated trustee had the whip hand in chapter X cases under the Act, in 1978 no one seems to have foreseen this alliance between the debtor and its principal secured creditor to manipulate the venue rules for their common interest. In fact the removal of the SEC has fostered the current bargain between the debtor and its principal secured creditor. Under chapter X, the SEC had the right to intervene as a party in interest in large bankruptcies, give an advisory report on the confirmation of the plan, and forestall confirmation of the plan by refusing to release the report. In addition the SEC had effective control over trustees by its ability to appoint and fix the compensation of all officers, attorneys and examiners. If neither the existing management nor its lawyers were going to be around after the petition was filed in chapter X, they had no incentive and little power to negotiate with any existing creditor. The removal of the SEC from the process and the replacement of the trustee with the DIP have created both the incentive and the possibility for the negotiations that we now observe.
Note too why any opposing cries from trade and most other unsecured creditors are muffled. Until the bankruptcy petition is filed, there is no creditor's committee and until then no unsecured creditor may have a large enough stake to make it worth his while to monitor the debtor's behavior or to bargain with him over place of filing. Some of the orders on cash collateral and perhaps on the DIP lending will be tentatively approved before any committee of unsecured creditors is appointed. My purpose is not to enter the debate over the merits of the venue rules but only to explain how those rules and the bargains struck between the DIP lender and the debtor facilitate the lender getting what it needs by agreement with the debtor.

A. Converting Pre-Petition Debts into Post-Petition “Rollups”
Section 364 authorizes a debtor in chapter 11 to “obtain credit.” Subsections (a) and (b) authorize unsecured lending and give those loans administrative expense status under section 503(b)(1). Implicit in the grant of administrative expense status is the right to receive market rate interest in the ordinary course and current repayment of principal. Subsection (c) authorizes secured debt and subsection (d) allows secured debt that primes existing secured debt. All of the debt authorized under section 364 primes pre petition unsecured debt.
If only pre-petition secured creditors could find a way to transform themselves into post-petition secured creditors with robust collateral, most of their concerns described above would be alleviated. Since they would be paid current interest at market rates, the opportunity to reinvest would be recaptured. Since they would have the pick of the collateral litter, concerns about insufficient collateral or about its decline in value leading up to the bankruptcy would be gone. Since they would be bargaining with a needy debtor, they could demand a large cushion of collateral and insist on protection of that position by the toughest of warranties and promises.
Nothing in the Code explicitly permits changing pre-petition debt into post-petition debt, and the logic of cases like In re Alyucan Interstate Corp. and United Savings Assoc. of Texas v. Timbers of Inwood Forest Assoc. conflicts with the idea that such a transformation of pre-petition debt into post-petition priority debt is permitted under the Code. If section 506 means that pre-petition debt earns no interest during the proceeding, what logic says that a new name on that old debt changes the legal rule? If there is no adequate protection for an equity cushion under Alyucan, what logic permits the securing of old debt with new assets of the bankrupt debtor?
A few early cases traveling under the name of “cross-collateralization” deal tangentially with these issues. In those cases the parties proposed to allow pre-petition secured debt to be secured by post-petition assets. Of course, such collateralization should be permitted to the extent that the new collateral replaced collateral that was held when the petition was filed and consumed in the debtor's business. But what about new collateral that does not replace the old? Under the Act, cross-collateralization may have been permissible but only on proper notice and a hearing confirming that the post-petition debt could not be obtained in any other fashion.

Some rollups are noisy. In some cases the DIP lender pays off the existing loan in full. That payment is treated as the first advance on the post-petition secured loan; it instantly transforms pre-petition debt to post-petition. No one could miss that event.
Under the guidelines, in Delaware rollups are permitted only where they are identified in the motion to approve financing and are “justified,” New York requires a hearing to approve rollup, and Massachusetts forbids securing pre-petition collateral with post-petition debt without a clear reason. Whether and how any particular rollup is “justified” is a question for another time. The absence of published judicial defenses of the practice might make one skeptical about courts' ability to find proper justification.

B. Debtor's Appointment of Creditor's Representative
In some cases the DIP lender insists on the DIP's informal or formal agreement to appoint a person called a Chief Restructuring Officer (CRO). In the words of several bankruptcy lawyers familiar with the practice, the DIP may appoint anyone in the world--as long as that person is on the secured creditor's list of three approved candidates. Many of these appointments go to members of three firms: AlixPartners LLC, Alvarez and Marsala, and Kroll Zolfo Cooper. While this person is not truly an agent of the secured creditor, usually his bread is buttered by the secured creditor not by the DIP. The CRO's are repeat players in the bankruptcy process, and they offend the secured creditor who nominated them only at the cost of losing future nominations.
For fear of making such a person truly an agent and so incurring liability for his acts or failure to act, the DIP lender would prefer to have the CRO's duties left to informal understandings or to general practices and expectations that do not rise to the level of formal agreements about the CRO's duty to his sponsor. For that reason one finds scarcely any reference to the CRO in the many pages of agreements signed by the DIP who has informally agreed to take on a CRO.
My interviews tell that there are considerable variations in the work and terms of employment of CRO's. In some cases the CRO has been hired by the debtor before the bankruptcy or at least before the DIP lender insisted on it. In those cases the CRO is beholden mostly to the debtor who brought him there, and not directly to the secured creditor. Also different CRO's have different skills. Some are accountants, there to straighten out the accounting; some are managers, there to manage in place of prior failed managers.
A CRO's experience as a professional manager of distressed companies may give him knowledge of solutions to problems that face companies in chapter 11 that far exceeds the knowledge of regular management. To that extent the CRO can be presented and regarded as a friendly advisor to the DIP. I suspect that a DIP lender sponsored CRO also fills a role not welcomed by the DIP; he can be a spy for the DIP lender to see that the DIP toes the line and to squeal on him when he does not.
Because of his status as the eminence grise little is written on the workings of the CRO and even less appears in the cases. Surely a good CRO brings experience and wise counsel to chapter 11 management that has never seen a chapter 11 proceeding before. One might expect that the CRO's suggestion to a patron DIP lender sometimes moves existing management out the door. His reports might call for a tightening of the DIP lending agreement, and presumably the CRO would have input to any decision of the lender to force liquidation. The CRO gives the DIP lender better intelligence and greater assurance that the DIP is conforming to his promises than the DIP lender would have otherwise.

Because a chapter 11 proceeding is instituted by the filing of a petition with a court and because that court and the parties in the proceeding are endowed with many statutory rights and burdened with many statutory obligations, it is inviting to think of a chapter 11 as primarily a judicial proceeding, like a civil suit that ends with a judicial determination of the parties' rights. One might visualize the conclusion of a chapter 11 as the court's confirmation of one plan of reorganization because it conforms more closely to the law than another. Alternatively one might liken a chapter 11 to a proceeding in front of an administrative agency such as FERC or the FCC where the culmination is an administrative order. None of that thinking was ever right; today it is farther from the truth than it ever was before.
Ignoring the pesky details of the Bankruptcy Reform Act of 1978 that I discuss above, what I describe in this paper is the rise of a private market for the reorganization and sale of public companies. I believe that the major effect of the Code on public companies' bankruptcy is its facilitation of that market. The participants in this market are the Bankruptcy Courts, the DIP, the professional DIP lenders, traders in bankruptcy debt, lawyers and investment bankers that specialize in bankruptcy, and bankruptcy managers (CRO's and others). The firm's assets and its non-management employees, are like hogs at auction, what is bargained over.
Three parts of the Code have facilitated the growth of this market. First is the banishing of the Securities and Exchange Commission from chapter 11. Second is the nearly insurmountable conditions for a court's appointment of a trustee that are found in section 1104. Third is the venue rules discussed in Part VI above.
With its right to appoint a trustee in chapter X, and its right to advise on any proposed plan, the SEC could influence if not control a chapter X. Its right to appoint (and practice of appointing) a trustee foreclosed existing management and their lawyers from a significant role in that chapter. It left no one home to negotiate with a prospective DIP lender or with anyone else. The SEC's right to interfere in the plan of reorganization and perhaps even to insist on certain terms over the opposition of the parties burdened the parties' negotiation of a plan. By depriving the SEC of status of party in interest, section 1109 keeps it even from asking for a trustee's appointment, for section 1104 permits only a "party in interest" to make that request. So the Code castrated the SEC; no SEC bureaucrat may mess with this market.
The statement in section 1104(a)(1) that a trustee can be appointed only for cause, such as "fraud dishonesty ... or gross mismanagement" and the statement that large size or large numbers of bond or stockholders are not enough to justify a trustee, has successfully warned the courts away from appointing trustees. This means that no party answerable to an uninvolved actor such as the SEC or a court appointed trustee will be at the controls in chapter 11. These rules in 1104 and 1109 were consciously chosen to have that effect.
The third set of rules, those on venue, has had at least as much influence, but this influence may have been unintended. As I show above, the generous venue rules allow a debtor and its potential DIP lender to chose among many courts. Bankruptcy judges everywhere are aware of these opportunities for forum shopping.
Judges appreciate that the legal issues in large chapter 11s are more interesting than those in one horse chapter 11s or in the huge gob of chapter 7's that gum up every bankruptcy court, and they know that the work of the lawyers in big cases will be carefully done, that the legal issues will be ably and fully argued. So the big cases will be more interesting than the small; they bring more than intellectual stimulation, for prominence and prestige also accompany these cases. An important decision might merit discussion in the popular business press.
Understand how the venue rules make this implicit bargain possible. The judges want big cases and the DIP's and DIP lenders want certainty, favorable law, and, most of all, laissez faire. Because the offerees' identity (potential DIP's and DIP lenders) is unknown and because an explicit, bilateral bargain would be at least unseemly and possibly illegal, this bargain can never be direct, open or, I suspect, legally binding. The judges are like the offeror of a unilateral contract. Like offerors of rewards, the judges necessarily make their offers for the ears of persons unknown. They make these offers by their decisions, by publishing friendly rules and, generally, by being laissez faire. They must depend on the offerees' agents--bankruptcy lawyers--to hear, interpret and report these offers. The acceptance of the offer is, of course, the act of filing a big chapter 11. The implicit deal between the judges on the one hand and the DIP and its lender on the other leaves the DIP and DIP lender free to make a bargain first between themselves and later with others in the bankruptcy without fear of interference from the court (at least if they stay within reasonable limits).
While it is more overt than the deal with the judges, the bargain between the DIP and the DIP lender is not quite forthright. Some of the DIPs most important promises have little or no effect on the DIP but a large effect on unsecured creditors. If, for example, the DIP agrees to a rollup of the DIP lender's pre-petition debt and if no plan of reorganization results, on liquidation the cost of the rollup will be borne by the unsecured creditors who will receive a smaller payout than they would have received if the secured creditor's debt had not been rolled up into post-petition debt. On liquidation the debtor and its management will be gone. So to some degree, the DIP is truly spending from the unsecureds' purse when it strikes a deal with the DIP lender.
Of course the DIP cannot be a complete whore in its bargain with the DIP lender. The DIP management may hope to ride out the chapter 11 and continue to operate the reorganized company. Since the unsecureds will be a large block of the new stockholders and since even before that they can stop approval of a plan by a large enough vote, the managers must have an eye on the unsecureds' interest too. If the DIP agrees to a deal too favorable to the DIP lender, the unsecured committee may vote it down or challenge it in court and, if the deal deviates too far from the norm, even a laissez faire court will reject it.
The unsecureds hold a weaker position in this market than the secureds for many reasons. First they enjoy none of the benefits of the secured creditors that I describe above. Second since the DIP and the DIP lender choose the venue and so confer a benefit on the judge, they, not the unsecureds, presumably command the lion's share of the benefit from that bargain; put differently no judge need fear the poorly organized rabble of unsecured creditors for they do not choose the venue. Only after the case is filed are the unsecureds invited.
Despite the fact that the unsecureds as a class are at the bottom of the bankruptcy hierarchy, much of the action is with them. Except for the claim of the DIP lender who goes from beginning to end, both secured and unsecured claims are bought and sold continuously in a large chapter 11. This part of the market is of course made possible by the earlier deals among the judge, the DIP and the DIP lender. Laissez faire not only entices the DIP lender, it also facilitates trades of the secured and unsecured debt of the bankrupt. The certainty that comes from a judge who will not interfere without reason and who has consistent and predictable behavior makes it simpler for these buyers and sellers to evaluate the worth of particular claims. A buyer or seller must evaluate the legal rights attached to a particular claim (its share of the pie) and he must evaluate the worth of the firm on its exit from chapter 11 (size of the pie). The first is mostly legal, the second is mostly economic. The laissez faire attitude of the court helps to answer the first, for it minimizes the chance that an outlier will convince the court to deviate from shared expectations about the law.
It is often asserted that most claims at the end of a large chapter 11 are not held by the same persons that held them at the beginning of the case. A majority of the claims have been traded at least once in this market. Without knowing more and assuming that the participants in this market have no disabilities, economic learning would say that the presence of a flourishing market in claims is ipso facto beneficial. Each trader here must think that he benefits from the trade, the buyer to take part in the bankruptcy and the seller to take his money elsewhere.
The bargaining that we see is probably made easier by the fact that professionals control it. The DIP lender enters with full understanding of the game; the unsecureds are recent buyers of the debtor's paper who have paid less than par, sometimes far less than par. All will be represented by lawyers and investment bankers skilled at the game. These lawyers must perceive the courts' offer of an implicit contract and urge their clients to accept it. They must understand not only the applicable law and practice in the District where the case is filed but, more important, the informal rules of the market and every other persons' probable expectations. They appreciate the damage that they can do to others and, better, that others can do to them. Working with the lawyers' evaluation on the first issue (size of a claim's share), the investment bankers can evaluate the probable economic payoff.
I hypothesize that these professional players are less likely to cling to impossible dreams; in the words of negotiation literature, the original lender may be "anchored" at 100 cents--his original expectation. The bankruptcy pros are more likely to have a realistic estimate of the probable payoff than inexperienced players would have and are less likely to be anchored at an unreasonable figure. That of course means that a bargain is likely to be struck and that no one will be put to the cost and risk of making the court decide.
The Code's adoption, and its application by the courts may have been necessary for this market to arise but neither the Code's adoption nor its application by the courts is sufficient to cause the market to exist. I suspect that the market's rise depends equally on the growth of chapter 11s by public companies and on the rise of a class of nationwide specialists
In conclusion I believe it is sensible to think of chapter 11s of public companies as large and unruly markets where many interrelated deals lead incrementally to a corporate reorganization. To be sure neither the law nor the courts are irrelevant, for the private bargain often depends on the courts' power to bind dissenting members of a class and the parties derive their bargaining power from rights granted by Article 9 and by many provisions of the Code. And of course, the judge must approve the plan and, perhaps, even resolve a conflict or two.
But make no mistake, these plans are not crammed down; they will have the agreement of every class. The parties will have chosen a venue where an outlier is unlikely to get his wish from the court and where the outcome negotiated in the private market and reflecting the economic power of the parties will control. The Code has made this market possible.

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