Golden Age of Corporate Bankruptcy

By Jonathan Batiste

Prof. David A. Skeel’s opines in his book, Debt’s Dominion, that there are three distinct eras in the history of corporate bankruptcy in the U.S..1 This article covers each era chronologically, and discusses how stakeholders can become better advocates by being familiar with the changes to our nation’s bankruptcy laws.

The origins of modern reorganization law, where courts facilitate bargaining among debtors and classes of creditors, lie in the equity receivership era of the late 19th century.2 New Deal reformers ushered in the second era with the Chandler Act of 1938, beginning the Dark Ages of corporate reorganization.3 Congress’s enactment of the 1978 Bankruptcy Code brought about the golden age of corporate bankruptcy.4 Reviewing the history of our nation’s bankruptcy laws can inform stakeholders about how they can use the law to promote their interests. By understanding the history of U.S. bankruptcy law, advocates can draw on custom-based reasoning, principle-based reasoning, and policy-based reasoning to advance their arguments.5

How Railroads Started It All

The reorganizations of the U.S. railroads are the first examples of large businesses turning to the judicial system for support when dealing with financial distress. The emerging investment banks connected the railroads to investors of the capital that fueled their rapid growth.6 While the existing laws were not designed to facilitate the reorganization of the large railroads’ complex capital structures, stakeholders needed a solution.7

Let’s next consider notable reorganizations and case law from this era. The 1884 Wabash, St. Louis and Pacific Railway receivership revolutionized corporate reorganizations by representing the beginning of voluntary reorganizations, while demonstrating that debtor management and their advisors maintained control of the reorganization process.8 Representatives of the Wabash successfully requested the commencement of a receivership before the railroad became insolvent, turning a creditor’s remedy into a tool for debtors.9 The Wabash’s reorganization demonstrated the pro-debtor underpinnings of modern bankruptcy law and the stakeholder proactivity it promotes.10

The Atchison, Topeka and Santa Fe (AT&SF) receivership consisted of a debtor-friendly creditor requesting the appointment of the railroad’s insiders as its receivers, an early form of modern debtor-in-possession practices.11 The junior bondholders and old equityholders paid for the reorganization in exchange for post-petition claims against the emerging company that were equal to the value of their pre-petition claims.12

The reorganization froze out bondholders of the Atlantic and Pacific (A&P), a subsidiary of the AT&SF, whose guarantee made them general creditors of the AT&SF and therefore senior to the old equity.13 When the court reviewed the reorganization plan, which extinguished the A&P bondholders’ rights as junior creditors, it found the practice to be permissible.14 When reviewing similar facts a few years later in Louisville Trust Co., the U.S. Supreme Court held that such practices are impermissible and that courts must ensure that all stakeholders can participate in the reorganization process.15 The Court later expounded on the courts’ duty to ensure that the bargaining process respects the rights of all rightful participants in Northern Pacific v. Boyd.16

In 1913, Boyd set the groundwork for the modified absolute-priority rule used today.17 Boyd established that the reorganization process is what matters; stakeholders must be able to participate and insist on being paid in full before junior classes receive anything.18 Shareholders and secured creditors would previously collude to reorganize the debtor, thus cutting unsecured creditors out of the bargaining process.19

However, legal tradition prohibits fraudulent conveyances and side deals that compromise general creditors’ rights; courts must review any transaction that may undermine creditor rights, such as the AT&SF reorganization that Boyd would have prohibited.20 Boyd also informs modern cramdown rules that protect dissenting creditors from being nonconsensually bound to reorganization plans that impair their claims while giving value to junior classes of creditors.21

Courts utilized an informal predecessor to the cramdown provision by setting “upset prices”22 for foreclosure sales, the equivalent of the hypothetical liquidation analysis that § 1129(a)(7) of the Bankruptcy Code requires as part of the best-interests-of-creditors test.23 Similar to the hypothetical liquidation analysis, the upset prices established minimum levels of recovery for impaired classes that could be nonconsensually bound to reorganization plans.24

These early cases show the creation of an informal form of modern corporate reorganization. The start of the Great Depression brought that to an end and spurred New Deal reformers into action.25

New Deal Reforms and the Dark Ages of Bankruptcy

Legislators destroyed corporate reorganization practice as it had existed in the 1930s. In 1937, William Douglas became chairman of the newly formed Securities and Exchange Commission (SEC).26 He and his ideological peers pushed Congress to enact the Chandler Act of 1938.27

Legislators dealt three blows to reorganizations through the Chandler Act. First, the Chandler Act required that independent, disinterested trustees take over debtor businesses and run the reorganization process.28 Second, courts were required to approve reorganization plans before any party could solicit them, further discouraging pre-petition bargaining.29 Third, the SEC gained a role scrutinizing all reorganizations involving public companies, evaluating all reorganization plans, and weighing in on any matter during a reorganization.30

Douglas continued to further New Deal objectives when he was later appointed to the Supreme Court.31He pushed his colleagues to hear Case v. Los Angeles Lumber Co. and took the lead in rendering the Court’s decision.32 Douglas interpreted “fair and equitable” to mean that strict absolute priority should apply to reorganizations, allowing individual creditors to insist on being paid in full and veto any reorganization plan.33

This decision destroyed the ability of stakeholders to bind dissenting creditors, prohibiting cramdown in any form, and created a greater risk of reorganization attempts failing.34 It was clear that reform was necessary by the mid-1970s.35 Reorganization professionals began advocating for change in the form of enacting the Bankruptcy Code.

Why Reorganization Thrives in a Post-Code World

The Bankruptcy Code has served as an antidote to the poison that the Chandler Act was to the world of corporate reorganizations.36 Well-advised stakeholders should be familiar with the changes introduced and the purposes behind them. The Code puts debtor management back in control of the reorganization process by eliminating the independent-trustee requirement introduced by the Chandler Act.37 The SEC is now out of the bargaining process. Consensus formed around a modified version of the absolute-priority rule that allows classes of claims to dissent instead of individual creditors. Legislators abandoned the strict absolute-priority rule set in Los Angeles Lumber.38 Proponents of the Code supported debtor proactivity in forming consensus before initiating formal proceedings, encouraging the use of prepackaged bankruptcies.39

Stakeholders can now negotiate restructuring-support agreements, creating clearer, quicker and more reliable reorganization plans.40 Stakeholders could not consider capital-structure theory until the end of the Dark Ages as modern theories of capital structure emerged in 1958.41 The prominent reorganizations of the 19th century predate such ideas about optimizing a debtor’s capital structure; the mandatory appointment of independent trustees under the Chandler Act prevented stakeholders from applying such ideas. Boards of directors have shifted from taking a mere ceremonial role to one of strategic leadership.42

The Code further incentivizes lenders to extend financing to debtors by offering them claims with super-priority status.43 Claims-trading has also reemerged under the Code.44 Investors in reorganizations can purchase claims to assert more control over the bargaining process.45 Evidence points toward a convergence of bankruptcy and M&A activity, as chapter 11 provides opportunities for investors to acquire or gain control of distressed debtors and their assets at discounted prices.46

Revolutions in financial technology and the markets for new financial instruments provide debtors greater access to capital. Financial innovation has enabled nontraditional market participants to contribute liquidity to markets for distressed-debt securities.47 The growth of the high-yield junk bond market has given debtors access to capital that was unavailable before the ability to issue high-yield, below-investment-grade bonds existed as a path of access to the bond markets.48 Control vulture investors, whose primary motivation is to push debtors toward long-term success, have emerged as new sources of capital and expertise for debtors in need.49

The availability of new financial instruments encourages lenders to provide financing to debtors undergoing reorganization. Credit derivatives emerged in 1991, allowing creditors to buy protection against the credit risk of underlying debt securities.50 Banks created these financial derivatives to manage the credit risks associated with their lending businesses.51

Credit default swaps enable lenders to hedge against credit events associated with nonperforming loans and to dilute the risk they carry at any given time.52 Credit-linked notes, which are funded variations of credit default swaps, allow lenders to buy protection against credit events without taking on any counterparty risk because they receive cash up front and only repay it if no credit event occurs.53 The use of these instruments has contributed to a significant amount of credit risk being transferred from commercial banks to other market participants, such as hedge funds speculating on credit quality.54

How Reorganization Became a Solution for Mass Tort Liability

The Bankruptcy Code opened the door for debtors to use reorganization to address mass tort liability by expanding the definition of a “claim.”55 The Johns-Manville reorganization demonstrated how reorganization can be used as a solution for indefinite tort liability.56 The pioneer of asbestos manufacturing used reorganization to handle plaintiffs’ claims for damages related to medical problems its product caused.57

The Supreme Court has since limited stakeholders’ ability to use reorganization as a global solution to litigation with its decisions in Harrington v. Purdue Pharma LP.58 The Court deemed discharges for nondebtor stakeholders to be impermissible, fraudulent schemes in violation of the principles underlying corporate reorganization law.59 The Sacklers sought to defeat creditors by fraudulently conveying debtor assets to themselves via their “milking program.”60 Purdue plays a role today similar to what Boyd did in its time; the Court recognized that the stakeholders exerting control over the reorganization processes impermissibly neglected creditors’ rights in both cases.

In the same way that the AT&SF reorganization successfully used a practice that the Court later prohibited in Boyd, the Boy Scouts of America (BSA) reorganization used a practice that the Court later prohibited in Purdue. Nondebtor stakeholders sought to receive a discharge of third-party tort liability, similar to the Sacklers, and were successful.61 Stakeholders in both the BSA and AT&SF reorganizations successfully utilized practices that the Court deemed impermissible soon after the reorganizations concluded.

Stakeholders’ Way Forward

Cases from each era demonstrate the boundaries set for stakeholder behavior. While stakeholders might act in furtherance of their own interests, they might not use bankruptcy laws to fraudulently strip others of their legal rights. Understanding this principle that underlies customs particular to bankruptcy law can save stakeholders from running afoul of what courts find to be permissible behavior.

The examples of stakeholders misusing bankruptcy law were followed by the Court ruling against such behavior. Stakeholders are wise to recognize the boundaries that have been drawn and to avoid inspiring legislators to destroy the system as they did in the 1930s. They should be familiar with recent financial innovations that facilitate the kind of behavior that proponents of the Bankruptcy Code favored. Understanding these factors can promote stakeholders’ ability to leverage the law to their advantage.

Advocates can appeal to the principles and customs that have inspired reorganization practice since its inception. Judges consider the policy implications of their decisions, take long-term views of legal issues, and have aversions to their decisions being reversed; familiarity with the policy considerations that influenced the Code can guide advocates to reasoning that judges will find agreeable.62

Conclusion

The Bankruptcy Code’s enactment has ushered in a golden age of corporate bankruptcy. Honest debtors seeking remedies for financial distress have a strong tool to resolve such distress in the bankruptcy process. Creditors enjoy the protection that judicial oversight and formal bargaining provide, negotiating to maximize the value of their claims.

The Code promotes the influx of new capital and proactiveness in the reorganization process. Financial innovation has improved the prospects of stakeholders dealing with debtors undergoing reorganization. As a result, the reorganization process as it exists today is better now than it has been at any point in history.

Jonathan Batiste is a Los Angeles-based student interested in chapter 11. He has completed judicial externships for Hon. Martin R. Barash of the U.S. Bankruptcy Court for the Central District of California and for Hon. Andre Gammage of the St. Joseph County Circuit Court.