By Sarah Paterson (LSE Law School) and Adrian Walters (Chicago-Kent College of Law)
[Editor’s Note: This article will be published in 55 Arizona State Law Journal Winter 2023.]
The core claim in our new paper is that Chapter 11 is not well adapted to selective restructuring. We characterise this as Chapter 11’s inclusivity problem.
We start by describing what we mean by selective restructuring – essentially any case in which the debtor seeks to restructure specific liabilities while everyone else rides through unscathed – and why it is attractive to debtors. We employ the model of the demise curve to draw a distinction between debtors who are facing “general default” – difficulty in paying all their liabilities – and debtors who have just started to experience pressure on cash and who will be able to return to normal trading if they can address a specific cash-draining problem. We use the examples of a debtor with too much financial debt, or off-market leases which it can no longer afford, or tort liabilities associated with past business practices. We explore why tools which target specific creditors selectively reduce the direct and indirect costs of the restructuring.
Our position is that selective restructuring is normatively defensible. We understand that this is likely to be anathema to scholars who conceive of a restructuring as an enforcement event in which the business is “sold” to the existing creditors and the proceeds allocated to the creditors and shareholders in accordance with distributional rules which reflect creditors’ liquidation priorities. However, we conceive of restructuring as solving a problem of rational bargaining which cannot be solved entirely through contract outside bankruptcy. At the same time, we take very seriously indeed the concern that if bankruptcy and restructuring laws become too permissive of selectivity, they will be exploited by opportunistic debtors.
This brings us to a detailed analysis of why Chapter 11 is poorly adapted for selective restructuring. We identify four principal issues. First, Chapter 11 is inclusive by design: the entire firm is brought into financial resolution. Second, Chapter 11’s cram down rules present challenges for a non-consensual selective restructuring. Third, a debtor seeking to pay creditors whose debts are not part of the proposed restructuring during the pendency of the case must navigate the mandatory automatic stay. Finally, federal circuits are divided in the ways they approach third party releases in Chapter 11, and in the wake of several high-profile mass torts cases such as Purdue Pharma, federal law is far from settled. The release of guarantees and security provided by non-debtor operating companies in a finance holding company’s Chapter 11 case is therefore not a straightforward matter.
Unsurprisingly, given the desirability of selective restructuring for debtors, we find that practitioners have engineered solutions to Chapter 11’s inclusivity problem. We explore these workarounds and find them highly problematic because they neutralize Chapter 11’s distributional rules and have the unintended pathological effect of limiting comprehensive review of the plan when it is arguably needed most. Moreover, we find that in some situations the lack of selective restructuring tools may incentivise the debtor to avoid Chapter 11 altogether until it has slipped further down the curve, perhaps attempting to raise more debt in the meantime. We regard this as even more problematic because it may result in debtors entering Chapter 11 too late, with even more liabilities, so that a rescue becomes impossible.
Our paper then takes a comparative turn, analysing selective restructuring in the UK and Europe. In the UK context we focus on Part 26 schemes of arrangement and Part 26A restructuring plans. We reveal how both procedures address the inclusivity problem head on, explicitly permitting a selective approach. We explore how the fairness of leaving entire classes of creditors outside the plan is addressed in the UK procedures, and the flexible way in which this is done. We find it useful that there is no automatic mandatory stay protection and that, even where stay protection is sought, it can be crafted in ways that do not inhibit the debtor from paying pre-bankruptcy liabilities of creditors who are unaffected by the plan. The release of third party guarantees and security is also straightforward. Emerging European variants that implement the Restructuring Directive exhibit many similar advantages. The most significant takeaway from our comparative analysis is that UK courts conduct a comprehensive, holistic fairness review in all scheme and restructuring plan cases. This contrasts starkly with the approach in Chapter 11 which is fragmentary and piecemeal. Creditors who wish to challenge the workarounds to Chapter 11’s inclusivity problem are forced to couch their objection on various narrow grounds none of which are effective proxies for a broad inquiry into the plan’s allocative fairness.
In the paper’s final section, we build on the National Bankruptcy Conference’s earlier proposal for the introduction of a new Chapter 16 of the Bankruptcy Code for bond restructuring. We argue that the NBC’s proposal could usefully be revisited while going beyond it to suggest a broader and more foundational approach that would be designed explicitly to address Chapter 11’s inclusivity problem and not be confined exclusively to bond restructuring. Reform aside, the paper’s main ambition is to integrate hitherto siloed debates about financial restructuring, landlord restructuring, and restructuring of tort liabilities into a single debate about the use and management of selective strategies in Chapter 11.
Click here to read the full paper.