#16694 - Debt Restructuring Introduction - Debt Restructuring

Theoretical Framework

Corporate insolvency as a “tragedy of the commons”:

• Debtor company has multiple creditors

• Race to first enforce = Each creditor exercising its individual enforcement right = Forcing the debtor into insolvency = Destroying the going concern surplus in the debtor company

  • The “going concern surplus” = The difference in value between the business being kept together as a single functioning unit, and the business being taken apart and sold of piecemeal basis

  • E.g. A functioning restaurant with a good chef and a good setup can be sold for greater value than taking it apart and selling its assets (such as kitchen equipment, furniture, etc.) separately

• Differentiating cash-flow distress from economic distress:

  • Financial distress may be temporary, such restructuring + keeping the debtor in business may actually preserve the value in its business

  • Economic distress = Fundamentally poor business setup, such that liquidation might be the better option

• The trend of collective enforcement stems from the “prisoners’ dilemma”:

• Socially optimal outcome = Both cooperate; preserve the going concern surplus of 12; each get 6

• But each creditor is incentivised to enforce (because he cannot be assured that, if the cooperates, the other creditor will do the same)

• Result = The nash equilibrium outcome of the 4;4 split

• “Tragedy of the commons” because of individual enforcement rights + absence of any mechanism to facilitate communication and collaboration

• Corporate insolvency law addressed this “tragedy of the commons”

  • Reducing the degree of mismatch between individual enforcement rights and the common pool

    • Privatisation (e.g. administrative receivership, where the rights of the creditors are bundled up and entrusted to a lead creditor, and the lead creditor takes over the insolvency process procedurally). This used to be the main procedure in English insolvency law until 2002.

    • Collectivisation (e.g. administration, where all the creditors forced into collective decision-making, and their individual enforcement rights are transformed into participation and voting rights). A comprehensive moratorium stops each creditor from enforcing individually and thus preserves the going concern surplus.

And a “tragedy of the anti-commons”:

• But collectivisation might also result in a “tragedy of the anti-commons”

  • Veto rights = Incentivising holdout behaviour, because a creditor may attempt to extract more value than he would otherwise get by threatening to thwart any attempt to take action

  • Solution = Majority voting, cramdowns (i.e. overcoming a holdout by any particular class of creditors), and information rights

• The “tragedy of the anti-commons” stems from the “game of chicken”:

• What is the difference between the two?

• The problem becomes more pronounced as the going concern value decreases

• C1 might push for too much because it thinks that the going concern value it greater than it actually is; C2 is incentivised to not cooperate at all; they thus arrive at the most socially inefficient outcome

• Fragmentation of debt + Increasing complexity of property rights = Worsening the “tragedy of the anti-commons”

  • Equity and debt derivatives

    • How do credit default swaps (“CDSs”) make cooperation even more difficult?

    • CDS = The creditor is hedged and protected against any losses

    • He does not care about preserving the going concern value of the debtor, because he will be compensated by his swap counterparty for his loss anyway

    • He may actually be better off by pushing as hard as he can during negotiations

    • Distortion of interests:
      T hedged creditor no longer has any economic interest in the debtor

  • Collateralised debt obligations

  • Distressed debt trading

    • Distressed debt traders buy up distressed debt at a massive discount

    • They are interested in quick and easy profits

    • This leads them to favour a piecemeal sale for quicker (albeit lesser) profits

    • They can profit either way because they purchased the distressed debt at such a steep discount

  • Distorted incentives

  • Opaque players

    • Repeat players — such as banks — might have a quid-pro-quo understanding with the other creditors

    • Hedge funds, private equity funds, and sovereign wealth funds, on the other hands, might not be repeat players and might therefore be unconcerned about their reputation altogether

  • Holdouts more likely

• Possible contractual solutions:

  • The “Menu Approach”: ex ante and ex post re-pricing of property rights

  • The “Bankruptcy Contract Approach”: switch from “collectivisation” to “privatisation” (and vice versa)

  • The “Bankruptcy Waiver Approach”: limited cooperation and insulation of cooperators from non-cooperators

Rasmussen’s “Menu Approach”

• Assumptions:

  • Bankruptcy law as an implicit term in the lending agreement

  • It determines the lender’s pay-out

  • It is factored into the lending decisions and risk assessment

  • The interest rate charged on the loan thus depends on the applicable bankruptcy law

  • No common pool problem, because the borrower would anticipate the common pool problem, and would therefore offer contractual terms that mimic the most efficient bankruptcy regime

    • N.b. “Bankruptcy” applies to both natural persons and corporations in US law, whereas, in UK law, the latter is known as corporate insolvency

    • Equity would bear the cost of an inefficient race

    • Equity would therefore draft the most beneficial bankruptcy regime

  • Standardisation through menu of bankruptcy options (both nationally and internationally)

    • US Chapter 7, liquidation

    • US Chapter 11, reorganisation

• Ex ante selection and re-pricing of property rights (e.g. through taxation):

• Imposing a 50% tax for non-cooperation

• The new nash equilibrium is therefore mutual cooperation, and this is also the socially optimal outcome

• How can this be done ex ante?

  • Upon formation

  • Selection of bankruptcy option in corporate charter

  • Creditors are thereby put on notice

• And ex post?

  • But risk of strategic manipulation

  • Requires consent of all affected creditors

  • And also mandatory safeguards

  • Ex post re-pricing is therefore more difficult and raises some difficult questions

• Menu approach and COMI

  • Articles 3 and 7 EUIR 2015

  • Centre of Main Interest (“COMI”) determines jurisdictions and the applicable insolvency law

  • Rebuttable presumption for registered office

  • Objective and ascertainable factors

  • Ex ante re-pricing and COMI:

    • Using the freedom of establishment

    • Establishing COMI in the desired Member State

    • Selecting that Member State’s insolvency law as applicable

  • Ex post re-pricing and COMI:

    • Transfer of COMI

    • Establishing head office Member State of destination

    • Business operated from there

    • Creditors duly notified

The Bankruptcy Contract Approach

• Overcoming the limitations of the Menu Approach

  • The “state dependency” and “asset specificity” of the optimal bankruptcy law

  • Initial menu choice may no longer be ideal later on

  • Charter amendments and COMI transfers are cumbersome

• The Bankruptcy Contract Approach essentially = Ex ante contract to make optimal choice ex post

  • Participation in the going concern surplus = “Bribe” to make optimal choice

  • Corporate managers in the US make insolvency decisions, and can therefore be incentivised into choosing to cooperate

• Remaining issues:

  • The optimal procedure and the optimal bribe may vary over time

  • Different creditors contract at different times

• Solution = Conversion clauses, where earlier earlier contracts are automatically converted to the new bargain

  • This is acceptable because of notice through registration of bankruptcy contracts

  • Lead creditor = The major secured or senior creditors

• The bankruptcy contract approach:

  • Switch from collectivisation to privatisation (and vice versa)

  • Bankruptcy bargain determined by senior secured lenders and debtor

  • Registrable security interest puts creditors on notice

  • Senior secured lenders and debtor drive the process

• The bankruptcy contract in practice:

  • Senior secured lenders with first ranking security on all the debtor’s assets

  • Equity in operating subsidiaries

  • Second lien and mezzanine lenders contractually or structurally subordinated

  • Intercreditor agreement with “waterfall” clause controlling enforcement

• “Collectivisation”: Administration (in the UK) and Chapter 11 (in the US) as collective insolvency procedures

  • Comprehensive moratorium and automatic stay

  • Control through administrator or debtor in possession

  • Information and...