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Tracing Equity: Realizing and Allocating Value in Corporate

RestructuringsComparative Perspectives on Commercial Contracts, Security Interests and Insolvency

University of Nottingham Commercial Law Centre

27 February 2019

Edward J. JangerDavid M. Barse Professor. Brooklyn Law School

Visiting Fellow, Harris Manchester College, Oxford University

February 27, 2019

Thank you!!

• Big Picture:– In “rescue” cases, who (if anybody)

“owns” the “going concern” increment?

Liquidation

Rescue

The Puzzle:• In business rescue regimes, how can/should we map pre-insolvency

entitlements onto distributions? – In liquidation this is simple, because asset value is realized and allocated

piecemeal.– In restructurings relative values of firm and assets may shift over time. – In going concern sales (prepacks), going concern value and option value

are blended into the sale price, and may or may not be liened.

• Common assumption in the US and UK: the single waterfall• Inevitable Reality: multiple waterfalls (asset/value/jurisdiction)• Solution: (1) pari passu baseline; (2) realization rules; (3) tracing.

Consider the implications in insolvency

• Liquidation– Little difference, because value is

situated in the assets.

• Going concern sale or restructuring?– Sale

• In UK all value to floating charge.• In US open question

– Restructuring/Administration

• Tricky question in both the US and UK• Suggest an answer under US Law, and

tentative normative suggestion for UK based on “crystallization.”

1st

Lien

2nd

Lien

Sale Price

GUC

GUC

Primer: Comparative Lien Law

US–Asset Based Liens• Liens are asset based

– Real property: mortgages– Personal property: Article 9 Security

Interest• Can cover almost all “property”• But

– Some exceptions.– Must be “property”

» Licenses? » Going concern value?» Optionality?

UK—Enterprise Lien• Fixed Charge

– Fixed and circulating assets• Floating Charge

– Everything else• Can lien enterprise value

– But subject to• Carveouts

– Preferential creditors,– Prescribed part.

US Law -- Takeaway

• Consensual lien holders only have a lien on the assets.• They do not have a lien on the going concern increment.• Liens on circulating assets “crystallize” on filing. • As a result, in going concern sales, secured creditors are not

entitled to priority in connection with:– Going concern increment in a sale• Includes otherwise unrealizable asset symmetries.

– Upside from operations in a restructuring

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Arrived at this view piecemeal and sideways:• Precursors

– Jacoby and Janger, Ice Cube Bonds: Allocating the Price of Process in Chapter 11 Bankruptcy , 123 YALE L.J. 862 (2014).

– Janger, The Logic and Limits of Liens, 2015 U. ILL. L. REV. 589.• Current

– Jacoby and Janger, Tracing Equity: Realizing and Allocating Value in Chapter 11, 96 TEX. L. REV. __ (2018). • How does the law allocate value in Chapter 11 cases over time?

– UCC Article 9 – Bankruptcy Code

• How should the law allocate value over time? – Janger, The Creditors’ Bargain Reconstituted (forthcoming)

• Comparing Equitable Realization to ”single waterfall” theories– Contractarianism– Relative Priority

Initial Concern: “hurry up all asset sales” – AKA “Prepacks”

• Jacoby and Janger, Ice Cube Bonds: Allocating the Price of Process in Chapter 11 Bankruptcy , 123 YALE L.J. 862 (2014).–We were concerned about the problem of excessive speed in all asset

sales outside the context of a plan• Analogous to UK ”Prepacks."

Chapter 11 Envisions a Judicially Supervised Process of Negotiation in the Shadow of Legal Entitlements.

– The “Melting ice cube” argument is used by the secured creditor to grab all the value of the debtor.• Eliminated effective judicial supervision• Short circuited process

– Increased valuation risk– Distorted entitlements.

Quick Sales Should only be Allowed if Ice Cube is Really Melting

• Speed Premium=• Expedited Sale Price-Hypothetical Plan Price

• Quick Sale Cost=• Increased Probability of Undervaluation*Undervaluation Amount

• One should only allow an all-asset sale outside a plan if • Speed Premium>Quick Sale Cost

Speed Premium

Concerns About Hurry-Up All Asset Sales

• Proposed Ice Cube Bond– Reserve proceeds (Bond) of non-

plan sale, against valuation error and misallocation.

– Now arguably required by recent Supreme Court Case: Jevic

Problem: The Single Waterfall

• Governance– If the secured creditor owns

everything, then it should get to make the decisions about what to do with the assets.• Reorganize• Going concern sale• Liquidate

• Distribution– The single waterfall.– All of the value goes to the secured

creditor.

1st Lien

2nd

Lien

Sale Price

GUC

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Common Wisdom: The Blanket Lien

• But is the single waterfall metaphor accurate?– Requires a blanket lien on going

concern value, enforceable in bankruptcy.

– The UK has the floating charge.• Does such a thing exist under US

Law? – What happens to it after filing a

proceeding?

1st Lien

2nd

Lien

Sale Price

GUC

State Law: Scope of Liens

• Janger, The Logic and Limits of Liens, 2015 U. Ill. L. Rev. 589.–What are the state law limits of ownership– US personal property security credit is asset-based, there’s no such

thing as a blanket lien on enterprise value under US law• There are limits on what property can be reached?• There are limits on what value can actually be realized?

Secured Creditor’s Blanket “Ownership” of Enterprise Value is a Myth!

• Limits of State Law Rights:– Scope and Perfection problems

1st Lien

2nd

Lien

GUC

Sale Price

Legal: The Limits of State Law Rights• Multiple lien systems and modes of

perfection– Real estate– Personal Property

• Article 9• Copyright• FAA

• Not all property is lienable– Goodwill?

• There may be gaps– Failure to perfect– Inability to trace proceeds

Real Estate

Cash

IP Rights

Airplane

Spectrum License

Human Capital

Inventory

Lien does not likely extend to the “going concern” or ”enterprise” value

• Is there such a think as “effective entity priority?”– Ed Smith– Chris Frost

Real Estate

Cash

IP Rights

Airplane

Spectrum License

Human Capital

Inventory

Practical: Going concern value not realizable outside of bankruptcy

• Secured creditor leverage is frequently used to sweep these defects under the rug. – Hurry up sale– Defensive DIP

• This is a problem!– It results in a windfall to the

secured creditor.

Real Estate

Cash

IP Rights

Airplane

Spectrum License

Human Capital

Inventory

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Further (Radical) Implications of the Single Waterfall

• Undersecured creditor is simultaneously the residual claimant and a super senior creditor.

• This elevates equity above debt, right?– Under property law, when the fee

and the lien merge, the lien is extinguished.

– Seems inequitable?

1st Lien

2nd

Lien

Sale Price

GUC

Treatment of Liens in Bankruptcy?

• Tracing Equity– How does the US Bankruptcy Code manage and allocate changes in • firm value and • asset value • over time?

The simple world of Liquidation (Chapter 7)

• Encumbered assets sold and proceeds distributed in order of priority.

• Unencumbered assets, including any equity in encumbered assets distributed to everybody else.

1st Lien

2nd

Lien

Sale Price

GUC

GUC

How does “Rescue” under Chapter 11 change that?

• Delays realization on– The value of assets– Value of the firm

• Takes time.– Need to allocate risk/and benefit of

changes in value over time.– To assets and to the firm.

1st

Lien

2nd

Lien

Sale Price

GUC

GUC

What does a rescue regime (Chapter 11) do?

• Delays realization on– The value of assets– Value of the firm

• Takes time.– Need to allocate risk/and benefit of

changes in value over time.– To assets and to the firm.

1st

Lien

2nd

Lien

Sale Price

GUC

GUC

Sale Price

Problems with the common wisdom:• Common wisdom in the US ignores

Code’s distinction between– Asset-based claims– Firm value-based claims

• Timing: – Common wisdom ignores Code’s rules

for the timing of asset realization– The Two-step

• Equitable Realization• Value Realization.

• Tracing: – Common wisdom ignores A9 and

Bankruptcy Code’s asset tracing rules

GUC

Sale Price

1st Lien

2nd

Lien

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Timing: The Two Step – Unsecured• Equitable Realization

– 502 – Share pro-rata– 502(b)(2) – No post-petition interest– Relative position of claims fixed on the

petition date.

• Value Realization – Value of claims determined upon

distribution pursuant to plan.– Can be fixed earlier if assets of firm are

sold under 363– Can be delayed if distribution under

plan taken in stock.

$5,000

$4,000

$1,000

Allowed Unsecured Claims

Creditor A Creditor BCreditor C

$500

$400

$100

Distribution to Unsecured Creditors

Creditor A Creditor BCredotr C

Timing: The Two Step – Secured• Equitable Realization – The pool of encumbered assets is fixed on the petition date

• 552(a) – floating liens stop floating• 552(b) – interest continues in proceeds (subject to tracing – the equities).• 551 – no moving up.

• Value Realization – Upon disposition of the collateral

• When the collateral is sold, its value is realized. • ASC is fixed.• Protected by a replacement lien on proceeds. 552(b)

– The value of the collateral is fixed, and the SI continues in the proceeds, but without increasing in value.

Like crystallization?

Implications: Equitable Realization

• Unsecured Creditors– Proportional share of residual firm value fixed on the petition date

• Secured Creditors –– Pool of assets subject to claim of priority fixed on the petition date

Implications: Value Realization

• Asset- Based Claims– Protected by adequate protection– Get collateral upside – subject to tracing– Floating collateral value effectively fixed on petition (or disposition)

date

• Value-Based Claims– Get income from post-petition operations–Must redeem the encumbered assets

Implications: Allocation of the “going concern” increment

• However, the redemption price is limited to the value of the assets.

• Therefore, the Bankruptcy Code allocates– Asset appreciation to the secured

creditor.– Firm value from operations to the

estate

1st

Lien

2nd

Lien

Sale Price

GUC

GUC

Sale Price

Normative Question: Is this the right rule?

• Limits judgment proofing– Can’t operate fully encumbered

• Limits intrafirm externality– Can’t subordinate employees, suppliers

• Limits social externality– tort claimants.

• Preserves the priority of debt over equity– Anti merger/rollup

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Fourth Article:

• Creditors’ Bargain Reconstituted• Turns to the “Creditor’s Bargain” heuristic • Compares current competing allocation/realization schemes

Evaluating: Competing Visions of Priority

US• Ex Ante Contractarianism

– Adler, Rasmussen• Single Waterfall Absolutism

– Jackson• Single Waterfall Relativism

– Baird and Casey• Dual Waterfall Absolutism

– Jacoby and Janger• Functional priority for operating creditors

in rescue

UK• Single Waterfall w/ Carveouts

– Goode/Warren/Bebchuck and Fried

Dual Waterfall Absolute Priority

• Two pools of value– Code preserves pre-bankruptcy distinction between asset-based priority

(liens) and value-based priority (debt over equity)• Asset-based priority

– 506(a)– 552– 1129(b)(2)(A) – Lien Strip

• Value-based priority– 502– 507– 1129(b)(2)(B) – Absolute Priority

• Claim – Most consistent with Jacksonian prescription

Why Distinguish Asset-Based and Value-Based Priority?

• Normative – Enforces the Pareto condition– Limits the scope of priority to where it cannot be used to redistribute

or externalize risk– “Equitable Realization” encourages• Adequate capitalization• Anti-subordination – Equitable Merger• Residual claim

Practical Objections:

• Valuation hearings are expensive: – Once torts or optionality come first you need a valuation hearing• Value of assets v. value of firm

– Tracing places the burden on the claimant seeking priority• What about the current world where restructurings are often

“limited to financial creditors”?– Equality of treatment remains a problem• Operational v. formerly operational creditors• Employees/pensioners

Conclusion: A General Solution to the Problem of Multiple Waterfalls -- Nortel

• Nortel– Large (integrated) corporate group

– Multiple subsidiaries

– Multiple claims to priority (waterfalls)

– Large pot of money– Very expensive priority fights

• Solution– Pari passu, unless

– Realizable priority• Can establish a realizable priority

entitlement

• Without the “going concern increment”

– Tracing• Can trace reorganization value to

contributed assets