Financial Disequilibrium

Corporate bankruptcy cases have recently undergone a shift. After decades where creditors exercised outsized control, private equity sponsors have now ascended the throne. This new group exploits contractual loopholes and employs coercive tactics to initiate creditor-on-creditor violence. The result is the ability to dictate outcomes in distress situations where equity sponsors would normally be idle passengers. The unwritten rules have been rewritten. 

This new disequilibrium has the potential to fundamentally harm the financial ecosystem. Scholars have successfully chronicled the new tactics, but formulating the means to mitigate market distortion has been elusive. Most scholars have appealed to the judiciary to intervene. Unfortunately, the judiciary has rejected this call, arguing that sophisticated parties should address coercion through contracts. What if that is not possible? An efficient public debt market relies on some sort of check on outright exploitation. The inability to manage bad actors renders these markets more volatile and amplifies contagion risk for national and global economies. Further, coercive measures allow a company that should have sought bankruptcy protection or some other substantive restructuring to artificially limp along. These zombie companies generate only enough revenue to service their debt. There is a significant risk that this iniquity destroys value, and there is little left to salvage by the time the company actually lands in bankruptcy. Companies that have implemented coercive exchanges recently have failed to recover. J.Crew, iHeart, and Serta Simmons all filed for bankruptcy, and Incora and Envision are soon to follow. The borrower’s maneuvering – which caused significant disruption and resource drain – may have helped the sponsor secure more fees and improve its position in the ultimate bankruptcy case, but that appears to be the primary benefit.   

My article, Financial Disequilibrium, argues that a significant movement towards equilibrium is attainable by adjusting two aspects of this ecosystem. Primarily, Delaware courts have limited creditors to derivative breach-of-fiduciary-duty actions, even when a corporation is insolvent and directors are actively attacking certain stakeholders. Delaware case law protects the mechanism by which equity sponsors implement coercion. I argue that when a corporation is insolvent, directors and officers who undertake hostile actions against specific creditors to whom they owe fiduciary duties should be subject to direct claims by those creditors. Unable to act with impunity, directors would be forced to properly consider all key stakeholders in formulating rehabilitation measures. Further, I advocate for amendment of section 546(e) of the Bankruptcy Code to exclude leveraged buyouts from the fraudulent transfer safe harbor. My proposal aligns the section with its historical underpinnings and acts as a natural check on debt levels in overly aggressive acquisitions. This proposal reduces the need for coercive restructuring measures when a corporation experiences financial distress. 

Samir D. Parikh is a Professor of Law at the Lewis & Clark Law School and Editor-in-Chief at Bloomberg Law Bankruptcy Treatise.