Bankruptcy’s Identity Crisis

Chapter 11 is experiencing an identity crisis. Current bankruptcy law assumes that troubled corporations have substantial amounts of unsecured debt held by widely scattered unsecured creditors.  This assumption is reflected in key features of Chapter 11 such as the creation of an estate-funded creditors’ committee in every substantial bankruptcy case to counteract collective action problems that might impede coordination by unsecured creditors. 

The large companies that currently file for Chapter 11 don’t look like this anymore. The liability side of their balance sheets is more complex and now consists primarily of secured rather than unsecured obligations. The developments that underlie this shift are in some respects quite beneficial. By providing access to credit for struggling companies, for instance, the emergence of leveraged loans (collateralized loans made to struggling companies) may sometimes make bankruptcy unnecessary for a firm whose distress would have landed it in Chapter 11 in an earlier era.

But the financing revolution has exacerbated several of the biggest problems in current Chapter 11 practice. The first is the unusually high variability in outcomes in large cases as lenders enter and exit the lending syndicates, and as debtors and creditors exploit loopholes in the credit documents to circumvent restrictions on new borrowing. If creditors sometimes find themselves on the losing side of efforts to exploit contractual loopholes, and sometimes find themselves winning, the variability of outcomes may not seem problematic. But even if the results were a wash overall, the uncertainty invites unnecessary costs as creditors jockey for inside position. 

The second problem in Chapter 11 is a growing perception that insiders—such as a small group of elite bankruptcy lawyers and financial institutions—benefit from Chapter 11 while outsiders often do not. This perception, which mirrors concerns that prompted radical bankruptcy reform in the 1930s, stems in part from controversial cases largely unrelated to the new financing techniques, such as the Purdue Pharma opioid case. But insider control is especially prevalent in cases involving the new financing techniques.

An unfortunate irony of the current landscape is that efforts to solve the first problem—uncertainty—frequently exacerbate both the perception and the reality of insider control. The most obvious illustration is the now-ubiquitous use of restructuring support agreements, or RSAs.  By committing the parties to the terms of a potential reorganization plan, RSAs help counteract an important source of uncertainty: the risk that a deal a debtor reaches with some of its creditors will fall apart if creditors sell their claims and the new holders do not share their predecessors’ perspective.  But RSAs are negotiated by insiders and usually benefit the insiders by, among other things, paying them to ‘backstop’ the sale of new stock when a company emerges from Chapter 11. The solution can be as dissatisfying as the problem, raising concerns that Chapter 11 no longer works as intended and may need to be rethought.

A key player in many of these developments is private equity funds. Roughly 70% of the large US companies that were in distress in 2020 were owned by private equity funds. A smaller but still startling percentage of large Chapter 11 cases also are owned by private equity companies. Nearly all the cases in which contractual loopholes have been exploited involve companies owned by private equity funds. The uncertainty and perception that restructuring practice is rigged in favor of insiders are not limited to private equity sponsored debtors, however. They are present in other cases as well.

My identification and exploration of these patterns uncovers a surprising fact about the emergence of leveraged loans and collateralized loan obligations (‘CLOs’)—which ordinarily are created by securitizing large numbers of leveraged loans. Unlike with other recent developments in Wall Street finance, which have been dominated by men, women such as Dominique Mielle (a partner at Canyon Capital) played a pioneering role in the early market for CLOs. I speculate in the article why this might be so.

The final part of the article considers a series of potential solutions and interventions that have been or might be proposed for addressing the downsides of the new Chapter 11 landscape. To some extent, but not entirely, the exploitation of contractual loopholes can be addressed by better contract drafting. After considering this possibility, I access potential correctives that would require judicial or legislative intervention: greater use of ‘priming liens’ to increase the competitiveness of bankruptcy financing; barring signing fees for those who commit to an RSA; imposing of a good faith duty for debt; and restricting or banning the use of third-party releases. The article generally advocates an incrementalist approach that favors limited intervention but also warns that, unless the perception that Chapter 11 is rigged in favor of insiders is addressed, pressure may build for more radical reform.

David A. Skeel is S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Carey Law School.