For all practical purposes, the relevant legislation for distressed securities investment in the United States is the BankruptcyReform Act of 1978, which applies to all bankruptcies filed since 1 October 1979. Thisenactment is referred to as ”The BankruptcyCode,”or ”United StatesCode”(Branch andRay, 2002). In theCode, there are several chapters of the substantive law of bankruptcy.Chapters 1, 3, and 5 generally apply to all cases, whereas Chapters 7, 9, 11, 12, and 13 provide specific treatment for particular types of cases. Of particular interest to distressedsecurities investors are Chapters 7 and 11, which provide specific treatments for, respectively,liquidations and reorganizations.
Branch and Ray pointed out that a U.S. Chapter 7 bankruptcy isconceptually (emphasisours) similar to the bankruptcy procedures followed in most other countries. That is, when aperson seeks protection under Chapter 7, that person’s assets are collected and liquidated andthe proceeds are distributed to creditors by an appointed bankruptcy trustee. The debtor isnormally discharged from the debts that were incurred prior to bankruptcy. As in most othercountries, under Chapter 7, rehabilitation of the debtor is not especially important. It is inthis sense that the U.S. Chapter 7 is conceptually similar to other countries.
In contrast, Chapter 11 emphasizes rehabilitation of the debtor and provides an opportunity for the reorganization (restructuring) of the debtor. This is the distinctive feature ofU.S. bankruptcy that separates it from most of the rest of the world (although a similarcode exists in Canada called the Companies’ Creditors Arrangement Act, or CCAA). This iswhere opportunity arises for distressed debt investors. In Chapter 11, the debtor (a businessseeking relief and protection) retains control of its assets (which will immediately pass intoa bankruptcy estate under the supervision of the court) and continues its operations. Whileunder this protection, the debtor, now known as a ”debtor-in-possession,” seeks to pay offcreditors (often at a discount) over a period of time according to a plan approved by thebankruptcy court. Some of the liabilities may be discharged. By filing Chapter 11, a debtorcan protect its productive assets from being seized by creditors and have time to plan theturnaround of the business.
A Chapter 11 case can be initiated voluntarily by a debtor or involuntarily by certainof the debtor’s creditors or their indenture trustee. The indenture trustee—typically a bank,trust company, or other secure, respected institution—is named in the indenture agreement(contract between bondholders and the bond issuer) as the bondholders’ agent charged withenforcing the terms of the indenture.
A plan of reorganization is submitted to the court for approval. The plan is typicallyproposed by the debtor with the blessings of creditors, especially the senior creditors. Inmost cases, the debtor works with its creditors to formulate a plan of reorganization. Thisplan details how much and over what period of time the creditors will be paid. Prospectivedistressed securities investors should pay attention to the exclusivity period. The exclusivityperiod occurs at the beginning of each case. During this time (set at 120 days but oftenextended by the court), only the debtor can file a plan of reorganization. After the exclusivityperiod expires, any party with an interest in the bankruptcy can file a plan proposing how theestate’s creditors are to be paid under Chapter 11. Creditors and shareholders of the debtoreventually must approve the plan and have it confirmed by the bankruptcy judge. The judgecan refuse to confirm a case if the plan is not proposed in good faith or if each creditor receivesless than it would receive in a Chapter 7 liquidation. The judge can overrule the disapprovalby some dissenting creditors, however, on economic grounds or for other considerations, suchas social or legal grounds. This is commonly referred to as thecram-down. Thus, a cram-downis basically a compromise between the debtor and certain classes of creditors when they cannotcome to an agreement on the reorganization plan. Referred to as the ”impaired class,” thosewho object to the reorganization plan are those who believe their interest in the reorganizationis impaired by the proposed plan.
Put another way, an approved reorganization plan by the court of law may not necessarilymake economic sense, and such an erroneous presumption may be costly to distressed securitiesinvesting.The uncertain nature of the outcome of legal proceedings makes analysis of such investmentchallenging, and it must be accompanied by extensive due diligence.
• Absolute Priority Rule In the United States, a reorganization plan must followthe rule of priority with respect to the order of claims by its security holders. In general, claimsfrom senior secured debtholders (typically, bank loans) will be satisfied first. The debtor’sbondholders come next. The distribution may be split between senior and subordinatedbondholders. Last on the list are the debtor’s shareholders.
In a cram-down in which the court overrules the objection of a dissenting class ofcreditors, the priority rule becomes absolute. The rule is absolute in the sense that, to be ”fairand equitable” to a class of dissenting unsecured creditors, the plan must provide either thatthe unsecured creditors receive property of a value equal to the allowed amount of the claimor that the holder of any claim or interest junior to the dissenting class does not receive orretain any property on account of the junior claim. In other words, the classes ranked belowthe dissenting unsecured class must receive nothing if the dissenting class is to be crammeddown. It is in this sense that the law treats the holders of claims or interest with similar legalrights fairly and equitably, even if they do not accept the proposed plan.
There is an exception to the absolute priority rule, which is referred to as thenew valueexception. In the new value exception, the debtor’s shareholders seek to retain all or a portion oftheir equity interest by making what amounts to a capital contribution. In exchange for theircontribution, they retain their interest even in the face of a dissenting vote by a senior class ofcreditors. The U.S. Supreme Court has held, however, that the new value exception does notpermit contribution of such value without competitive bidding or some other mechanism toestablish the adequacy of the contribution. Branch and Ray (2002) concluded that this rulingremoves substantial uncertainty over whether or not a lower class of creditors can receivedistribution under a plan of reorganization by contributing new value to the bankruptcyconfirmation process. In other words, it helps reduce uncertainty in purchasing an interest ina Chapter 11 debtor.
Most of the time, holders of senior secured debts are ”made whole” whereas the debtor’sshareholders often receive nothing on their original equity capital. This is the residual risk thatequity shareholders ultimately must bear.