The (Il)Legitimacy of Bankruptcies for the Benefit of Secured Creditors
30 Pages Posted: 24 Aug 2014 Last revised: 17 Apr 2015
Date Written: 2015
This paper explores the legitimacy -- or illegitimacy -- of filing and maintaining a case under the Bankruptcy Code when the sole or principal beneficiary or beneficiaries of the case would be a secured creditor or secured creditors. In the situation posited here, the application of the usual distributional priority rules would not produce any distribution for the general, unsecured creditors of the debtor. In the prototypical case virtually all of the assets of the debtor would be subject to secured claims securing obligations that exceed the value of the collateral, i.e., the secured creditor would be undersecured and there would be no equity in the collateral for the benefit of the debtor's estate (a "secured creditor bankruptcy").
The paper first offers a brief overview of several bankruptcy-law-related settings and contexts in which the appropriateness of a secured creditor bankruptcy might be questioned: (i) a proposed sale of substantially all of a debtor's assets under Bankruptcy Code section 363, often relatively early in a Chapter 11 case, free and clear of the secured creditor's security interest; (ii) a sale of substantially all of a debtor's assets, in a transaction similar to a 363 sale, but pursuant to a Chapter 11 plan of reorganization; (iii) conversion of a secured creditor Chapter 11 bankruptcy to a Chapter 7 case or dismissal of the secured creditor bankruptcy; and (iv) the practice of "gifting" in a secured creditor bankruptcy under which, with the secured creditor's consent, a distribution is made to or set aside for a person whose claim or interest is junior to the secured creditor's claim. It also provides a summary of the treatment of secured party bankruptcies by the courts, including "carve-outs" from collateral.
The paper next focuses primarily on the bankruptcy policy implications of secured party bankruptcies -- primarily policies that underpin Chapter 11. It asks and offers a range of answers to the question: How should bankruptcy law treat secured creditor bankruptcies? Two competing visions of secured party bankruptcies are presented. One view is generally critical and opposed, the "Against" position, and the other generally supportive, the "For" position. It then offers rebuttals and surrebuttals of the Against and For positions and discusses and critiques the issues that these positions raise. Finally, the paper concludes that some secured creditor bankruptcies are appropriate and consistent with bankruptcy policies, but subject to several caveats.
Keywords: secured creditor bankruptcies, substantial asset 363 sales, unsecured creditors, distributional priority in bankruptcy, melting ice cube, liquidation, Chapter 11 reorganization, absolute priority rule, secured creditor gifting, carve outs
JEL Classification: G33, G38, K12
Suggested Citation: Suggested Citation