Bankruptcy's Identity Crisis

Abstract

The large companies that currently file for Chapter 11 look very different than the typical Chapter 11 cases of the past. The liability side of debtors’ balance sheets is much more complex and now consists primarily of secured rather than unsecured obligations. Many firms that might once have borrowed on a secured basis from a bank and on an unsecured basis from bondholders now have first and second liens instead. Leveraged loans have further contributed to the prevalence of secured debt.

While these developments are beneficial in many respects, they have exacerbated two serious problems in Chapter 11. 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 through “uptiering” and “dropdown” or “trapdoor” transactions. Second is a growing perception that insiders benefit from Chapter 11 and outsiders often do not. An unfortunate irony is that efforts (such as restructuring support agreements) to reduce the first problem, uncertainty, often exacerbate the second, insider control.

Part I of the Article recounts the shift in debtors’ capital structure due to the new financing techniques, highlighting a surprising feature of the emergence of the leveraged loan and CLO markets: women played an unusually prominent role. Part II explores the close, though partial, relationship between private equity funds and these recent developments. The final part considers a series of potential solutions and interventions for addressing the downsides of the new financing techniques. The Part advocates an incrementalist approach while warning that, unless the perception that Chapter 11 is rigged in favor of insiders is addressed, pressure may build for more radical reform.

Keywords: bankruptcy law, Chapter 11, secured obligations, corporate bankruptcy, corporations, unsecured creditors, leveraged loans, private equity, CLO, collateralized loan obligation, capital structures, RSA fees.

JEL Classification: G23, G24, G32, G33, K22