On Thursday, I am speaking at New York University’s Stern School of Business on a panel on Dodd-Frank’s orderly liquidation authority. It seemed like an appropriate time to discuss why, although I’m no huge fan of the authority, I also have my doubts about its leading alternative.
I refer to the “Chapter 14″ proposal put forth by the Hoover Institute group at Stanford.
First, the Chapter 14 proposal throws away most of the benefits of using the existing bankruptcy system by calling for cases to be heard by Federal District Court judges.
Our current bankruptcy court structure plainly has its problems, to put it mildly, but one of the main reasons that Chapter 11 works as well as it does has to do with the experienced bankruptcy judges, particularly in New York and Delaware.
Next, and most important, the Chapter 14 proposal has what can only be called a ridiculous funding mechanism I have previously noted the dubious assumption in Chapter 14 that private debtor-in-possession financing will be available in times of financial distress, especially in the size a large financial institution would need.
But the even bigger problem with Chapter 14, which has gotten very little coverage, is its attempt to penalize the provider of DIP financing if the new funding is used to “overpay†creditors.
For example, if a counterparty received a 50 percent upfront recovery made possible by the DIP financing, and unsecured creditors latter received only 35 percent in the Chapter 14 case, the proposal would subordinate the DIP lenders’ claim by that extra 15 percent.
That pretty much kills off any chance of private DIP funding, and even raises some serious doubts about future government DIP funding too. What lucky Treasury employee gets the job of estimating all of these variables, and then facing the consequences if he or she estimates wrongly
Moreover, it provides exactly the wrong incentives upon the failure of a big financial institution. One of the key reasons to have something like DIP financing is to stabilize the debtor’s business upon failure. In the case of a financial institution, such stability has added systemic benefits too.
But if the lender gets penalized for providing too much stability, there is every incentive to be stingy with the DIP funding. I may be a mere bankruptcy lawyer, but as I understand it, that’s the exact opposite of what commentators going back to Bagehot have argued should be done during a banking crisis.
A lot of this discussion seemed to be based on the faulty notion that Chapter 11 DIP financing goes only to pay ongoing operations, while the new Chapter 14 funding would be needed for paying pre-bankruptcy claim. That reflects a basic misunderstanding of how Chapter 11 actually works. After all, when a corporate debtor uses DIP financing to pay “critical trade creditors,†or to cure past defaults before assuming an executor contract, it’s not really so much about paying for ongoing operations.
If I had to guess, General Motors and Chrysler are looming behind this funding mess in Chapter 14. Those two automakers provide us with the best example of what government-provided DIP financing might look like, and the Hoover people are clearly no big fans of that.
But the basic reality is that the lender who provides the big bucks to keep a debtor alive gets lots of power in return, whether they be bank or U.S. Treasury. Chapter 14 is fighting against that reality.
And somewhat strangely, Chapter 14 as proposed does very little to address the key issue of speed. Lehman Brothers likely represented the outer edge of what can be done with regard to conducting a quick 363 sale: the sale happened a week after filing. But even that was only enabled by keeping Lehman’s broker-dealer out of bankruptcy (more precisely, SIPA) for that week and propped up by the Fed. Not clear that the Fed can do that anymore.
Our next best example is the automotive cases, but even a few weeks in Chapter 11 might well be fatal for a financial institution. But again, the Chapter 14 people don’t want to go there.
Stephen J. Lubben is the Harvey Washington Wiley Chair in corporate governance and business ethics at Seton Hall Law School and an expert on bankruptcy.
