“Junior institutional creditors are paid for the extra risk they are taking on; on average 200 basis points more than senior secured loans,” says Elliot Ganz, general counsel and executive vice president of the Loan Syndications and Trading Association.

The American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11 has released its long-awaited recommendations for making it less expensive and time consuming for struggling companies to reorganize. The 370-page report, released Dec. 8, includes a number of proposals that could reduce recoveries for banks and other senior lenders, though any changes would have to be enacted by Congress and would probably not be effective for a couple of years.

Here are some important takeaways for secured creditors, including collateralized loan obligations.

It would alter debtor-in-possession financing.

Companies entering bankruptcy often have liens against most or all of their assets, making it difficult to obtain additional financing needed to stay in business while they reorganize. The Bankruptcy Code entitles their existing senior lenders to “adequate protection” of their interest in the borrower’s property in any financing that they obtain in Chapter 11. Courts have generally interpreted this to mean compensation for any reduction in the value of their interest as a result of the debtor’s use of the collateral during the bankruptcy case.

The Commission would like to change the way that this collateral is valued to determine the amount of adequate protection that senior lenders are due to the “foreclosure value” of the assets, rather than their “going concern” value.  Foreclosure value means the net value that a secured creditor would realize in a hypothetical foreclosure sale of the collateral. It would often be less than a going concern value.

Distributions to claim holders on the plan of reorganization’s effective date would still be made based on the going concern value (if the company reorganized as a going concern), but the amount of administrative priority DIP claim paid ahead of the pre-petition secured creditors (and junior creditors) may be higher if a lower ‘foreclosure value’ was initially used to size the amount of adequate protection and there was a larger DIP loan.

It could alter the timing of ‘363’ sales.

Section 363 of the Bankruptcy Code allows trustees to sell a debtor’s assets, typically via a public auction. Prior to 2000, the process could take three months or more, but courts have been increasingly willing to approve expedited sales of all or substantially all of a debtor’s assets, provided that a debtor can demonstrate exigency and certain other showings. This has raised questions as to whether value is being removed from the estate by permitting sales to take place too early and too quickly.

After extensive deliberation, the Commission found that in many cases, the potential harm to the estate from a sale that is pushed through the process more quickly than necessary under the circumstances significantly outweighs any potential benefits of such a sale. Accordingly, it recommended that the Bankruptcy Code should include a 60-day moratorium on section 363 sales, absent the most extraordinary of circumstances, “which must be established by clear and convincing evidence at the hearing on the motion requesting an expedited sale process.”

It introduces the concept of relative priority of claims.

Another proposal that could reduce recoveries for creditors first in line to be repaid calls for allocating a “redemption option value” to the class second in line to get paid in the event that this class receives no distribution under the plan of reorganization or from the asset sale proceeds. The redemption option is intended to address the fact that a bankruptcy may occur during an economic downturn, resulting in a lower valuation for the company and therefore a lower recovery for junior creditors.

Fitch Ratings noted in a Dec. 9 report that the concept would change the existing rules of priority to incorporate a mechanism to determine whether distributions to stakeholders should be adjusted due to the possibility of material changes in the value of the firm. The “redemption option value” is the value of a hypothetical option to purchase the entire firm with an exercise price equal to the redemption price and a duration equal to the redemption period.

Elliot Ganz, general counsel and executive vice president of the Loan Syndications and Trading Association, said that the concept is “fairly radical.”  It also “adds complexity, including valuing the supposed theoretical option value in some kind of a judicial valuation process, and there’s no evidence value of collateral isn’t already taking in some kind of option value. It’s a huge waste of time and resources and introduces a foreign concept with which we disagree.”

“I would also add that junior institutional creditors are paid for the extra risk they are taking; on average 200 basis points more than senior secured loans.”

In a related proposed amendment, bankruptcy plans could be crammed down on a junior creditor if they are given the redemption option value but still reject the plan and on a senior class that rejects the plan solely based on the allocation of the value.

Credit bidding is in the clear. 

It’s not all bad news. The commission upheld the principle of credit bidding, which has been under attack in the courts. Credit bids allow lienholders to bypass cash bids and use forgiven debt as an offer and apply it toward their purchase — ensuring the assets are not sold for less than the size of the claim. Both federal and state law allow a lienholder to credit bid up to the amount of its allowed claim, though the federal Bankruptcy Code provides that a court may order otherwise, “for cause.”

The report notes that courts typically have found cause to limit a credit bid in two types of situations, either because the amount of the creditor’s claim was disputed, or based on the conduct of the creditor. For example, In re Free Lance-Star Publishing Co., the court found cause to limit the creditor’s right to credit bid, among other reasons, because the creditor acquired the loan for the sole purpose of obtaining the right to credit bid and discourage any competitive bidding.

The commission agreed that the conduct of a secured credit can have a chilling effect on an auction process. But it noted that all credit bidding chills an auction process to some extent, and in some cases it may be difficult to discern the chilling effect caused by the credit bid itself from the chilling effect resulting from the creditor’s conducts.

As a result, the commissioners did not believe that the chilling effects of credit bidding alone should suffice as cause.

A footnote to the report cites a written statement submitted by Danielle Spinelli, a partner at WilmerHale, in November 2012 field hearing. The argument that other potential bidders would be discouraged if they fear being outbid by a secured creditor “lacks force,” Spinelli wrote. “That would be equally true of any deep-pocketed bidder, and no auction can afford to exclude the bidders with the greatest resources on the ground that they might outbid everyone else.”

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