In a previous post (The Argentinian Sovereign Bond Litigation, Part I), I roughly described the factual background for the Argentinian bond litigation, culminating in the July 30th Argentine default of bonds. Incidentally, Joseph Cotterill (Commentator, Financial Times’ FT Alphaville) tells us that on August 7, 2014, the Argentine Republic filed a case in the International Court of Justice in the Hague, claiming that “US court decisions . . . have violated its sovereign immunity in public international law.” That story can be found here.
In this post, I would like to focus on the particular clause which has served as the basis for the judicial decisions enjoining Argentina from paying its restructured creditors unless it also paid the holdout creditors in full. That clause is the pari passu clause – the contractual provision that promises that all (pari passu-designated) bondholders will be treated on an equal footing. A common variant of the clause reads: “The Notes will rank equally (or Pari Passu) in right of payment with all other present and future unsecured and unsubordinated External Indebtedness of the issuer.” Although the pari passu clause is ubiquitous in sovereign bonds, its meaning (or application) in the sovereign debt context is highly disputed. In fact, an empirical study, based on extensive interviews of sovereign debt lawyers, reveals at least five possible explanations, ranging from “the clause was simply the product of mindless copying from corporate bonds” to “the clause was intended to prohibit sovereigns from passing laws that would have the effect of involuntarily subordinating certain creditors.”
Why the confusion/disagreement over its meaning? In a corporate liquidation, the clause helps ensure that pari passu-ranking creditors receive equal shares of the proceeds. But in the sovereign debt context, no liquidation is possible. Unlike private debtors, sovereigns cannot go bankrupt and their assets cannot be seized, pooled and distributed to a fixed group of claimants at a single moment of reckoning.
So what is the purpose of the pari passu clause in a sovereign bond? The federal district court in Manhattan and then the Second Circuit in NML Capital v. Argentina offered an interpretation of pari passu. They expressed the view that the pari passuclause required a debtor who was unable to pay all its creditors in full to pay each creditor proportionately or “ratably.” Hence, the sovereign debtor could not be permitted to stiff creditors who had refused to restructure their debts while paying the other creditors who had assented to the restructuring. To do so would violate the promise of equal treatment under the pari passu clause (according to these courts). And, by upholding an injunction against the third party financial intermediary responsible for transferring payments to the restructured creditors, the pari passu clause was given not only meaning but also teeth—a concrete remedy that could be used by the hold-out creditor to induce the sovereign debtor to pay its debt. These decisions disturbed many, because they threatened to make future sovereign debt restructurings more difficult—by encouraging, perhaps, more holdout strategies.
The July volume of the Capital Markets Law Journal (CMLJ) happens to be devoted to the pari passu clause. (Links to all the CMLJ articles can be found here (subscription required), and links to the authors’ prior SSRN drafts are provided below where available.) (Apologies in advance to authors if I’ve mischaracterized some of their arguments or omitted them. I tried to be as judicious as possible.)
The centerpiece of the CMLJ volume is a fascinating work of history. Benjamin Remy Chabot (Federal Reserve Bank of Chicago) and G. Mitu Gulati (Duke) have discovered what appears to be the first use of pari passu principle in connection with a sovereign bond issue. In their article, "Santa Anna and His Black Eagle: The Origins of Pari Passu?" , they show that the spirit of the pari passu concept can be traced back to General Santa Anna’s 1843 decree promising that foreign holders of Mexican Black Eagle bonds would be treated with a “just equality among the creditors, as much as regards the rate of interest as the order of payment.” Similar language appeared in the preamble of the Black Eagle bonds, although not as a contractual provision per se. Chabot and Gulati show that the promise of equality was drafted in response to foreign outrage expressed against a former debt restructuring. This restructuring treated holders of identical claims differently based on their nationality or country of residence. Thus, the pari passu language in respect of the Black Eagle bonds appears to have been intended to prevent discrimination in payments among nationalities of the creditors in the context of a sovereign default.
Chabot and Gulati’s findings, of course, raise the question: why is the original (first) meaning of a clause relevant? Stated another way, what is the relevance of history as a guide to contract interpretation? Chabot and Gulati offer a response:
“Even if lawyers today are copying the clause by rote, surely the earliest drafters of the clause were not doing that. Someone had to have thought of this clause first. If we could find them, and figure out what they were thinking, that we potentially have a way of cutting the Gordian knot.”
W. Mark C. Weidemaier (UNC) addresses this question (“why is the original meaning of a clause relevant?”) in “Indiana Jones, Contracts Originalist”. With wit and humor, Weidemaier reminds us that, in the absence of contemporaneous evidence of the parties’ intentions, judges would ordinarily assign the clause’s historically-accepted meaning if one exists. But in a situation (such as this) where there is no historically-accepted meaning, Weidemaier asks, “ . . . why should the judge try to uncover the intentions of the first drafters?” He then answers, “Whatever the merits of originalism as an approach to constitutional interpretation, surely the originators of a contract term have only a modest claim to authority.” (But a modest claim is arguably still better than no claim, right?) Surveying the available historical evidence, including the Black Eagle bond story, Weidemaier concludes that there is no known precedent to support the Second Circuit’s interpretation that the pari passu clause grants each bondholder a unilateral right to block payments to restructured bondholders. Therefore, the million dollar question is the normative one: whether the pari passu clause, which has not traditionally served the purpose imbued it by the Second Circuit, should be repurposed to do so.
Sovereign debt guru, Lee C. Buchheit (Clearly Gottlieb), invites us to think more generally and deeply about the effort to excavate examples of contracts or clauses from a fragmentary historical record. In “A Note on Contract Paleontology,” Buchheit notes that while the Black Eagle bond story may not much clarify the substantive meaning of the modern version of the pari passu clause, it may explain “why some people have an emotional attachment to the notion of ratable payments in a distressed situation” and why modern litigants are prepared to stretch their interpretation of this boilerplate provision to assign it a meaning that neither the text nor the history of the clause can support.
My article, “Pari Passu: The Nazi Gambit” takes us through a pre-war instance of pari passu. In the paper, I present what might be the clearest historical evidence of what the clause was understood to mean in the pre-war period. I discovered this evidence while studying the protests lodged against the German government when Germany first defaulted on two international loans entered into by it during the aftermath of the First World War. When Germany, in response to its financial crisis, selectively defaulted on the American tranches of the Dawes and Young Loans, parties defending the interest of American bondholders invoked pari passu in their protests against Germany’s discriminatory practices. In claiming that Germany violated the pari passu clause, the protesters adopted the meaning that the clause promised parity in servicing across the various tranches of the Dawes and Young Loans. In other words, bondholders of the various tranches were entitled to be repaid in proportion to their holdings of debt. What’s more, based on the evidence, Germany seems to have acquiesced in this interpretation of pari passu. Perhaps more pertinent to the Argentinian bond litigation, I find no evidence to suggest that the pari passu clause was understood as entitling the aggrieved creditor to a unilateral right to block payments to bondholders who assented to a government’s restructuring proposal. In fact, neither the investors (in the Dawes and Young loans) nor the Bank for International Settlements (trustee) seemed to have interpreted the clause as a tool by which one investor could interfere with payments to another. That said, the failure to invoke an inter-creditor remedy may simply reflect the more mundane fact that legal redress of sovereign debt defaults was highly unlikely during this period.
John V. Orth (UNC) provides useful perspective in “A Gathering of Eagles.” Orth reminds us that the pari passu clause addresses a ubiquitous problem in the borrowing context: unequal payments to creditors of equal rank. Seen in this light, the story of the Mexican Black Eagle bonds is an instantiation of this ubiquitous problem. Accordingly, the meaning of the pari passu clause is clear: it promises equal treatment for all creditors of the same priority. The only problem is the application of the clause to the sovereign debt context, where it is difficult to enforce the terms against a sovereign debtor, which is the same problem with all other clauses of a sovereign bond. The implication of Orth’s piece (I think) is that the pari passu clause is not materially different from all other sovereign promises: they are all “ultimately unenforceable” and “will continue to multiply until there is an effective resolution regime for sovereign defaults.” So, in the end, Orth emphasizes the lack of a practical mechanism of resolving these types of disputes with sovereigns.
Lachlan Burn (Linklaters) is skeptical of the value of historical spelunking for interpreting the pari passu clause in sovereign debt issues governed by English law. In “History – ‘Bunk’ or a Useful Tool for Contractual Interpretation?”, Burn argues that English courts would interpret contracts in a “commercially sensible” way, which he believes “would prevent any due weight being given to the Black Eagle bonds.” After all, Burn notes, as these Mexican bonds have been sitting in a basement until their recent discovery, “[t]hey formed no part of the background information available to the sovereign issuer of bonds or the investors during the last hundred years or so.” Moreover, Burn cautions that “historical precedent will often be a dangerous tool for interpreting contracts.” Finally, Burn argues that enforcement, rather than the meaning of the pari passu clause, is the central issue underlying the Argentinian litigation. (This last point is similar to the one made by Orth.)
Tolek Petch (Slaughter and May) in “NML v. Argentina in an English Legal Setting” notes that under English law, the legal history of a clause is relevant but not determinative. Ordinarily, the court would find an interpretation that accords with business common sense as it would have been understood by both parties at the time that the bonds were issued. Therefore, English courts can and have overturned centuries of precedent on the basis that the proposed construction was not in conformity with the intentions of the parties. Petch discounts the significance of the fact that in the pre-war period Americans protestested against German discriminatory treatment because they are basically ex post facto arguments that will be seen as inherently self-serving and, more pertinently, not contemporaneous with the drafting/negotiation of the disputed provision. (Excellent point, but would Petch or English law accord any significance to the fact that Germans themselves apparently acquiesced in the Americans’ interpretation of pari passu?) Applying the “business common sense” principle of English courts, Petch in the end rejects the “rateable” interpretation of the clause, in part because “no sovereign borrower would agree to” it. Argentina (and many sovereign debt experts) would agree with Petch’s last point!
In “Interpreting the Pari Passu Clause in Sovereign Bond Contracts: It’s All Hebrew (and Aramaic) to Me,” Mark L.J. Wright (Federal Reserve Bank of Chicago/NBER) argues that the Second Circuit “has, if not completely misinterpreted the meaning of the pari passu clause, then at least misapplied it.” He stresses the importance of interpreting the pari passu clause in the context of long-existing social norms among sovereign debt market participants. In short, it has been customary to treat holders of similar debts similarly, i.e., to repay them in proportion to their holdings of debt (measured at face value plus deferred interest). But custom also reveals a complementary “principle of differentiation,” under which certain claims (e.g., claims that had been reduced in value as a result of a prior default) were accorded preferential treatment precisely because they were meaningfully different. Applying the principle of differentiation and observing that Argentina’s restructured creditors hold bonds that have been reduced by almost 70% of their value, Wright argues that the NML decision got it all wrong and ignored the principle of differentiation.
Side-stepping the debate over the relevance of historical origins, in “NML v. Argentina: The Borrower, the Banker, and the Lawyer – Contract Reform at a Snail’s Pace,” Leland Goss (Int’l Capital Markets Ass’n) looks to the present and the future and asks: Why have most of the foreign law governed sovereign bonds issued since the Second Circuit’s ruling failed to change their pari passu clauses? After surveying a number of explanations, e.g., network effects theory, blaming the lawyers’ risk aversion, he offers his own highly entertaining theory.
In “The injunction has landed: the ‘Black Eagle’, pari passu and sovereign debt enforcement,” Joseph Cotterill (Financial Times) recounts the Black Eagle bond history and key moments in the Argentine bond litigation to remind us that “the enforcement of sovereign debt can take many forms” and that “Pari passu is one strategy among many others,” including, e.g., discovery of assets, injunctions, and courts’ powers of equity. The Black Eagle Bond story is just as much about ad hoc enforcement of sovereign debts as it is about pari passu. And that ad hoc enforcement is what we see even today – 171 years after General Santa Anna’s decree.
In “The origins and future of non-discrimination in sovereign bankruptcies: a comment,” Philip Wood (Allen & Overy) puts the pari passu clause into the context of the broader principle of non-discrimination and equality in payment between creditors. Wood speculates that the “concept of equality of payment by law was well established by the second century BC in Roman law.” This is evident from the laws against fraudulent conveyances, which developed around this time. Wood then provides a very helpful exposition of the byzantine devices used in sovereign debt contracts for restructurings in light of the non-discrimination principle.
In the same CMLJ volume, Jeffrey Golden (CMLJ, PRIME Fin. Found’n), Anna Gelpern (Georgetown, Petersen Inst. for Int’l Econ.), and Joanna Benjamin (London School of Econ.) also have very interesting contributions (but not on the topic of the pari passu clause).
What’s the long-term impact of the judicial rulings? Anna Gelpern (Georgetown, Petersen Inst. for Int’l Econ.) has some interesting thoughts in her “Sovereign Damage Control.”
Argentina has appealed from Judge Greisa's "shoot the village" sanctions order in the long-running litigation against a hold out hedge fund that refused to go along with a debt restructuring; it has the financial community in a tizzy because it requires financial intermediaries to help the court enforce its controversial judgment in favor of the hedge fund. But the oral argument did not go well. As DealBook observes:
The dispute started out over a relatively small amount of debt that Argentina defaulted on over 10 years ago. But, as the case progressed in the United States courts, its significance has grown. Its outcome will test the extent to which an American court can pressure a foreign government to take actions to comply with American laws. Some debt market specialists believe a defeat for Argentina could make it harder for countries overwhelmed by debt to ease their obligations through a managed default.
And Anna Gelpern has a massively comprehensive post on the whole thing over at Credit Slips, including an interesting observation that the country, which does not look to be doing well in all of this, is preparing its own shoot-the-village-we-hate-foreign-courts response:
One of the bigger bombshells of the day came from Argentina in the form of the statement that it would default on everyone unless the Court adopted something like its payment formula. The fact that the statement was made with the Vice President and the Economy Minister sitting in the room made it feel like an even bigger deal. Jonathan Blackman's [ed.: Argentina's lawyer] contention was that sovereigns do not and cannot -- and Argentina will not -- "voluntarily obey" foreign judgments against their own domestic law and public policy. Argentina's submission to U.S. jurisdiction was made subject to the understanding that under FSIA, some judgments could go unenforced, and them's the ropes.
A small sampling of recent legal scholarship on "shadow banking" (a topic of I've written about myself):
- Chrystin Ondersma (Rutgers Newark): Shadow Banking and Financial Distress: The Treatment of 'Money-Claims' in Bankruptcy; and
- Ed Greene & Elizabeth Broomfield (both, Cleary Gottlieb): Promoting Risk Mitigation, not Migration: a Comparative Analysis of Shadow Banking Reforms by the FSB, USA and EU (in the Capital Markets Law Journal)
Steve Schwarcz of Duke also produced a bevy of articles on the topic at the end of last year.
DealBook, on Treasury's plan to sell off its GM holdings:
Unlike the A.I.G. rescue, however, the government’s wind-down of its G.M. bailout is expected to lose money. The Treasury Department’s break-even pricepoint is generally estimated at about $53 a share, following the car maker’s I.P.O.
But the Treasury Department has long argued that the auto makers’ bailout was always expected to be unprofitable, offset by both the A.I.G. rescue and the bank recapitalization program.
Shares in G.M. were up 5.7 percent in early morning trading, at $26.93.
As in a bad horror movie (or a great Rolling Stones song), observers of the current crisis may have been disquieted that one of the central characters in this disaster also played a central role in the Enron era. Is it coincidence that special purpose entities (SPEs) were at the core of both the Enron transactions and many of the structured finance deals that fell part in the Panic of 2007-2008?
Bill Bratton (Penn) and Adam Levitin (Georgetown) think not. Bratton and Levin have a really fine new paper out, A Transactional Genealogy of Scandal, that not only draws deep connections between these two episodes, but also traces back the lineage of collateralized debt obligations (CDOs) back to Michael Millken. The paper provides a masterful guided tour of the history of CDOs from the S&L/junk bond era to the innovations of J.P. Morgan through to the Goldman ABACUS deals and the freeze of the asset-backed commercial paper market .
Their account argues that the development of the SPE is the apotheosis of the firm as “nexus of contracts.” These shell companies, after all, are nothing but contracts. This feature, according to Bratton & Levin, allows SPEs to become ideal tools either for deceiving investors or arbitraging financial regulations.
Here is their abstract:
Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together — a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership.
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.
The paper should be on the reading list of scholars in securities and financial institution regulation. The historical account also provides a rich source of material for corporate law scholars engaged in the Theory of the Firm literature.
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It's hard to know what to think about MF Global. On the one hand, hedge funds are buying up IOUs from those who still don't have their money back from the firm at about 100 cents on the dollar. And the idea that $600 million would just disappear in this day and age is a stretch. It's really hard to spend $600 million ill-gotten customer dollars to zero! Even if you're the imperious CEO of a pirate ship of modern finance, which Jon Corzine only might be. Anyway, put these surmises together and it looks to me like the money went out for collateral calls, and therefore should come back.
On the other, everyone is talking, and they are talking to congressional committees. The firm's lawyer is testiyfing! It may suggest that she doesn't have much to hide ... but to me it looks like the scandal is taking on a Washington style drip-drip reveal-reveal mein that can't be good for Corzine, despite his former senator status. He seems to be handling the matter the right way - with delay. And Washington scandals are arbitrary and random - health care may end up distracting everyone from the dispute such that it just stops being pursued. But it's all a rather strange next step in a still pretty mysterious case.
Although I teach, write and practiced predominantly in corporate and commercial law, I also have an LL.M. in Tax. Granted, my LL.M. coursework largely focused on business taxation, and therefore falls squarely within my interests. Nonetheless, given that tax and corporate/commercial law are treated as separate legal disciplines, I see tremendous opportunities for comparative and interdisciplinary analysis among tax, corporate and commercial law.
For instance, I find it intriguing that courts employ highly divergent decision-making approaches in these realms. In the tax realm, courts tend to focus on the actual economic arrangement of the parties, in an effort to identify economic substance rather than mere contractual form. Courts presiding over tax cases tend to utilize more expansive and contextual interpretive methodologies, and routinely scrutinize objective and subjective intent and other "facts and circumstances." These approaches stand in contrast to the dominant, textualist interpretive paradigm in corporate and commercial law, which relies almost exclusively upon strict interpretive norms (such as rules of contract interpretation) to construe written agreements.
To be sure, these divergent methodologies reflect the differing goals of tax, corporate and commercial law. While jurisprudence across all three disciplines emphasizes the need for certainty, uniformity and predictability in the law, tax law remains manifestly skeptical of the party autonomy that corporate and commercial law strive to protect. Courts presiding over tax cases are often called upon to examine possible crimes against the public fisc; in contrast, courts presiding over corporate and commercial law cases are generally called upon to manage disputes among sophisticated parties to voluntary, utility-maximizing arrangements.
Yet despite these distinctions, courts are increasingly importing tax doctrine into the corporate and commercial law context. A classic example is the "debt recharacterization doctrine." In the federal income tax realm, considerably high stakes turn on the proper classification as debt or equity of a person's interest in a corporation. Generally speaking, the characterization of the investment as a loan means that payments of interest will be includible in gross income. In contrast, to the extent the investment is deemed to be an equity capital contribution, then the principal amount of the investment must be capitalized into the investor's basis in the corporation's stock. The tax treatment of any repayment will be determined pursuant to rules governing corporate distributions, with any amounts deemed to be a dividend includible in gross income. In light of these differing tax consequences, courts have developed multi-factor, highly facts-intensive and contextual analyses to recharacterize a purported debt instrument into an equity investment, and to reassign tax consequences accordingly.
The debt recharacterization doctrine was subsequently imported into the bankruptcy realm. In that context, if a court determines that an investment is equity rather than debt, then the claim will be treated as an equity ownership interest in respect of which no distribution of corporate assets can be made unless creditor claims are satisfied. Even within the less formalistic realm of bankruptcy, the importation of the debt recharacterization doctrine is a major departure from dominant jurisprudential norms. As a general matter, bankruptcy courts look to state contract law when matters arise under private agreements and there is no statutory law on point. For this reason, although bankruptcy courts have wide latitude to exercise legal and equitable powers, most matters that arise in respect of contracts are construed in accordance with state contract law, including rules of contract interpretation.
Of course, the bankruptcy context, much like the tax realm, may provide inherent justifications for the application of more expansive judicial methodologies. In particular, courts applying the debt recharacterization doctrine in bankruptcy matters are frequently responding to the plight of third party creditors who may recover less due to the crafty maneuvers of shareholders.
More recent cases demonstrate a willingness to import tax doctrine into corporate and commercial law even where the justifications for doing so are less obvious. For instance, in Coughlan v NXP BV, C.A. No. 5110-VCG (Del. Ch. Nov. 4, 2011), the Delaware Court of Chancery applied tax law's "step transaction doctrine" to an action brought by a stockholder representative seeking to construe terms of a merger agreement. In tax law, the step transaction doctrine is applied where parties engage in multiple transfers to circumvent rules that would apply to a more direct transfer. In Coughlan, the merger agreement provided that, in the event of a change in control of NXP or of pertinent corporate assets, the person acquiring NXP or the assets would be required to accelerate certain contingent payments or assume the obligations. The stockholder representative argued that NXP's two-step transfer of assets to a joint venture amounted to a change in control. NXP argued that it engaged in two transfers that were each permitted under the merger agreement. The court applied the step transaction doctrine, finding that the two transfers should be analyzed as a single transaction that ultimately effectuated a change in control.
The court explained that the step transaction doctrine has been imported into the Delaware corporate and transactional context as well as the bankruptcy realm. It cited a 2007 case construing provisions in a partnership agreement, whereby the Court of Chancery defended application of the doctrine: "I see no reason as a matter of law or equity why the step transaction principle should not be applied here. Indeed, partnership agreements in Delaware are treated exactly as they are treated in tax law, as contracts between the parties." Twin Bridges Ltd. P’ship v. Draper, 2007 WL 2744609, at *10 (Del. Ch. Sept. 14, 2007).
To be sure, such a rationale denies fundamental differences in tax, corporate and commercial law. However, in terms of judicial decision-making methodologies, the increased application of tax doctrine to cases in the corporate and commercial law realm may signal a movement away from formalism, and a rising interest in identifying the actual economic arrangement of parties as opposed to merely construing contractual form. Indeed, the Court of Chancery articulates this point in Coughlan, issuing words of caution to parties who rely on the written word in their business planning and legal advocacy: "transactional formalities will not blind the court to what truly occurred." Coughlan, C.A. No. 5110-VCG at 23.
- Why is Judge Rakoff suggesting that there might be constitutional problems with clawing back Madoff money from the Mets owners? My guess is that he's thinking about Due Process issues (a lack of notice, and a switch in legal regimes based not on the conduct of the Wilpons, but on Madoff's conduct). But bankruptcy has usually been able to get around these sorts of problems.
- If you missed it, the Times built a story around Bob Lawless's explanations for the decline in consumer bankruptcies.
Cross-border resolution authority is a form of bankruptcy, and getting the sovereigns to agree on bankruptcy coordination rules is difficult, as Stephen Lubben explains in DealBook. Chapter 15 was amended in 2005 to try to encourage more coordination in international bankruptcies. Here's Lubben:
But Chapter 15 does nothing to address the crucial problem an international enterprise faces upon bankruptcy. Before a bankruptcy, the enterprise might operate seamlessly across borders, but after the filing, each corporation that makes up the enterprise becomes a separate case. When all the constituent corporations are from the United States, for example, these cases are easily consolidated in a single forum with a motion for “joint administration.” Thus, all of MGM’s 160 bankruptcy cases are pending before a single court in New York.
But if the various corporate pieces of a debtor are spread across several countries, the problems of dueling bankruptcy cases are not easily addressed. Even after the passage of Chapter 15, and the enactment of similar laws in other developed economies, international corporate bankruptcy largely remains a country-by-country affair.
Similar concerns, of course, apply to resolution authority, which is one reason it has become a matter of international diplomacy for financial regulators, rather than merely a matter of extraterritorial application of the FDIC's resolution rules. Hence the entrance of the Basel Committee, and I'll address that a bit tomorrow.
The General Accounting Office has released TROUBLED ASSET RELIEF PROGRAM: Automaker Pension Funding and Multiple Federal Roles Pose Challenges for the Future, brought to my attention by my colleague, Anne Lawton. The general subject is the impact of GM/Chrysler failure on the Pension Benefit Guaranty Corporation ("PGBC") and the conflict inherent in the government's role as shareholder. Anne has looked over the executive summary and what follows is based on her report.
First point. Over the next 5 years, GM and Chrysler will need to make significant contributions in order to satisfy minimum funding requirements for their defined benefit plans. For example, GM projects that total to be $12.3 billion for 2013 and 2014, with the possibility of additional further contributions. That's fine if the firms are profitable enough to make those contributions. But, what happens if the pension funds fail? About a year ago, PBGC estimated that the losses from failure of GM's and Chrysler's defined benefit plans would be $14.5 billion.
Second point. The Treasury is a shareholder in the firms. But, PBGC is governed by a three-member board and the Treasury Secretary (along with Labor and Commerce Secretaries) are the board members (right now, the Assistant Secretary of the Treasury for Financial Institutions is the board rep.) So, the report asks, how is the government "dealing with the potential tensions between its multiple roles as pension regulator and insurer, and its new roles as shareholder and creditor?"
That's a good question. To remind you, the report is here.
Almost exactly one (short) month after a hearing on February 2, 2010, Bankruptcy Judge Burton Lifland has issued an opinion upholding Trustee Irving Picard's calculation of "Net Equity" in untangling Bernard Madoff's Ponzi scheme (referred to by the judge as the "Net Investment Method"). (Story here; opinion here; prior posts here and here.)Though many victims had argued that their claims were equal to the balances on their November 20, 2008 statements from Bernard L. Madoff Investment Securities LLC, the judge held that this "Last Statement Method" ignored the fictitious nature of the returns reflected there and any withdrawals made, which necessarily were paid out of victim principal. Therefore, the judge upheld the Net Investment Method, which defines a valid claim as the principal paid in less withdrawals. The judge acknowledges that this method will lessen or extinguish many victims' claims. However, the court states that "[t]he Net Investment Method harmonizes the definition of Net Equity with these avoidance provisions [from the Bankruptcy Code] by similarly discrediting transfers of purely fictitious amounts and unwinding, rather than legitimizing, the fraudulent scheme."
In anticipation of this ruling, three "net winner" victims have filed a lawsuit in New Jersey against the President and Directors of SIPC for running a "fraudulent investment insurance scheme." Two of the victims have lessened or extinguished claims under the ruling because of withdrawals, but one victim seems to run afoul of the definition of "customer" (she is a member of an LLC that was a customer). As they say, we will stay tuned.
Don't miss the Faculty Lounge's series on Greek sovereign debt, curated by Kim Krawiec and featuring contributions by Lee Buchheit, Mitu Gulati, and Anna Gelpern so far ... it's just the sort of rare mini-symposium that you don't often see in the blogosphere that often, present company excepted (we'll speak no ill of the Conglomerate here). The writing is pretty witty, too, as it so often is whenever the subject is sovereign debt. Do give it a look.
While in Vegas I attended a great session on the gaming industry and bankruptcy. I took a lot of notes, but what's stuck with me are Frank Merola's remarks origins of the gaming industry and their effect on gaming regulation.
According to Merola’s account, when the gaming industry was born in the 1950s, no banks would lend money to casinos, and they lacked access to the public markets as well. So casino operators financed each other’s operations by taking a minority interest in a competitor (Caveat: I’m not sure of the accuracy of this assertion—everything I know about the casino industry I learned from…well…Casino). Given this background, there was a real emphasis on knowing with whom you’re doing business (insert mafia joke here). When Nevada enacted its Gaming Control Act in the late 1950s, it also focused on who was investing money, i.e., the state’s strict licensing requirements took their cues from the underlying structure of casino financing.
Of course, the modern financial landscape looks very
different from the 1950s, and it took a while for
Instructed to be provocative, the illustriously named former Sen. Gordon Smith’s opening remarks included the observation that "All great nations in history presaged their declines with massive debt" and a reference to the "awful arithmetic" of our national debt. He closed by asking whether there should be a bankruptcy remedy for states, as there is for municipalities or counties. David Skeel responded that he doubted whether Congress would allow this, but hypothesized that states could issue bonds with voting provisions in place that would allow the debt to be restructured midstream. Smith was skeptical of the market’s appetite for such debt. There was a lot of debate over the Chrysler and GM bankruptcies, and in particular the "aggressive" use of Section 363 of the Bankruptcy Code, the provision that allowed for a quick sale of Chrysler’s assets in bankruptcy. The question came down to whether the sale was a good thing (Claude D. Montgomery 's view, because it was fast and the company had effectively been "on the block" for months) or a troubling thing (Skeel's view, because there wasn’t a robust auction, and the creditors and shareholders of Old Chrysler wound up owning the lion’s share of New Chrysler). Michelle White observed that economists in general want fast sales in bankruptcy, but also want "true" sales--which Chrysler was not. Because she characterized only 20% of Chrysler as "worth saving," she was unhappy with the government bailout. White also gave a helpful summary of the issues in mortgage crisis. First she framed the high costs of foreclosures: homeowners and renters must relocate; moving makes kids switch schools, and families lose established neighborhood ties. Vacancies cause blight, tax revenues fall, so cities cut public services. Foreclosures cause more foreclosures by driving down values. Given the above, lenders foreclose too often. Although they lose 1/3 to 1/2 of their investment, many of foreclosure’s costs are borne by others. Although the Obama administration’s Help for Homeowners program has resulted in 500,000 modifications, only a few thousand have permanent modifications—ie., a reduction in principal. Why so few? Because lenders can and do veto permanent modifications, and for rational reasons. Securitized mortgages come with "pooling and servicing agreements" that compensate lenders for the cost of foreclosure, but not for the cost of modifying loans. Couple that with the fact that 30% of mortgage defaults "self-cure" (debtors scrape together the money), and that 30-45% of modifications re-default within 6 months (so lenders just have to renegotiate modifications, or foreclose on a property that’s now worth even less), and you have no lender incentive for modification. Chapter 13 is supposed to help homeowners save homes, but White calculates that only 1% save them that otherwise would have lost them. So what if we let bankruptcy judges cram down mortgages in Chapter 13? Smith thought this wouldn’t be worth the cost to the mortgage market as a whole—presumably lenders would charge more upfront to compensate for the risk of cramdown at the back end. Moderator and bankruptcy judge Leif Clark suggested the market effect would be ameliorated by time-limiting the cramdown power to the loans made during the bubble, and then sunsetting it. Skeel then made a shrewd observation. Despite the title of this panel and blogpost, the Obama administration has really just continued Bush’s economic policies. Skeel had thought that there would be support from Obama for mortgage cramdowns, and has been surprised not to see a departure here from Bush policies—at least, not yet.
Instructed to be provocative, the illustriously named former Sen. Gordon Smith’s opening remarks included the observation that "All great nations in history presaged their declines with massive debt" and a reference to the "awful arithmetic" of our national debt. He closed by asking whether there should be a bankruptcy remedy for states, as there is for municipalities or counties. David Skeel responded that he doubted whether Congress would allow this, but hypothesized that states could issue bonds with voting provisions in place that would allow the debt to be restructured midstream. Smith was skeptical of the market’s appetite for such debt.
There was a lot of debate over the Chrysler and GM bankruptcies, and in particular the "aggressive" use of Section 363 of the Bankruptcy Code, the provision that allowed for a quick sale of Chrysler’s assets in bankruptcy. The question came down to whether the sale was a good thing (Claude D. Montgomery 's view, because it was fast and the company had effectively been "on the block" for months) or a troubling thing (Skeel's view, because there wasn’t a robust auction, and the creditors and shareholders of Old Chrysler wound up owning the lion’s share of New Chrysler). Michelle White observed that economists in general want fast sales in bankruptcy, but also want "true" sales--which Chrysler was not. Because she characterized only 20% of Chrysler as "worth saving," she was unhappy with the government bailout.
White also gave a helpful summary of the issues in mortgage crisis. First she framed the high costs of foreclosures: homeowners and renters must relocate; moving makes kids switch schools, and families lose established neighborhood ties. Vacancies cause blight, tax revenues fall, so cities cut public services. Foreclosures cause more foreclosures by driving down values.
Given the above, lenders foreclose too often. Although they lose 1/3 to 1/2 of their investment, many of foreclosure’s costs are borne by others. Although the Obama administration’s Help for Homeowners program has resulted in 500,000 modifications, only a few thousand have permanent modifications—ie., a reduction in principal.
Why so few? Because lenders can and do veto permanent modifications, and for rational reasons. Securitized mortgages come with "pooling and servicing agreements" that compensate lenders for the cost of foreclosure, but not for the cost of modifying loans. Couple that with the fact that 30% of mortgage defaults "self-cure" (debtors scrape together the money), and that 30-45% of modifications re-default within 6 months (so lenders just have to renegotiate modifications, or foreclose on a property that’s now worth even less), and you have no lender incentive for modification.
Chapter 13 is supposed to help homeowners save homes, but White calculates that only 1% save them that otherwise would have lost them. So what if we let bankruptcy judges cram down mortgages in Chapter 13? Smith thought this wouldn’t be worth the cost to the mortgage market as a whole—presumably lenders would charge more upfront to compensate for the risk of cramdown at the back end. Moderator and bankruptcy judge Leif Clark suggested the market effect would be ameliorated by time-limiting the cramdown power to the loans made during the bubble, and then sunsetting it.
Skeel then made a shrewd observation. Despite the title of this panel and blogpost, the Obama administration has really just continued Bush’s economic policies. Skeel had thought that there would be support from Obama for mortgage cramdowns, and has been surprised not to see a departure here from Bush policies—at least, not yet.
At least, so says Rick Chesley, head of Paul Hasting's bankruptcy practice, in today's WSJ. The article describes a "heated auction" for the remains of Polaroid Corp, an exciting story about 28 bids and counter-bids, and victory snatched from the top bidder by the bankruptcy judge.
I still remember the magic of the polaroids of my youth--click a button, hear a whirr, a odd-sized, thick piece of paper comes out, you wave it and maybe blow on it, and await an image snatched from just minutes ago. Today's digital cameras offer more instant gratification, but polaroid anticipation was a large part of the fun. The WSJ eschews such nostalgic indulgences in favor of couture-commentary worthy of People magazine, describing the auction as follows:
"The 49-year old Ms. Tilton, sporting a 13-karat yellow diamond ring and four-inch Alexander McQueen stiletto heels, hardly looked the part of a Wall Street vulture....And the 5-foot-5-inch Mr. Salter is no sartorial slouch either. Dressed in a Dolce & Gabbana suit, Ferragamo loafers and a Brioni necktie, he carried a Louis Vuitton briefcase."
But I digress from my topic: What does it mean that bankruptcy is "the new M&A?" According to the article, 67 deals in 2009 have come from bankrupcty courts. At my old firm the M&A attorneys were Masters of the Universe, swooping into tense situations, taking stock and taking charge, subsisting on Diet Coke for weeks at a time as they leapfrogged from deal to deal. One told a fellow associate, "When I walk into a room, I know I can dominate everyone else there, physically and mentally." Bankruptcy lawyers generally had a more conciliatory personality, part-counselor, part-bulldog. I wonder whether Chesley was trying to claim a little of that old M&A lustre for himself? If bankruptcy really is the new M&A, there will be lots of M&A lawyers looking for a piece of the action.