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.

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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.

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One of my favorite podcasts, in addition to banquet of delights contained the UChannel series (quite the array of luminaries there, and, uh, Jonah Goldberg), is EconTalk, which comes out once a week, takes about an hour, and gets a pretty good, if right leaning, set of guests.  If only they had more lawyers though!  Sunstein did one last year, and I'm happy to point you to Todd Zywicki in this week's episode.

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Every commercial law teacher and bankruptcy teacher should distribute this story on the first day of class.  About a year and half ago, BofA mistakenly terminated both its and Citibank's financing statements perfecting security interests against Heller Ehrman, the California law firm that is now in dissolution.  Basically, someone checked the wrong box on this form!  This could turn out to be something close to a $57 MM clerical error. 

The firm had already paid the banks $51 MM since the firm announced its dissolution in September.  The banks tried to file a "correction" in October; the firm's dissolution committee discovered the termination document in November; in December the firm filed for Chapter 11 and has asked the court to throw out the banks' attempted October correction.  Assuming a strict application of the UCC, the attempted October correction would be a preferential transfer of a security interest, which would be avoided.  That makes the $51 MM in payments to the banks (or whatever portion was paid within the 90 days before Heller's bankruptcy filing) preferential.  So they have to give it back.  And the remaining $6 MM owed by the firm would also be unsecured.  So the banks might end up with something close to a $57 MM unsecured claim, instead of the secured position they thought they had.  Ugh.  Everyone make sure your malpractice premiums are paid up!

Apologies if your eyes glazed over while reading that last paragraph.  Can you tell I've been grading bankruptcy exams?  I actually thought about saving this fact pattern for next year's exam, but it's just too good not to share!

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As the Big Three automakers' pleas for emergency bailout money appear to have fallen on deaf ears on Capitol Hill, the blogosphere is awash with discussion of bankruptcy scenarios (see, e.g., here, here, and here).  "Prepackaged" bankruptcy in particular seems to be a popular solution (see here and here).  But I find it hard to see how a prepack would work here.  Unlike a standard Chapter 11 filing, a prepack is a bankruptcy filing where the debtor and its major constituents--in this case, bondholders, banks, employees, unions, management, dealers (have I left anyone out?)--already have a deal worked out before they file.  Instead of negotiating in Chapter 11 (i.e., after the Chapter 11 filing), management and the major constituents work out the company's financial restructuring, new financing, and anticipated operational changes beforehand, and when they file for bankruptcy, they include not just the bankruptcy petition, but also the plan of reorganization and all the creditor consents required to confirm the plan.

Just judging from what I read in the paper, it is not apparent that the Big Three have had any discussions with their banks or bondholders or dealers about how to share the pain of a restructuring, or who would provide financing in bankruptcy.  Now, this may be just posturing on the part of companies.  They seem to be playing chicken with Congress, on the "too-big-to-fail" theory.  Needless to say, that's a dangerous game.  Especially during the interregnum, the specter of political gridlock looms large.

There may just be some usage issues here:  when commentators say "prepackaged," they might instead mean some kind of bankruptcy filing with strong government involvement.  For example, the government could offer bankruptcy financing conditioned on specific operational and managerial changes.  Not a bad idea.  But that's not a prepack.

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In April 2008, U.S. business bankruptcy filings were up over 49% from the previous April.  That percentage has continued to increase, peaking recently with several high-profile bankruptcy cases, including Lehman Brothers, Washington Mutual and Circuit City.  During the past 90 days alone, according to filings posted on PACER, 395 chapter 11 cases were filed in the District of Delaware and 107 such cases were filed in the Southern District of New York.  (These numbers do not reflect businesses that have filed for liquidation under chapter 7 of the U.S. Bankruptcy Code.)  A similar trend is emerging in the United Kingdom, where business bankruptcies are up 26%.

And based on October sales numbers, the trend most likely will continue.  Retail sales were down 2.8% (4.1% from one year ago).  The breakdown shows retail sales, excluding autos, down by 2.2% and auto sales down an estimated 5.5%.  So, how will this current wave of corporate bankruptcies affect the economy?  Certainly, consumers may benefit from lower prices.  Reports suggest that retailers already are offering discounts similar to those traditionally reserved for the Friday after Thanksgiving and the few days before Christmas.  Gasoline prices also have dropped precipitously.  Of course, corporate bankruptcies are not all good news for consumers.  As Lisa Fairfax noted in a pair of informative posts last week (see here and here), unemployment is on the rise.  Corporate bankruptcies typically pose some risk of layoffs for employees, but that risk appears to be especially acute in the current wave of bankruptcies.

Corporate rehabilitation and the attendant preservation of jobs are important goals underlying chapter 11 bankruptcy.  A debtor needs cash flow, however, to accomplish these goals.  This fact does not change in bankruptcy.  A debtor that lacks adequate financing during the bankruptcy case or a viable business model simply cannot continue in business.  Unfortunately, many corporations that have filed for bankruptcy recently could not secure adequate debtor-in-possession financing or cannot generate sufficient revenues to sustain their business models.  Both problems stem, in part, from the current credit crunch—banks are not lending and consumers and business customers are not spending.

The result is an increase in corporate liquidations and resulting job losses, particularly in the chapter 11 context.  (A recent article notes that Edward Altman has predicted not only an increase in corporate bankruptcies and bond defaults, but that “the unemployment rate could peak as high as 9.5 percent.”)  Just a few examples of recent chapter 11 liquidations include Lehman Brothers, Washington Mutual, Mervyns, Whitehall Jewelers and Steve & Barry’s.  For interesting and thoughtful discussions of the pros and cons of liquidating a business under chapter 11 versus chapter 7 of the U.S. Bankruptcy Code, see Stephen Lubben’s 2007 article and a recent article by Michael Cooley posted on the TMA website, which explores the issue from a strategic perspective.

The trend of corporate liquidations also may be good news for market competitors.  In fact, several observers are speculating that Best Buy will benefit from Circuit City’s bankruptcy filing because it allows Best Buy to gain market share.  (Even if Circuit City does not ultimately liquidate in chapter 11, it already has announced plans to close 155 stores.)  Likewise, Wal-Mart reported third-quarter earnings of $3.14 billion and an increase in sales.  This competitive edge is somewhat the inverse of what happened during the last bankruptcy cycle, where reorganized debtors emerged from bankruptcy with trimmed down balance sheets and an edge over their non-debtor, leveraged competitors.

Finally, more corporate bankruptcies mean more work for bankruptcy lawyers, financial advisers, investment bankers and other professionals that work in the bankruptcy field.  For an extensive and extremely well done exploration of professional fees in bankruptcy, see Stephen Lubben’s 2007 report.  By way of example, observers predict that professionals’ fees in the Lehman Brothers’ liquidation will top $1.4 billion, plus costs of hiring experts to assist in the winddown (estimated at $200 million).  These numbers certainly prove the old saying that you can’t be broke to file bankruptcy.

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If you take the way the Fed has used its discount window so far as legal, then you wouldn't think that Treasury and the Fed would need to go to the Hill for authority for a massive bailout of everyone else.  I guess the institutions are beginning to run out of money, though.  I'd like to see a few more collapses before there is a superbailout, but do admit that the way each rescue has been done so far hasn't really contributed to moral hazard too much; the shareholders at Bear and AIG, and management at Frannie, have essentially lost everything by going under government protection.  Anyway, more skepticism about the use of the authority so far from Eric Posner, and don't miss this post by Steven Davidoff.

If I were the Fed, I'd get a retroactive blessing for the AIG takeover and for Bear too, for that matter, along with prospective bailout legislation.  The retroactive blessing wouldn't make the takeovers okay when they were done, but it would probably moot any efforts to undo those arrangements (if a plaintiff could figure out a way to get standing, and noting that courts don't usually supervise bailouts, etc).

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AIG wants access to the Federal Reserve's so-called discount window, investment banks already get it, the Fed is planning to expand it dramatically, and other companies, like the automakers, are wondering whether they can also benefit from taxpayer largesse.  Who can access the Fed's discount window? 

The short, but surprising, answer is that any of these institutions could access that window if the Fed wished to permit it.  Congress created the discount window with 1932 amendments to the Federal Reserve Act, and those Great Depression agencies (the SEC is another one of them, so is the FCC and NLRB) were given very broad statutory mandates.  Section 13(3) of the act provides

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

Section 14(d), referenced above, simply authorizes the Fed to set these rates, which "shall be fixed with a view of accommodating commerce and business."

It is, like I said, a lot of power, and it was invoked by the Fed when it extended the discount window to investment banks (which the Fed doesn't regulate) in the wake of the disappearance of Bear Stearns.  Here's what the Fed said in the minutes it released on that decision:

[in deciding whether to offer] an extension of credit to any individual, partnership, or corporation under section 13(3) of the Federal Reserve Act, all available Board members then in office unanimously determined, in connection with the authorization of the extension of credit, that (1) unusual and exigent circumstances existed; (2) Bear Stearns, and possibly other primary securities dealers, were unable to secure adequate credit accommodations elsewhere; (3) this action was necessary to prevent, correct, or mitigate serious harm to the economy or financial stability; ... and (6) any credit extended will be payable on demand.

(Also discussed here.)  So upon a finding of unusual and exigent circumstances, the Fed can lend at bargain rates to just about anyone - and take pretty worthless collateral in exchange for its government-guaranteed money.

No big conclusion here, we're just being descriptive.  But the next time someone tells you that bureaucrats inevitably expand their powers to the outer limits of their statutory authority, ask them the last time the Fed got involved in a personal bankruptcy.  Or ask them about Lehman.

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Lehman hoped to sell itself this weekend, but the government wouldn't backstop the deal.  That means liquidation is nigh, filing probably will have occured by the time you read this.  A consortium of banks will provide that backstop, although the Fed will also purchase some of the bank's least sellable assets.  Dealbreaker is a great resource, and has been for a while, on the crisis.

Many will cheer this as the market being allowed to work, and venerable banks going on notice that they aren't too big to fail.  But not, maybe, quite so fast.  The government was all over the cajoling of the consortium of other firms to step up and deal with Lehman's losses.  From an administrative law perspective, this is government action at its least reviewable - no rule is passed, no policy announced, there is just the making of some quiet phone calls.  The fact that Japan's regulatory system often works precisely this way has occasionally driven American trade officials to distraction.  They suspect that Japan actually has a protectionist trade policy, promulgated the way Treasury handled Lehman ... only no one can see it. 

It means that no one will be able to sue the Fed or Treasury over its Lehman policy, but they definitely had one, they just didn't have to announce it or put it through notice and comment.  Congress hasn't authorized the FedNY to step in but the Fed spent the weekend adjudicating Lehman's fate.  I'm not a government in the sunshine maven, and am definitely not a big proponent of suing the government at all times.  And heck, I'm kinda glad that this was the outcome chosen by Treasury.  Maybe, though, this is worth remembering the next time you hear Master of the Universe style paeans to the barracuda-like competitiveness on Wall Street.

Ribstein has more, including on the lack of attention paid to this big, big story by papers run by their Washington bureaus, and noting that Merrill Lynch is about to be sold, and AIG reorganized, all in one amazing weekend.  Those two transactions appear to be pushed by private parties, but, of course, when you buy ML, you get the Fed's discount window too.

Finally, and amusingly, can you profit off Lehman?

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And the incentives (or not) for credit reporting companies to get things right, by Elizabeth Warren:

Why should consumers be saddled with the responsibility to monitor the errors of credit reporting agencies? It is MY information about ME.  Someone else is collecting it, creating errors, and passing those errors along to other people. Those errors can cost me a job, denial of homeowners' insurance, a higher premium on my car loan, a higher price to buy a car even for cash, and, of course, a higher price for a mortgage, a credit card, a car loan, or any other loan. And the system says, in effect, it is my problem to monitor the information. It isn't enough that I don't impair my own credit. It is also my problem to find errors that the company has put in, to document the correct those errors, to fight with the company if they won't believe me, to check to make sure the errors were removed and to make sure those errors never reappear. I can even pay for insurance to help me if a credit reporting company makes a mistake.   

Since I already have a full-time job and a life outside that job, I resent this capture of my time. I also believe that a law that puts the burden on consumers to correct errors and puts no penalty on the credit reporting companies for passing along bad information is designed to encourage a high error rate.  There are simply not enough incentives for the credit issuers to spend their money to reduce errors in the credit reporting system or to make correction cheap and quick....

A lot of people end up paying for bad credit reports. Many never know it because they don't know that the price quoted for insurance or a car was based on their credit score. They will just be poorer than they would have been if the credit reporting companies had more incentive to get it right.

All of that sounds right. I have never obtained a loan without needing to clear up something on my credit report. Mistaken transactions are the inevitable fate of a person named Smith, at least under the present system.

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The housing bust has even hit The O.C., where foreclosures topped 1,000 in May.  To catch a glimpse of the situation on the ground, you can view a slideshow of foreclosed properties at the O.C. Register.  Just click the blue More Photos button in column 2.  HT to Calculated Risk.

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Judge Leslie Tchaikovsky, a bankruptcy judge in the Northern District of California, has issued a whopper of an opinion holding that a mortgage lender on a stated income loan is not entitled to rely on the "stated" income in the loan application for purposes of bankruptcy discharge. 

A stated income loan, of course, is a loan where the borrower "states" her income without also being required to document the amount of said income--e.g., cough up pay stubs.  Whether the lender could "reasonably rely" on the stated income is critical to the question whether a debtor may discharge the debt in bankruptcy.  Section 523(a)(2) of the bankruptcy code precludes the discharge of certain debts procured by fraud.  In this case, the lender would have had to reasonably rely on the false statement of income in the debtors' loan application, in order for the debt to be deemed not dischargeable.

The mortgage loan at issue was an equity line that was underwater and rendered unsecured after the first mortgage lender foreclosed on the debtors' house.  Judge T. apparently did not believe the debtors' protestations that they unwittingly signed the false loan app.  However, the lender didn't get any sympathy either.  Not only did the judge question the reasonable reliance of the individual lender, but she questioned whether industry guidelines on stated income loans were objectively reasonable.  The minimal verification for stated income loans suggests that they're essential asset-based loans--loans made in reliance only on the value of the collateral!

Now, this seems intuitively right to me.  Personally, I never liked the term "liar loan."  I know perfectly respectable borrowers and lenders who engage in these stated income deals--especially for purchase money mortgages--with all parties understanding that it's really the big downpayment that enables the deal.  When it gets to equity lines, though, it starts to look more speculative.  Especially in the actual case, the debtors' last credit extension from the lender was a $50,000 extension on their HELOC--from $200K to $250K--six months after the HELOC was first made.  This extension relied on an appraisal that showed a 9% increase in the value of the house over six months.  Not that appreciation like that is impossible in some parts of NorCal, but it seems pretty aggressive nonetheless, especially for a no-doc loan.

Big win for borrowers--even undeserving ones, as the case illustrates.  As if things weren't ugly enough in the mortgage and residential MBS markets.  OTOH, separating deserving from undeserving borrowers may be cost-prohibitive.  Even good debtors are likely to have trouble footing the bill for nondischargeability litigation, so that as a practical matter, many good but wealth constrained debtors would end up settling on disadvantageous terms.  As between informed banks and the mixed pool of deserving and undeserving debtors--depending on your assumptions about the mix--it's probably better to put the costs on the lenders, both on fairness and efficiency grounds.

HT to Tanta at CalculatedRISK.  As far as I can tell, the decision has not yet been published.  But keep an eye out:  In re Hill (City National Bank v. Hill), United States Bankruptcy Court, Northern District of California, Case No. A.P. 07-4106 (May 28, 2008).

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In recent months, both BusinessWeek and Inc.com have featured articles describing the explosion of merchant cash advances as a funding source for small businesses.  BusinessWeek reports that the size of the merchant cash advance industry “jumped 50% in 2007, to around $700 million.”  The industry even has its own trade association, the North American Merchant Advance Association. 

What are merchant cash advances?  Traditionally, banks have lent money to small businesses and taken credit card receivables as collateral.  As would be expected, the business pays back the loan over time with interest.  In many cases, the loan agreement specifies that payments to the bank will be taken directly from the business’s credit card collections.  Merchant cash advances are functionally very similar to credit card receivables lending – except that merchant cash providers are quick to point out that their agreements are not loans.  According to AdvanceMe, the industry leader, a merchant cash provider “purchase[s] a portion of … future credit and debit sales at a discount.”  For example, a merchant cash provider might give a business $100,000 in exchange for $130,000 of future credit card receivables.  Then the merchant cash provider collects “a fixed percentage of daily credit [card] sales” until the agreement has been satisfied.  Merchant cash providers claim they are supplying much needed liquidity to small businesses that have been squeezed by the credit crunch.

But the merchant cash advance industry is not without its critics.  Because merchant cash advances are structured as sales and not loans, merchant cash advances need not comply with state usury law.  Merchant cash advances are unquestionably more costly than traditional bank loan financing.  Inc.com reports a typical 25% fee, but other press has reported more costly advances. 

In addition, merchant cash advance agreements are treated differently from loans in bankruptcy proceedings.  Merchant cash providers contend that they can continue to collect from credit card receipts even after a business has filed for bankruptcy (when the automatic stay protects the business from most loan collection efforts).  Merchant cash advance agreements are not discharged in bankruptcy.

Of course, some courts may be willing to look beyond the form of the merchant cash advance agreement to find that the agreement is, in substance, a loan.  (Courts have long struggled to distinguish leases from loans and have generally tried to look beyond the form of the transaction to the economics of the agreement.)  If this happens, usury and/or bankruptcy laws could be applied directly to merchant cash advance agreements. 

It is also possible that the rapid growth of the industry will attract legislation.  I tend to favor free markets and believe that heavy-handed regulation here would be a mistake.  It seems to me that the case for usury laws here is weaker than for the average consumer loan because small businesses should have some financial sophistication.  Regardless of what happens, it should be interesting to watch this emerging industry.

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I am sitting in on the fascinating conference "A Debtor World:  Interdisciplinary Academic Symposium on Debt" hosted by the University of Illinois and the American Bankruptcy Institute.  Teresa A. Sullivan, Provost, Executive Vice President for Academic Affairs and Professor of Sociology at the University of Michigan, has just finished a very interesting presentation entitled "Debt and the Simulation of Social Class."  Provost Sullivan's paper seeks to use data to explore how Americans actually use debt and hypothesizes that debt is not used to simulate a higher status but instead to maintain the illusion of one's status and prevent sliding into a lower class.  Provost Sullivan also, as an aside, pointed out that better-off debtors use debt wisely (invest in education, etc.) at the same time poorer debtors use debt as damage control.

This helped solidify some vague thoughts I've been having lately on consumer debt.  One cannot turn on the television or read the newspaper (especially the NYT, it seems), without reading a personal story of a family being forced out of their home after foreclosure or being in fear of such foreclosure.  The stories always seem to involve people who seem just like me -- or even much wealthier than me.  The ads on television that tout consumer credit services show what appears to be a family that looks just like mine being forced out of their house that looks just like mine.  I think I'm developing debt anxiety -- I have real fears that I am going to become just like these nicely dressed, nicely coiffed WASP-ish people who through very little conscious effort on their part lose their nice McMansion.  Can this happen to me?

I'm not really joking.  Although we have literally no debt beyond our 15-year mortgage, which we are in no danger of being under water on, I get nervous every time I see these ads or read these personal stories of how the economic downturn is affecting a stereotypical family.  How does this tie into Provost Sullivan's statement about how better-off Americans use debt?  Here it is -- I'm afraid to use debt.  I used to be a finance attorney.  I understand leverage.  I used to throw around statements such as "I don't want to eat the negative arbitrage."  I know that debt is tax-preferred.  But I am letting my fears get in the way of my math ability.  For example, we are involved in a remodeling project that is fairly expensive.  I know that paying for this out of savings is not mathematically wise.  I should take out a home equity loan, which will have a much lower rate of interest (after taxes) than I should be able to earn off my savings if invested.  But I just can't do it.  That would take me one step closer to being profiled in the NYT and quoted as saying, "I thought we were doing what we were supposed to do.  I thought we were living the American Dream.  But now we can't pay our mortgage and no one will work with us."

My colleague Amitai Aviram writes about bias arbitrage and how the media and regulators prey on upward miscalculations of risk to their advantage.  I'll have to talk to him about my hypothesis of homeowners miscalculating the risk of mortgage debt upward.

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Bob Lawless explores why people don't walk away from homes with underwater mortgages.

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