Bankruptcy-Remote Structuring: Reallocating Risk Through Law.

• Author: Schwarcz, Steven L.

TABLE OF CONTENTS Introduction I. Typology of Bankruptcy-Remote Structuring A. Structured Finance B. Ring-Fencing II. Analyzing Bankruptcy-Remote Structuring from a Public Policy Standpoint A. Freedom of Contract B. Bankruptcy-Law Policy C. Balancing Contractual Freedom and Bankruptcy-Law Policy III. Analyzing Bankruptcy-Remote Structuring from a Cost-Benefit Standpoint A. Public Benefits B. Social Costs C. Balancing Public Benefits and Social Costs IV. Reforming Bankruptcy-Remote Structuring to Reduce Externalities A. Reducing Moral Hazard B. Increasing Lender Monitoring C. Increasing Financial Transparency D. Reducing Maturity-Transformation Default Risk E. Reducing the Expansion of Financial Risk F. Reexamining Cost-Benefit Analysis Based on These Reforms Conclusions INTRODUCTION

Bankruptcy has many meanings. In business, it refers to the financial state of a firm, project, or other entity that cannot pay its debts as they come due or that is the subject of a case under bankruptcy law. (1) In the United States, bankruptcy law is governed primarily by the federal Bankruptcy Code (the "Code"), (2) which is designed to reorganize potentially viable entities and to liquidate other entities. (3)

Bankruptcy remoteness means that an entity is effectively protected (4) from factors--whether internal or external to the entity--that might prevent it from paying its debts as they come due or that might make it the subject of a bankruptcy case. (5) Internal factors include the normal risks of operating a business, such as the risk that expenses will exceed income. External factors include risks associated with the entity's affiliates. Affiliate risks are especially important for an entity that is part of a larger corporate group, as most entities are today. (6)

Bankruptcy-remote structuring, the legal strategy used to achieve bankruptcy remoteness, is critical to a wide range of important business and financing ventures. Investors in securitization, project finance, covered bonds, oil-and-gas and mineral production payments, and other types of structured finance transactions--valued at many trillion of dollars of securities outstanding (7)--require both the entity issuing securities and the transaction itself to be structured as bankruptcy remote. (8) Public service commissions and other regulators also require many utilities (9) and other publicly essential firms to be ring-fenced, a structure equivalent to being bankruptcy remote. (10)

Bankruptcy-remote structuring can provide valuable economic benefits. These include optimizing resource utilization by functioning as a risk- allocation device and reducing information asymmetry. (11) Investors in a bankruptcy-remote entity, for example, assume the risks associated with its assets or cash flows but few of the risks associated with the entity's affiliates or with ordinary business operations. This risk allocation can make the entity more attractive to investors, which reduces the entity's cost of capital. (12) To further reduce the cost of capital, bankruptcy-remote entities often are structured to assign higher risk to yield-seeking investors. (13) At lower borrowing costs, entities can pursue a wider range of projects and business opportunities--potentially increasing employment and shareholder wealth. (14)

Bankruptcy-remote structuring also can encourage productive risk-taking and innovation. It can enable a firm to undertake ventures that might otherwise be considered too risky within the corporate group. Investors that seek exposure to a particular project or technological development could invest in a bankruptcy-remote entity focused only on that project or development, rather than taking on risks more broadly associated with an operating business. Bankruptcy-remote structuring thereby can help to ensure that promising new ventures receive adequate capital and attention.

Parties engaging in bankruptcy-remote structuring usually seek to reallocate risk more optimally. (15) In reality, though, such structuring can create harmful externalities (16) by shifting risk from the contracting parties to the public. Some blame bankruptcy-remote securitization transactions, for example, for triggering the 2007-08 global financial crisis ("financial crisis") by inadvertently creating systemic financial risk. (17)

This Article undertakes a normative analysis of bankruptcy-remote structuring, examining the extent to which parties should have the right contractually to reallocate bankruptcy risk. It is the first to do so both from the standpoint of public policy-examining how bankruptcy-law policy should limit freedom of contract; and also from the standpoint of costbenefit analysis-examining how externalities should limit freedom of contract. (18) The Article also shows why its cost-benefit analysis should go beyond simple Kaldor-Hicks efficiency (19) and, instead, balance public benefits against social costs.

To those ends, Part I of the Article offers a typology of bankruptcy-remote structuring, explaining the most widely used categories of bankruptcy-remote structures. Part II then analyzes bankruptcy-remote structuring from a public policy standpoint, focusing on the tension between the freedom of contract that facilitates such structuring and the bankruptcy-law policies that such structuring can impair. Part III of the Article analyzes bankruptcy-remote structuring from a cost-benefit standpoint, balancing the public benefits of such structuring against its social costs. Part III examines how to reform bankruptcy-remote structuring to reduce those social costs and potentially achieve net positive benefits.

The Article's scope excludes certain industry lobbied, and somewhat idiosyncratic (if not misguided (20)), legislated rights to reallocate bankruptcy risk. (21) For example, it excludes the statutory right to foreclose on aircraft and shipping-related collateral, notwithstanding the Code's stay of foreclosure and other enforcement actions. (22) It also excludes the statutory right to enforce close-out netting against parties to derivatives and related contracts, notwithstanding the aforesaid stay of enforcement actions. (23)

1. Typology of Bankruptcy-Remote Structuring

   As mentioned, (24) two categories of bankruptcy-remote structures have evolved: structured finance transactions, such as securitizations and project finance, and the ring-fencing of utilities and other publicly essential firms. This Part I explains these categories.

   1. Structured Finance

      For structured finance transactions, the central goal of bankruptcyremote structuring is to reallocate risk by creating securities-issuing special purpose entities (25) (SPE) that, absent the bankruptcy risks inherent to operating businesses, can attract investments based on specified cash flows. (26) Except for European covered bonds, (27) this structuring relies primarily on contract. Securitization and project financing epitomize structured finance transactions.

      1. Securitization. In a typical securitization, the transaction's sponsor ("sponsor") purchases a pool of loans or other rights to payment ("financial assets") from firms, such as mortgage lenders, originating those assets ("originators") and then sells them to an SPE. (28) The SPE pays a negotiated market-value price for those assets, which it raises by issuing debt securities to investors; those securities are repayable from collections on the financial assets. (29) Investors in the SPE's securities take the risks associated with the financial assets, but they do not take bankruptcy risks associated with the sponsor or the originators. (30) Figure 1 illustrates this transaction structure.

         Securitization transactions reallocate those bankruptcy risks in two ways: by structuring the SPE to be bankruptcy remote, and by structuring the transfers of the financial assets as "true sales" to the SPE under bankruptcy law. (31) Structuring the SPE to be bankruptcy remote requires protecting it against all the ways that it might become the subject of a bankruptcy case, of which there are three: voluntary bankruptcy, (32) involuntary bankruptcy, (33) and substantive consolidation. (34)

         Protecting an SPE against voluntary bankruptcy usually is done by restricting the circumstances, as a matter of corporate governance, under which the SPE could choose to file for bankruptcy. For example, the SPE's articles of incorporation or other organizational documents typically require the consent of one or more independent directors, whose interests would be allied with investors in the SPE's securities, in order to authorize a voluntary bankruptcy filing. (35) Protecting an SPE against involuntary bankruptcy usually is done by restricting the SPE's creditors to investors in its securities. (36)

         Protecting an SPE against substantive consolidation can be slightly more complicated. (37) Substantive consolidation is an equitable doctrine of bankruptcy law that enables a court, under appropriate circumstances, to consolidate the assets and liabilities of otherwise legally separate firms or other entities. (38) Bankruptcy courts assess substantive consolidation on a case-by-case basis, after consideration of the relevant facts of each case. (39) They consider the nature of the relationship between the entities to be consolidated, examining whether there is substantial identity between those entities. (40) If a court determines that there is such a substantial identity, there are two schools of thought as to how it should rule. One school of thought applies a balancing test, the other applies more of a "do-no-harm" test.

         The balancing test currently is applied in the D.C. Circuit (41) as well as in the Eleventh and Ninth Circuits. (42) This test allows substantive consolidation if its benefits "'heavily' outweigh the harm." (43) The do-no-harm test currently is applied in the Second and Third Circuits. (44) That test, which recognizes that an equitable remedy should not be used...