Distorted Choice in Corporate Bankruptcy.

• Author: Skeel, David A.

ARTICLE CONTENTS

INTRODUCTION 369 I. THE NEW DISTORTIVE TECHNIQUES 378 A. RSAs (and PSAs): The ResCap Case 379 B. Deathtrap Plan Provisions: The Momentive Case 381 C. A Brief History of the New Distortive Techniques 383 1. The Rise of Restructuring and Plan Support Agreements 384 2. The Expanding Role of Deathtrap Provisions 386 II. WHY IS DISTORTION TOLERATED? 388 A. The Baseline Is Not Neutral. 390 B. The Case for Permitting (Some) Distortion 392 III. RULES OF THUMB FOR THE NEW DISTORTIVE TECHNIQUES 395 A. Are Holdouts Present (or Likely) ? 396 B. How Coercive Is the Distortive Technique? 398 C. The Presence of Independent Justifications 401 D. Is the Holdout Risk Created by Contract? 404 E. Should Creditors Be Permitted to Change Their Votes? 406 IV. APPLYING THE FRAMEWORK: FOUR CASE STUDIES 407 A. PREPA: A Complex RSA 407 B. Momentive: A Complex Deathtrap 412 C. Coal Company RSAs and Deathtraps 414 l. Arch Coal 414 2. Peabody Energy 416 V. EXTENSIONS 421 A. Gifting Transactions 421 B. Coercive Bond Exchanges 423 CONCLUSION 426 INTRODUCTION

We ordinarily assume--or at least pretend to assume--that a central objective of every voting process is ensuring an undistorted vote. Protecting the integrity of a vote is sometimes difficult, and the best way to achieve this may be contested, as reflected in the controversies over the Supreme Court's voting-rights jurisprudence and in debates over possible foreign interference in the last presidential election. (1) But nearly everyone agrees that the goal should be to remove distortions so that voters can resolve the question at hand on the merits.

Recent developments in corporate bankruptcy are quite puzzling from this perspective. Chapter 11 is organized around an elaborate vote. The debtor or other proponent of a reorganization plan divides the creditors and shareholders of the company into different classes, (2) and the creditors or shareholders in each class vote to approve or reject the proposed plan. (3) If every class of creditors and shareholders votes in favor of the proposed plan, and it satisfies a number of other requirements, the bankruptcy judge will confirm the plan. (4) Bankruptcy law gives the bankruptcy judge ample tools to police any distortions. Voting cannot begin until the court approves a disclosure statement giving the creditors and shareholders "adequate information" about the proposed plan, (5) for instance, and the judge can disqualify problematic votes. (6) The law on the books is intended to produce a simple undistorted vote.

Yet the law as it plays out in practice looks radically different. Two of the most important developments in recent bankruptcy practice are intended to distort, and clearly do distort, the voting process. They remove creditors' ability to vote simply on the merits--that is, to vote based on the plan's proposed payout for their class.

The first is the emergence of restructuring support agreements (RSAs). (7) In the simplest type of RSA, the debtor negotiates the terms of a potential reorganization plan with a subset of its creditors--often focusing on multiple classes of creditors but sometimes targeting a single class. The RSA commits its signatories to support a future reorganization plan that conforms to the terms of the RSA, including the proposed payout to each creditor class. A creditor that signs the RSA relinquishes its ability to decide independently whether to support a reorganization plan subsequently proposed by the debtor. It does this before--often long before--a disclosure statement is approved and the proposed reorganization is submitted to creditors for a vote.

Many recent RSAs further distort the decisionmaking process by offering to pay a "support fee" to creditors who sign the RSA. Such "signing-fee RSAs" offer compensation that may reimburse creditors for the professional fees they incurred while negotiating the RSA. A signing-fee RSA may also include a fee for supporting the reorganization plan when it is proposed and waiving the right to object, as in agreements involving Puerto Rico's electricity company and Peabody Energy. (8)

Alternatively, the RSA may provide a benefit to signatories, such as the right to provide debtor-in-possession financing during the case or to participate in a rights offering after the debtor's reorganization plan is confirmed. (9) These inducements, which are available only to those who sign the RSA, look like a form of vote buying, since they compensate signatories who commit to supporting an upcoming plan.

The second recent development is the use of "deathtrap" provisions in proposed reorganization plans. In a traditional deathtrap provision, the debtor proposes to give a creditor class some form of compensation if it votes "yes," but cuts it off altogether if it votes "no." The reorganization plan in the Trident Holding Company bankruptcy said, for instance, that if the first lien classes and the second lien classes "are Accepting Classes, each Holder of an Allowed Second Lien Claim shall receive its Pro Rata share and interest in 1% of the Warrants," but if the First Lien Classes or the Second Lien Classes "are not Accepting Classes, Holders of Allowed Second Lien Claims shall not receive any distributions on account of such Allowed Second Lien Claims." (10)

A more elaborate version--the "individually targeted deathtrap"--may offer one form of compensation to individual creditors who vote "yes" and a different compensation to individual creditors who vote "no." (11) In each case, the point is to apply pressure, using both a carrot (the compensation for a "yes" vote) and a stick (worse treatment of "no" votes) to nudge the creditors or shareholders to vote in favor of the plan. (12)

RSAs and deathtraps can distort the voting process in at least three ways. (13) First, if they include supplemental payments, the additional compensation pressures creditors to vote for the reorganization plan even if creditors believe the payout is too low. These payments require a creditor to forgo compensation if she or the class votes "no," and thus make a "no" vote more expensive and less attractive for reasons unrelated to the creditor's views on the underlying merits of the plan. Second, distortive techniques can procedurally warp the voting process by binding creditors before the plan has been formally proposed and using exploding offers to induce creditors to commit early on. Third, RSAs and deathtraps may even distort the voting process by decreasing creditors' likelihood of success in challenging the plan in the event the class of creditors votes "no." (14) By making the alternative to voting "yes" less attractive, these techniques can coerce creditors to vote for the plan. (15)

Despite the ubiquity of the new distortive techniques, they are just beginning to attract attention in the scholarly literature. Several scholars have written about RSAs, (16) but I am not aware of any articles that devote meaningful attention to the use of deathtrap provisions or to the increase in voting distortions more generally. This Article is the first to attempt a more comprehensive analysis of the new landscape of distorted voting.

One obvious solution to bankruptcy's voting distortions might be to prohibit or sharply restrict their use. This is the usual strategy elsewhere, and in corporate law, Delaware courts have in fact banned a somewhat analogous distortion that featured in freeze-out mergers. (17) In the past, a corporate parent could use subtle forms of coercion when freezing out the minority shares of a subsidiary. If the parent made a tender offer for the minority shares, for instance, it could hint that any untendered shares would be neglected after the tender offer, (18) thus diminishing the value of untendered shares. Delaware courts have cracked down on these practices by imposing a stringent antidistortion rule. (19)

The same approach could easily be employed in Chapter 11. In its strong form, an antidistortion rule would ban the use of RSAs and deathtrap provisions altogether, since each distorts the voting process. Under a weaker antidistortion rule, courts might prohibit only the variations of RSAs and deathtraps that introduce the most significant distortions, such as signing-fee RSAs and individually targeted deathtraps.

The antidistortion approach has considerable appeal, especially for those of us who already are attracted to rule-of-law moralism. It would ensure a much more unbiased Chapter 11 vote than the vote in most current reorganization cases, while also reducing the risk of windfalls to favored creditors. It also would be relatively simple to implement. As already noted, existing bankruptcy law gives judges powerful tools to curb voting distortions. Before the debtor can solicit votes on a proposed reorganization plan during the case, for instance, the bankruptcy court must find that the disclosure statement provides "adequate information" to creditors. (20) A court could easily hold that an RSA violates this provision--and on rare occasions, courts have done precisely this. (21) RSAs and deathtrap provisions also could be struck down as inconsistent with the obligation that the plan be "proposed in good faith and not by any means forbidden by law." (22) If antidistortion is the best solution, it lies readily at hand.

The first clue that banning the new distortive techniques may not be the optimal solution comes from the response of the bankruptcy courts. With only a few exceptions, most of them in the early 2000s, bankruptcy judges have upheld both RSAs and deathtrap provisions. To be sure, bankruptcy judges' endorsement does not necessarily mean there is no reason to worry about the distortive techniques. It is possible that judges have not yet fully recognized the distortive effects of the new techniques, or that bankruptcy judges are too quick to approve the use of provisions that make successful reorganization more likely. But courts'...