Ice cube bonds: allocating the price of process in Chapter 11 bankruptcy.

• Author: Jacoby, Melissa B.
• Position: Introduction through II. Rethinking the Theoretical Debate B. Cataloguing the Problems with Expedited All-Asset Sales 1. Valuation Problems, p. 862-905

ARTICLE CONTENTS INTRODUCTION I. EXPEDITED SALES OF ALL OR SUBSTANTIALLY ALL ASSETS: ARTICULATING THE PROBLEM A. The Doctrinal Framework for Chapter 11 Sales B. Chrysler and the Problem of Melting Ice Cube Leverage II. RETHINKING THE THEORETICAL DEBATE A. The Value Created by Bankruptcy (Sales) B. Cataloguing the Problems with Expedited All-Asset Sales 1. Valuation Problems a. Information Scarcity and the Informational Sweet Spot b. Information Asymmetry c. Leverage d. Conflicts and Principal-Agent Problems e. Institutional Capacity (Ex Ante) 2. Distributional Consequences C. Quantifying and Allocating the Costs and Benefits of Expedited All-Asset Sales 1. The Speed Premium and Increased Error Costs--Kaldor-Hicks Efficiency 2. Distributional Consequences--Pareto Optimality and Bargaining over the Speed Premium a. Baseline Distributions--Best Interests and Pareto Optimality b. Allocating the Speed Premium i. Who Is Entitled to the Speed Premium? ii. Delayed Realization, Chapter-11-Created Value, and the Limits of Proceeds iii. Gaps in Security and Priority iv. Impact of Bankruptcy Priority Rules on Allocation of the Bankruptcy-Code-Created Value III. ICE CUBE BONDS A. Authorization Under Current Law B. Operationalizing the Ice Cube Bond 1. How Much? 2. Who Pays? 3. When to Release? C. Potential Concerns 1. Priority Rules 2. Institutional Competence 3. Incentives 4. Bargaining 5. Comparison with Other Lock-up Related Proposals CONCLUSION INTRODUCTION

Financially distressed companies can melt like ice cubes: every day that a company burns through more cash than it earns, it loses value. (1) In Chrysler's Chapter 11 bankruptcy, the bankruptcy court's finding that the car company was losing $100 million per day justified a hurry-up going-concern sale of all of its assets under [section] 363(b) of the Bankruptcy Code. (2) The Second Circuit agreed that these exigent circumstances justified the procedural shortcuts taken to accomplish the sale, citing the "melting ice cube" theory. (3)

Though the Supreme Court vacated the Second Circuit decision in Chrysler, (4) the Second Circuit's use of the melting ice cube argument was well within the judicial mainstream. (5) The government's role as a source of debtor-in-possession and exit financing was novel, but the expedited sale of all the company's assets outside a plan of reorganization was not. Hurry-up all-asset sales under [section] 363 of the Code ("363 sales") are now a common feature in the bankruptcies of large public companies. (6) A decade ago, Douglas Baird and Robert Rasmussen declared the classic business reorganization dead; the going-concern sale had replaced the traditional Chapter 11 reorganization. (7) While the claim may have been overstated as an empirical matter, many high-profile Chapter 11 cases, including the bankruptcies of Enron, Adelphia, and Lehman Brothers, have disposed of major assets through sales outside of a Chapter 11 plan. (8) Members of Congress were sufficiently concerned after the Gulf oil spill that BP would try to engineer a quick 363 sale to shed liabilities that they preemptively sought to change the Code. (9) Pleas for quick 363 sales frequently feature the melting ice cube argument--a "strong assertion of nonviability" because of an alleged rapid wasting of assets--as a justification for short-circuiting the Chapter 11 plan process. (10) The practical effect is to lock up the proposed sale package, and to raise the cost of investigating alternatives.

Although the largest cases attract public attention, small- and mid-market cases also feature proposals for quick all-asset sales. (11) Smaller debtors may have fewer assets to burn, fewer financing options, a weaker corporate infrastructure to help keep the business together, less publicly available financial information, and a lower likelihood of an active creditors' committee to counterbalance other forces. A going-concern sale may be the best, or only, option, but, as these cases often involve non-public companies, concerns about leverage resulting from timing-related information asymmetries may be even greater. (12) In such cases, the disclosure regime associated with Chapter 11 plan confirmation may be of particular value.

Quick sales, therefore, raise a policy question in bankruptcies of all sizes: is Chapter 11's speed and flexibility a bug or a feature? Do these sales maximize value for the bankruptcy estate? Or do they facilitate collusive deals between incumbent managers, senior creditors, and potential purchasers? The answer is a little bit of both. Some companies really are melting away--worth far more today than they will be tomorrow. Acting quickly will benefit all stakeholders. But calling something a melting ice cube does not make it one. And, even the fact of a melting ice cube does not justify exploitation of the resulting transactional leverage to disadvantage other claimants. It is, therefore, crucial to distinguish a case in which the court and claimants have good information about the company's value and the costs of delay, from a case in which sale proponents (13) are seeking to exploit information asymmetries and crisis-created leverage to strong-arm a deal that opportunistically appropriates value. (14)

Speed comes at a cost. Early in a bankruptcy case, information is limited on two separate axes: the value of claims against the firm and the cost of taking time to learn more. Characterizing the company as a melting ice cube ratchets up the perceived costs of learning more and enables a prospective purchaser to present its terms as "now or never," or "my way or the highway." The melting ice cube argument is, thus, a tool that can be used to lock-in or strong-arm a particular deal. (15) In this regard, we join a number of corporate and bankruptcy scholars who have raised concerns about management-sponsored corporate sales, in which parties with leverage cement a favored deal through devices such as lock-up agreements, topping fees, bidder protections, or breakup fees. (16)

As currently applied, the Code and case law are inadequate to address the challenges posed by expedited all-asset sales. Section 363(b) of the Code provides, in relevant part, that the debtor may sell property of the estate "other than in the ordinary course of business" with court approval after "notice and hearing." (17) This language applies equally to sales of a single company car as it does to the sale of an entire car company. The Code provides no substantive guidance or remedial nuance to enable the court or creditors to sort between positive and negative value sales, or to determine when delaying the sale would be beneficial to the estate. (18)

The leading decision in the Second Circuit, Lionel, overturned a bankruptcy court order approving the sale of stock in a subsidiary because the debtor-in-possession proffered no "business justification" for short-circuiting the Chapter 11 plan process. (19) Yet, the Lionel standard has evolved to provide a blueprint for hurry-up sale motions. (20) Under current practice, if the sale proponent offers a plausible business justification, the court can (and, we believe, usually does) approve it. (21) Some courts have issued guidelines or local rules of procedure to put more flesh onto the sale review process. (22) Sales sometimes do not go forward due to other challenges. But when a proposed sale is presented as a unique, time-limited opportunity, judges understandably are reluctant to stand in the way. If delay risks destroying millions of dollars in value, that is a high price to pay for process. (23) Those pushing the quick sale can thus exploit this Hobson's choice to their advantage.

Recent empirical work by Lynn LoPucki and Joseph Doherty suggests that this concern is not merely theoretical. After finding that 363 sales yielded a substantially lower percentage of book value than reorganizations in large public company bankruptcies, they concluded that quick all-asset sales were working to the benefit of purchasers (and senior creditors), but to the detriment of other claimants and the bankruptcy estate. (24) Other commentators have interpreted LoPucki and Doherty's results as showing that [section] 363 allows senior secured creditors to push for "inefficient fire sale[s]." (25)

Chrysler notwithstanding, in recent years, senior secured creditors have more typically played a significant, if not dominant, role in the decision to pursue a 363 sale. (26) Frequently, the secured creditor asserts a first-priority lien on all of the company's assets and further asserts that the company is worth less than the amount of its claims. (27) If other claimants are deeply under water, why should they have anything to say about the sale's timing and terms?

We see several reasons. First, a so-called blanket lien may not be comprehensive due to creditor error, gaps in the scope of statutory schemes, and value that is not lienable at all or not traceable to the lender's collateral. (28) Second, it is not obvious that the secured creditor is entitled to the firm's reorganization premium or the speed premium allegedly created by a quick sale. (29) Early all-asset sales also foreclose any hope for junior claim or interest holders that the assets will increase in value during the case, either by waiting to sell at a later date, or by reorganizing the business. This reorganization option has monetary value, and therefore should be considered when analyzing the costs of a quick sale. (30) All-asset sales outside a Chapter 11 plan constitute a realization on the debtor's assets, foreclosing the reorganization option, and transferring any upside to the purchaser. (31) These points undercut the argument that a senior secured creditor should be treated functionally as a sole owner of a bankrupt firm for governance purposes. (32)

The recent literature on 363 sales has been polarized, especially after Chrysler. Some critics have focused on speed and...