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

• Author: Jacoby, Melissa B.
• Position: II. Rethinking the Theoretical Debate, B. Cataloguing the Problems with Expedited All-Asset Sales 2. Distributional Consequences through Conclusion, with footnotes, p. 905-947

2. Distributional Consequences

   The cases that raise the most explicit distributional issues involve sale orders that contain explicit instructions about how to allocate value. These sales are often attacked as "sub rosa" plans--plans of reorganization disguised as sales in order to evade the requirements of plan confirmation. (163) The procedures that govern the Chapter 11 plan process do not apply to the debtor-in-possession's powers to administer the estate, such as the power to sell and use property of the estate under [section] 363, or the power to incur debt under [section] 364. But when the power to sell includes selling everything, and the power to borrow includes terms that predetermine the distribution of proceeds, the plan process can be rendered irrelevant. Thus, early sales, coupled with restrictive financing, facilitate the use of transactional leverage for individualized benefit, particularly by creditors holding prepetition undersecured claims. But even sales that lack obvious sub rosa features can have significant distributional consequences and are procedurally noncompliant, in that they short-circuit the safeguards of Chapter 11.

   As we describe below, the Code contains well-developed procedures, with a long historical provenance, that allows parties to negotiate an allocation of enterprise value in the shadow of an established disclosure regime (applicable to Chapter 11 plans), a mandatory set of legal findings, and a distributional scheme established by state law and the priority rules for Chapter 7 liquidations. The Chapter 11 plan confirmation process imposes important limits on the use of transactional leverage to divert value.

   Section 1125 of the Code requires a disclosure statement that provides claimants with "adequate information" to make an informed decision whether to support or oppose a plan of reorganization. (164) Section 1129(a)(7) requires a finding that each claimant will receive at least as much under the plan as they would if the debtor were liquidated under Chapter 7. (165) This means that the distributions under the proposed plan must respect the distributional priorities contained in Chapter 7.

   Code-authorized priorities among unsecured claims are rooted both in the exigencies of bankruptcy, and in other public policy considerations. For example, unpaid employee wage claims get special priority, (166) and Chapter 11 entitles such claimants to payment in full in cash on the effective date of a confirmed plan. (167) The Code also requires the debtor-in-possession to cure defaults in executory contracts that will be assumed and performed. The estate's counterparty goes from being entitled to only a pro rata share of the debtor's unencumbered assets, to being entitled to one hundred percent payment of its prepetition claim. (168) Debtors-in-possession can seek court permission to give super-priority or secured status to lenders offering to extend credit to the bankruptcy estate. (169) These Code-authorized liens and priorities subordinate prepetition creditors in the interest of a successful reorganization.

   Yet, a common theme of these Code-authorized priorities is that they do not exacerbate, and are often designed specifically to limit, the leverage of prepetition creditors on the eve of, and early in, a bankruptcy case. The employee wage priority protects people who often have little leverage. (170) The executory contract provisions allow the debtor to hold a non-debtor to its contract notwithstanding bankruptcy, and sometimes require the non-debtor to accept a contractual assignment, even if the non-debtor would prefer to do business with someone else. The financing provisions are meant to prevent prepetition creditors from placing a credit stranglehold on the debtor.

   Other mechanisms for redistributing value have developed (sometimes on shaky statutory grounds) through bankruptcy practice or been placed into the statute as a result of interest group lobbying. (171) Rather than reducing stakeholder leverage, many reflect the power of certain participants in the bankruptcy process. Texlon-type cross-collateralization and critical vendor motions, discussed below, are two prominent examples.

   Texlon-type cross-collateralization, named for the first case to criticize it, (172) involves the granting of postpetition liens to secure unsecured prepetition debt. The postpetition priorities and liens authorized in [section] 364 speak only of security for new postpetition loans and do not disturb the relative priority of prepetition obligations. (173) The Code does not expressly authorize debtor-in-possession financing orders that use new liens to secure, and effectively pay, prepetition debt. But the case law of some jurisdictions permits cross-collateralization or arrangements such as roll-ups, if deemed to be in the best interest of the estate after considering multiple factors. (174) Just like the melting ice cube sale, the call for financing deals with these terms typically depends on an assertion that the situation is dire, that there is no other possible financing, and no other prospect of preserving value for stakeholders. (175)

   Similarly, some courts permit debtors to invoke the equitable "doctrine of necessity" to give special treatment to so-called critical vendors, with whom business relationships must be preserved, by paying their prepetition debts in full and early in a case. (176) Supporters of these payments assert, sometimes without much evidence, that the deviation from priority makes creditors better off as a whole--a small price to pay, they say, if the absence of critical vendor cooperation will undermine the entire reorganization. But if too many parties exploit their leverage, and courts do not enforce the "critical" standard rigorously, those demands for cash and special treatment early in the bankruptcy case will have the opposite effect: smaller payouts for other creditors and a lower likelihood of reorganization. (177)

   Quick all-asset sales raise the same kinds of questions as these suspect types of priority. (178) Indeed, the push for a quick sale can be tightly intertwined with proposed debtor-in-possession financing by a prepetition secured creditor, with the financing order (rather than the sale order) realigning statutory priorities. It is possible that the transaction is still in the best interest of creditors notwithstanding the distortion of bankruptcy priorities. Highly charged sale environments, in which parties proclaim the need for speed, make it difficult to determine whether the buyer is walking away with more than its share, leaving others with less. (179)

   While we do not inherently prefer reorganizations over going-concern sales, we do favor sales with more information and opportunity for bargaining in the shadow of the Code over sales concluded with less. We therefore favor going-concern sales accompanied by the procedural protections of a Chapter 11 plan to those conducted under [section] 363 without disclosure, solicitation, voting, and judicial confirmation. If a going-concern sale is proposed as part of a Chapter 11 plan, the plan proponent must provide "adequate information" in a disclosure statement, usually including an explicit comparison to a Chapter 7 liquidation, as well as adequate time to evaluate the proposal. (180) Expedited 363 sales, by contrast, run the risk of cutting short the opportunity to compare the value of the assets to the proposed price, to compare the proposed price to what might be offered were the debtor to be exposed to the market over a longer period of time, or to consider the benefits of a true reorganization. In other words, expedited all-asset sales of alleged melting ice cubes shift the risk of undervaluation to the estate and allow distributional distortions--even if the sale does not expressly dictate allocation as the Chrysler sale did. Our Ice Cube Bond proposal in Part III seeks to reduce this reallocation of risk and seeks to limit the leverage associated with a melting ice cube crisis.

   3. Quantifying and Allocating the Costs and Benefits of Expedited All-Asset Sales

   The discussion so far, reduced to its essentials, suggests that the bankruptcy estate benefits from a quick 363 sale under some but not all conditions, and that parties with conflicts of interest may use the melting ice cube argument to distort the choice between a quick sale outside a plan, a sale under a plan, and a reorganization under a plan. In this next Section, we explore how to sort between value-maximizing and opportunistic quick sales.

1. The Speed Premium and Increased Error Costs--Kaldor-Hicks Efficiency

   Chapter 11 can help maximize the value of a debtor in a number of ways. As explored in Part I, Chapter 11 captures value that would have been lost in a piecemeal sale under ordinary state law mechanisms or in a Chapter 7 liquidation. This value can be preserved through a traditional plan of reorganization, or through a Chapter 11 plan with a going-concern sale as its centerpiece. This sale-created value derives in part from the flexibility of Chapter 11, which in practice allows pragmatic structuring of sales, a short timeframe (even under a plan), and, most importantly, the transfer of clear title. (181)

   Sometimes, however, preservation of this Chapter-11-created value may require a quick 363 sale prior to plan confirmation; this increment of preserved value is what we call the "Speed Premium." The Speed Premium is the difference between the proposed "Expedited Sale Price," (182) and the present value of the price if one delays the sale until approval of a Chapter 11 plan or substitutes a traditional reorganization (the "Hypothetical Plan Price"):

   Speed Premium = Expedited Sale Price--Hypothetical Plan Price

   The asserted benefit of a quick sale does not exist unless, at the very least, the quick sale price exceeds the anticipated price under a Chapter 11 plan. (183) In other words, the value of the assets...