Behind Closed Doors: the Influence of Creditors in Business Reorganizations

• Publication year: 2011

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 34, No. 4SUMMER 2011

Behind Closed Doors: The Influence of Creditors in Business Reorganizations

Michelle M. Harner(fn*) and Jamie Marincic(fn**)

Abstract

General corporate law delegates the power to manage a corporation to the board of directors. The board, in turn, acts as a fiduciary and generally owes its duties to the corporation and its shareholders. Many courts and commentators summarize the board's primary objective as maximizing shareholder wealth. Accordingly, one would expect a board's conduct to be governed largely by the interests of the corporation and its shareholders.

Yet anecdotal and increasing empirical evidence suggest that large creditors wield significant influence over their corporate debtors. Although this influence is most apparent when a corporation approaches insolvency, often the strength of the creditors' negotiating position is based on the terms of the pre-insolvency contract. Creditors typically obtain restrictive covenants and veto rights that allow them to assert control over various corporate actions. Nevertheless, the extent of creditor influence is hard to gauge accurately because it frequently materializes behind closed doors in negotiations be-tween the corporation and creditors over refinancing terms, for-bearance agreements, covenant waivers, or rescue financing.

This Article sheds some light on the nature and extent of creditor influence by examining creditor influence over corporate debtors and creditors' committees in chapter 11 reorganization cases. Specifically, the Article reports and analyzes data from an empirical survey of professionals and individual creditors participating in the chapter 11 process. In many respects, the data confirm what commentators have gleaned from the terms of creditors' contracts and activity documented on chapter 11 dockets: creditors are exerting greater influence over corporate decisions in the restructuring context.

Introduction

Chapter 11 of the U.S. Bankruptcy Code is the primary tool for restructuring the financial obligations of a distressed company in a single forum-the U.S. bankruptcy court. When a company files a chapter 11 case, it is subject to extensive disclosure requirements, including a detailed listing of its assets and liabilities, information regarding its financial affairs, and monthly operating reports.(fn1) All of these disclosures must be filed with the bankruptcy court and made available to the public. In addition, parties holding claims against, or interests in, the company may request information from the company, either informally or through a formal examination under § 343 of the Bankruptcy Code and Rule 2004 of the Federal Rules of Bankruptcy Procedure.(fn2) As a result, a debtor often is said to be "operating in a fishbowl" during the pendency of its chapter 11 case.(fn3)

Notably, these disclosure requirements generally apply only to the debtor, and they primarily concern the debtor's business operations and financial condition. They do not, for example, apply to the debtor's creditors or shareholders or necessarily describe discussions or negotiations among these parties.(fn4) In fact, much of what transpires in a chapter 11 case happens "off-docket"-i.e., the parties stake their positions and negotiate potential resolutions to the case behind closed doors, disclosing only limited information to the bankruptcy court and other parties in interest and only on an as-needed or as-required basis.(fn5)

The delayed or selective disclosure of information concerning negotiations in a chapter 11 case may facilitate a consensual resolution to the case.(fn6) Debtors often have multiple stakeholders with competing interests; with latitude to negotiate out of the public spotlight, debtors are able to understand their stakeholders' real issues and motivations without the noise frequently associated with parties jockeying for position before the court. This type of off-docket activity is common in chapter 11 cases and has helped numerous debtors reorganize successfully.(fn7) Yet as the parties and dynamics of chapter 11 cases change, the typical off-docket activity may produce unintended consequences.(fn8)

One such unintended consequence is a shift in control of the restructuring process from debtors to one or more creditors.(fn9) Commentators have observed that creditors-particularly secured creditors-are exerting more control over debtors, including if and how the debtors reorganize in chapter 11.(fn10) Secured creditors often obtain this position of influence through covenants and rights in their credit documents with debtors. These rights can be significant and can lead to a "loan to own" situation whereby the lender converts its debt into an ownership stake in the reorganized company.(fn11) The concern arises because creditors owe no duty to other stakeholders in the chapter 11 case, and their self-interested conduct may impair value to the direct detriment of junior stakeholders.

The scope of chapter 11 disclosures and the off-docket activity in chapter 11 cases also provide opportunities for unsecured creditors to influence the restructuring process. These parties can accumulate a debtor's unsecured debt to obtain a seat at the negotiating table.(fn12) The debtor is rarely aware that the creditor is amassing a majority position, and the creditor typically has an agenda different from the debtor's other stakeholders. Because the creditor is not required to disclose its position, and because only select parties are privy to the debtor's restructuring negotiations, the creditor may be able to leverage the process to its distinct advantage.(fn13) Again, the interests of junior stakeholders and the company itself may be harmed in the process.

The Bankruptcy Code contemplates a statutory committee of unsecured creditors (creditors' committees) as one of the parties at the negotiating table with the ability to monitor the activities of the debtor and its stakeholders.(fn14) In theory, the creditors' committee should temper the influence of secured and unsecured creditors trying to use the chapter 11 process for their personal gain rather than for the benefit of the debtor and all of its stakeholders. In practice, however, creditors' committees also are vulnerable to the influence of certain creditors, leaving no objective check on the restructuring process.(fn15)

This Article contributes to the ongoing dialogue regarding governance and creditor influence in chapter 11 cases by presenting empirical survey data collected from professionals who work in these cases and creditors who serve on chapter 11 creditors' committees. Part I describes the methodology and basic components of the survey. Part II explains the key survey data, providing not only informative descriptive information but also several interesting analyses regarding potential motivations and characteristics underlying key survey responses. Part III concludes by considering the implications of the survey data in light of a related empirical study performed on 296 chapter 11 cases and encouraging more research and discussion regarding the challenges created by, and the potential benefits of, the evolving role of creditors in chapter 11 cases.

I. Purpose and Scope of Survey

Chapter 11 of the Bankruptcy Code allows a company to file a bankruptcy case without losing control of its assets, business operations, or restructuring efforts. The company acts as a "debtor in possession" (DIP) in the chapter 11 case, which allows the company's management to continue to make key decisions on behalf of the company and its stakeholders.(fn16) The U.S. trustee oversees the administration of the case, and it appoints one or more committees of creditors and equity holders (such as the creditors' committee) to monitor the debtor's conduct and advocate the interests of the represented class of stakeholders in the case.(fn17)

Although the bankruptcy court presides over the chapter 11 case, and a debtor must obtain bankruptcy court approval of its plan of reorganization and most major transactions in the case, neither the bankruptcy court nor the U.S. trustee supervise the debtor's day-to-day operations or its dealings with stakeholders.(fn18) Thus, the bankruptcy court and U.S. trustee typically become aware of issues only after the debtor or stakeholder files a pleading.(fn19) As a result, the role of the creditors' committee often is central to ensuring a fair and successful reorganization process.(fn20)

In many cases, the creditors' committee and the debtor cooperate to restructure the debtor's financial obligations and, in some instances, business operations, in a manner consistent with the dual goals of the Bankruptcy Code-rehabilitating financially troubled companies and maximizing the returns to creditors.(fn21) Yet in other cases, a single creditor or a small group of creditors influence the debtor or the creditors' committee-or both-in a manner that jeopardizes the debtor's restructuring efforts or potentially decreases the value available to all stakeholders.(fn22) Unchecked creditor influence can lead to costly disputes among stakeholders, conflicts of interest, and self-dealing.

Anecdotal evidence suggests that creditor influence in chapter 11 cases is increasing, and several empirical studies confirm this trend.(fn23) The increasing influence of creditors raises interesting questions about the role...