TAKING CONTROL RIGHTS SERIOUSLY.

• Date: 01 June 2018
• Author: Rasmussen, Robert K.

INTRODUCTION 1749 I. THE ALLOCATION OF CONTROL RIGHTS OUTSIDE OF BANKRUPTCY 1756 II. CONTROL RIGHTS INSIDE BANKRUPTCY 1765 III. CONTRACTING FOR CONTROL 1769 CONCLUSION 1775 INTRODUCTION

The Bankruptcy Code deals first and foremost with the cash flow rights of the debtor's various investors. The immediate cause of most corporate bankruptcy filings is a company's pending inability to pay off its obligations that are becoming due. The firm has made promises to pay various parties, and it does not have the financial wherewithal to live up to those obligations. It lacks the liquidity necessary to continue to service its debt and has either defaulted on its obligations or faces imminent default. In short, there is a mismatch between the company's capital structure and its future revenues.

Restructuring the business's balance sheet under Chapter 11 is designed to address this mismatch between obligations and available resources. The goal is to create a capital structure that better reflects the future revenues of the firm. The heart of Chapter 11 is the absolute priority rule. It sets forth the conditions that must be met for an investor to see her cash flow rights changed over her objection. (1) Those holding secured debt can see their principal reduced, the interest rates on the debt trimmed, and the term of the loan extended. Unsecured debt can be reduced, paid off at pennies to the dollar, or converted to equity. Equity can be drastically diluted or even wiped out in full. Specifying the extent to which the various parties' rights can be adjusted over their objection structures the bargaining process that leads to a plan of reorganization.

Over the decades, much ink has been spilled over the extent to which there are deviations from absolute priority in practice and the extent to which other mechanisms could be implemented that would vindicate the rule. (2) Recently, there has been serious questioning of the wisdom of the Code's strict adherence to absolute priority, with the suggestion that we return to the world of relative priority. (3) Regardless of which flavor of priority one prefers, in every reorganization case the central issue that is the focus of reorganization law is how cash flow rights are adjusted--what claims will the prebankruptcy investors have against the restructured company?

The Code deals with cash flow rights in other ways besides adjusting investors' rights to cash flow at the end of the proceeding via a plan of reorganization. For example, all rights to receive payments based on prepetition debts are stayed by the filing of a bankruptcy petition. (4) Some transfers of money made on the eve of bankruptcy can be undone. (5) Transactions of the last few years can be scrutinized to see whether the debtor received an adequate return for property that it has transferred to others. (6) The debtor can decide whether to continue with transactions in progress. (7) All of these situations adjust outside parties' legal rights to receive money from the debtor.

Bankruptcy law, in contrast, has little to say about control rights over the running of the business. (8) It by and large allows the existing management to remain in charge of the debtor. (9) State law vests the ultimate authority over a company's operations with the firm's board of directors, (10) and bankruptcy law leaves that structure in place. Boards, in turn, delegate the running of the company to the CEO and the executive team, and the Code takes this allocation of authority as the baseline for operating the debtor, both during the case and afterwards.

To be sure, the Code modestly curtails the board's and managers' sphere of autonomy in some situations. To the extent that the managers want to do something out of the ordinary, they need court approval. A court must grant permission to pay off prepetition suppliers that the managers deem critical to the debtor's continued operations. (11) Borrowing money outside of the ordinary course of business needs court approval. (12) Decisions to sell most or all of the assets of the business require the court's blessing. (13) Yet the Code provides little guidance to the bankruptcy judge on how to assess a request when those in charge seek the requisite permission. Case law suggests that for major transactions, such as the sale of an entire firm, the burden on the managers is to articulate a "business justification" for the proposed action. (14) On its face, this articulation sounds a bit more demanding than the "business judgment rule" that effectively insulates most corporate transactions outside of bankruptcy from judicial questioning. The increase in scrutiny, however, is modest at best. Few cases can be found where the bankruptcy judge rejects the justification that the managers put forward. The upshot is that, at least as a formal legal matter, control of the company prior to the confirmation of a plan of reorganization remains with those who had control prior to the commencement of the case.

There is a change of control rights at the end of the case when a plan of reorganization is confirmed. It is not, however, that lenders receive the legal authority to make decisions with respect to the deployment of the company's assets, as lenders. Rather, lenders are given new interests in the reorganized company. In most cases where the debtor is not sold to a new owner, (15) the standard result is that shares in the reorganized company are distributed to the prebankruptcy investors. They do not go to the old shareholders; (16) instead, they go to the former debt holders. Precisely how the securities are distributed depends on where in the waterfall the value of the company runs out. (17) The point is that Chapter 11 does not give control rights to creditors. Rather, it changes the creditors (or at least some of them) into shareholders. (18)

However, bankruptcy law does one thing in the area of control rights. It abrogates all efforts to parcel out control rights via contract. To the extent that the parties have contracted for the debtor to take certain action, the debtor can reject the contract. (19) Attempts by third parties to exercise control over the assets of the estate, even if these parties are otherwise legally entitled to take such action, are blocked by the Code's automatic stay. (20)

One can question the Code's obsession with cash flow rights and the relative neglect of control rights. From a societal perspective, getting the right decisions as to the deployment of assets matters more than who collects the spoils. Control rights in the end determine the size of the pie. Cash flow rights merely determine how the pie is sliced. The paramount question facing any enterprise is who makes the decisions regarding the future of the business. When scholars look at corporate decisions, they have a tendency to focus on the incentives caused by cash flow rights. It is undoubtedly true that incentives matter. Consider, for example, the issue of executive compensation. Tying a CEO's compensation to the company's stock price will lead to different outcomes than would tying her compensation to the company's market share. But focusing only on incentives elides the question of the quality of the person making the decisions. Some folks have better judgment; some are a better fit with the organization. To look at it another way, it is not that the CEOs who fail necessarily have bad incentives. Tinkering with the terms of a compensation agreement would not turn a mediocre CEO into an outstanding one. The converse is true as well. A poorly structured compensation package will not consign a talented leader to failure.

The bottom line is that giving someone the best incentives does not give them the wisdom to make the right judgments. Having someone in control who makes good decisions matters a lot to investors. For example, it is common in lending agreements to include a change of control covenant. The typical provision provides that a change in a borrower's leadership constitutes a default under the loan. However, it is not that the bank invariably calls the loan when such a change is made. Rather, the bank achieved a level of comfort with the team that was in charge at the time it made the loan; by having a "change of control" provision, the bank can assess whether it has the same level of comfort with the new team or whether it wants to terminate the relationship.

This relative lack of attention to control rights by bankruptcy law has not always been the case. At one point, the formal shift of control rights loomed large in the law of corporate reorganizations. The Bankruptcy Act, the predecessor to today's Code, paid close attention to control rights. The drafters of the Act distinguished between two types of companies: one was the small business. The fate of such an operation, then as now, was tied up with its owner. The company may or may not be able to be reorganized successfully. If it was, however, there was no doubt that it would be under the control of the prebankruptcy owner. Not surprisingly, under the Act's Chapter XI, the owner/manager remained in charge of the business during the restructuring effort. Putting someone else in place would make little sense. Outside of bankruptcy there was little separation between ownership and control, and there was no reason to cleave the two once a bankruptcy petition had been filed. (21)

The Bankruptcy Act treated publicly traded firms differently. Such businesses were run by professional managers rather than the owners of the company. One could easily imagine transferring control over the company to a new set of hands. Chapter X of the Act was to be the home for companies overseen by professional managers. As the law was originally envisioned, the old managers were shown the door when the company filed for reorganization, and the SEC would step in and appoint new people to run the company. (22)

The drafters of the Chandler Act were acutely aware...