Water Under the Bridge? a Look at the Proposal for a New Chapter 16 of the Bankruptcy Code from a Comparative Law Perspective

• Citation: Vol. 37 No. 2
• Publication year: 2021

Water Under the Bridge? A Look at the Proposal for a New Chapter 16 of the Bankruptcy Code from a Comparative Law Perspective

Tobias Wetlitzky

WATER UNDER THE BRIDGE? A LOOK AT THE PROPOSAL FOR A NEW CHAPTER 16 OF THE BANKRUPTCY CODE FROM A COMPARATIVE LAW PERSPECTIVE

Tobias Wetlitzky^*

Abstract

In light of the ongoing COVID-19 pandemic, bankruptcy law will play a crucial role in addressing the consequences of the global economic shutdown. Many large corporations in the U.S. will need to undergo chapter 11 bankruptcy proceedings or may attempt to reorganize their financial debt in an out-of-court workout. However, section 316(b) of the Trust Indenture Act of 1939 has long been blamed for making out-of-court restructurings practically impossible, because it requires unanimous approval from bondholders. In 2014, the National Bankruptcy Conference presented a solution for the inefficiencies in bond workouts by proposing a streamlined debt reorganization procedure for borrowed money in a new chapter 16 of the Bankruptcy Code. This Article argues that now is time to take a new look at the 2014 proposal from a comparative law perspective. Considering the legal situation in England and Wales as well as Germany, the Article outlines a proposal for a modern workout mechanism for bond debt.

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Introduction.............................................................................................257

I. The Current Framework for Bond Debt Workouts ..............258

A. The Trust Indenture Act and Its Effects on Workouts............... 259
B. The Shock: Southern District of New York's Broad Interpretation............................................................................ 262
C. The Proposal: A New Chapter 16 of the Bankruptcy Code...... 264
D. The Correction: Court of Appeals for the Second Circuit's Revision .................................................................................... 266
E. The Present: A New Normal? ................................................... 267

II. Need for a Codified Restructuring Mechanism for Bond Debt..................................................................................................267

A. Can the Market Find Ways to Successfully Implement Bond Workouts? ................................................................................. 268
B. A Codified Bond Workout Framework Offers Legal Certainty 270

III. Proposed Design of the Workout Mechanism..........................273

A. Repeal of TIA Section 316(b)?.................................................. 273
B. Creating a New Chapter 16 of the Bankruptcy Code? ............. 276

1. The Scheme of Arrangement in England and Wales .......... 277
2. Bond Workouts under the German Debt Securities Act ..... 278
3. Reform Proposal: A Modern Workout Mechanism in the Trust Indenture Act ............................................................. 280

Conclusion.................................................................................................283

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Introduction

The ongoing COVID-19 pandemic and the restrictions many countries have imposed in an effort to halt the spread of the virus had significant effects on economies around the globe. In the United States, the economy shrank at an unprecedented rate in the first half of the year,¹ and weekly unemployment filings hit record highs.² Despite the ray of hope in the form of quickly developed vaccines, a new surge in coronavirus cases slowed down economic recovery by the end of the year 2020.³ In line with expectations,⁴ a wave of companies experienced financial distress and chose to undergo a corporate reorganization under chapter 11 of the Bankruptcy Code to restructure their outstanding debt.⁵ other companies avoided bankruptcy by contractually restructuring their bond debt ("workouts").⁶ However, this illuminated a well-known problem in the world of corporate distress: because an out-of-court restructuring requires the cooperation of nearly all lenders, companies frequently do not succeed in their

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restructuring attempts.⁷ Often, they are then only left with the option of entering a lengthy and expensive chapter 11 proceeding.

Back in 2014, the National Bankruptcy Conference ("NBC")—an organization composed of about sixty leading bankruptcy judges, professors, and practitioners—developed a solution to the inefficiencies in out-of-court restructurings.⁸ The NBC envisaged a streamlined procedure "for a workout involving only borrowed money and court supervision of the process to protect the minority while reducing the expense and complexity of using chapter 11's pre-packaged plan process."⁹ However, the proposal never became legislative reality, and it appears there are no plans to implement it in the near future. More than five years after its initial presentation, this Article assesses whether the proposal fits into the world of modern corporate distress and whether it could add value to the bankruptcy law framework. It will conclude that the NBC identified important issues with today's bond debt workouts, but that they are more efficiently addressed in a modern workout mechanism outside of the Bankruptcy Code that draws from other jurisdictions' experience. This Article proceeds in Part I with an overview of the current framework for bond debt workouts and the judicial upheavals that coincided with the NBC's reform proposal. In Part II, this Article discusses whether—in light of current market practice—there is a need for a codified restructuring mechanism. Part III addresses common reform discussions and—from a comparative law perspective—outlines a proposal for a modern workout mechanism for bond debt. The final Part concludes.

I. The Current Framework for Bond Debt Workouts

When a company finds itself in financial distress despite a viable business model, it will attempt to restructure the right-hand side of its balance sheet. The restructuring of financial obligations can be achieved under chapter 11 of the Code or by an out-of-court workout.¹⁰ The latter is a contractual agreement

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between the company in distress and its creditors in which the parties modify outstanding debt.¹¹ Ideally, the workout would constitute a faster and cheaper option for the debtor than a chapter 11 proceeding and would provide creditors with a greater amount than they would expect through bankruptcy.¹² This Section first presents the common hurdles to implementing a successful workout and upheavals in relevant case law. Second, this Section details the NBC's reform efforts and describes the current state of bond debt workouts.

A. The Trust Indenture Act and Its Effects on Workouts

The Trust Indenture Act of 1939 ("TIA") contains strict requirements for bond workouts and has long been blamed for making out-of-court restructurings practically impossible.¹³ In particular, TIA section 316(b) requires the debtor to obtain unanimous consent from creditors in order to modify "the right . . . to receive payment of the principal of and interest on" the bond.¹⁴ Whereas creditors are grouped into classes in chapter 11 bankruptcy proceedings, every single creditor needs to consent to the proposed bond term modifications for the workout.¹⁵ This is because the TIA is meant to prevent out-of-court restructuring measures being forced on minority bondholders.¹⁶ It prohibits bond terms from providing for majority decisions ("collective-action clauses"), unless the bond

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is issued under an exemption of the SEC registration requirements.¹⁷ Thus, a single dissenting bondholder can prevent the successful implementation of a bond term modification by refusing its consent or initiating enforcement actions while the workout is under negotiation.¹⁸

Alternatively, a debtor can ask bondholders to exchange their existing bonds for new ones that contain scaled-down terms with lighter financial obligations for the debtor.¹⁹ This process is called an "exchange offer" and does not require all creditors to participate in order to take effect.²⁰ However, a number of issues with the potential to impede a successful workout arise in connection with exchange offers. First, if only some of the bondholders accept the exchange offer, non-consenting creditors may have better chances of getting paid because of the creditor's overall improved financial situation.²¹ This incentivizes the latter to stick with the more favorable original bond terms ("free riders").²² Second, if the exchange offer is conditioned on a tender threshold, minority bondholders could strategically demand extra compensation before committing to accept the offer ("holdouts").²³ In light of this, bondholders who would otherwise be willing to participate may refuse to make concessions if costs and benefits of the workout are unequally distributed.²⁴

On the other hand, it is not uncommon for issuers to implement equally distorting techniques: issuers frequently connect their exchange offer with a request to strip the old bond of protective covenants ("exit consents").²⁵ The

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modification of business covenants that do not affect core payment rights is often subject to a majority or supermajority vote as provided for in the bond terms.²⁶ In case a majority of bondholders decided to accept the exchange offer, they also agree to the modifications and thereby substantially decrease the old bond's attractiveness.²⁷ Facing this scenario, a bondholder could decide to take the exchange offer than being stuck with the old, stripped-down bond.²⁸ Moreover, issuers may strategically offer higher compensation for earlier tender acceptance and set a short tender period to make it more difficult for bondholders to coordinate.²⁹

over the past decades, dissenting bondholders were only able to challenge an exchange offer with exit consents by invoking a breach of the implied contractual duty of good faith and fair dealing.³⁰ However, issuers were in the clear as long as they adhered to the standard...