In review: insolvency law, policy and procedure in USA
An extract from The Insolvency Review, 7th Edition
Insolvency law, policy and procedure
i Statutory framework and substantive law
Although individual states in the United States have laws that govern the relationship between debtors and their creditors, insolvency law is primarily dictated by federal law because Article 1, Section 8 of the United States Constitution grants Congress the power to enact ‘uniform Laws on the subject of Bankruptcies’. While over time several different bankruptcy statutes have been passed by Congress, the US bankruptcy regime is currently set forth in Title 11 of the United States Code (the Bankruptcy Code), which codified the Bankruptcy Reform Act of 1978 and subsequent amendments. The most recent significant amendment to the Bankruptcy Code was the 2005 Bankruptcy Abuse and Consumer Protection Act.
The Bankruptcy Code is composed of nine chapters. Chapters 1, 3 and 5 provide the structural components that generally apply to all bankruptcy cases, and Chapters 7, 9, 11, 12, 13 and 15 lay out general procedures specific to certain types of bankruptcies. In general terms, these specific types of bankruptcies are:
- trustee-administered liquidation (Chapter 7);
- municipality bankruptcy (Chapter 9);
- debtor-in-possession (DIP) managed reorganisation or liquidation (Chapter 11);
- family farmer and fisherman bankruptcies (Chapter 12);
- individual bankruptcies (Chapter 13); and
- cross-border cases (Chapter 15).
In general terms, with respect to plenary corporate bankruptcies, US insolvency law provides for two distinct regimes: a trustee-controlled liquidation under Chapter 7 and a DIP-controlled reorganisation or structured liquidation under Chapter 11. This chapter focuses on Chapter 11 proceedings. Certain key provisions of US insolvency law are discussed in the remainder of this section.
The automatic stay
One of the most important provisions of the US insolvency regime is the ‘automatic stay’, which is codified in Section 362 of the Bankruptcy Code. The automatic stay is a statutory injunction that applies immediately upon the commencement of a bankruptcy proceeding. Generally, the automatic stay operates to enjoin most creditors from pursuing actions or exercising remedies to recover against a debtor’s property. There are limited exceptions to the automatic stay and it can be modified by a court upon a showing of cause. The automatic stay provides the breathing room necessary for the debtor or trustee to assess and assemble all the property of the estate without creditors seeking remedies to protect their own self-interests. Accordingly, the automatic stay allows for the preservation of a debtor’s assets and the maximisation of their value, and for an equitable distribution of those assets to creditors.
One important exception to the automatic stay is that it generally does not apply to contracts that are colloquially referred to as ‘financial contracts’. Specifically, the automatic stay does not apply to certain delineated counterparties’ ability to offset, net, liquidate, terminate or accelerate securities contracts, commodities contracts, forward contracts, repurchase agreements, swap agreements or master netting agreements with a debtor, provided that the counterparty may be required to exercise its remedies promptly. In addition, a debtor may not avoid as a fraudulent transfer a transfer to such a counterparty under one of these contracts unless the transfer is intentionally fraudulent.
The absolute priority rule
The absolute priority rule provides that creditors with higher priority must be paid in full before creditors of lower priority receive any distribution from a bankruptcy estate, and thereby ensures a ‘fair and equitable’ distribution of the debtor’s property consistent with the priorities under the applicable non-bankruptcy law. As a result, in the absence of consent, secured claims must be paid in full from collateral before general unsecured creditors receive any recovery. Similarly, because equity holders have the lowest priority, in the absence of consent, they cannot receive any distribution until all creditors have received payment in full on account of their allowed claims. Consent to the payment of a junior class can be obtained through a vote of the senior class on a plan of reorganisation.
The Bankruptcy Code also provides a number of procedures that allow a debtor or trustee to avoid a pre-bankruptcy transfer of property from the bankruptcy estate. This allows the debtor to maximise the value of the bankruptcy estate and prevent a depletion of the estate prior to the commencement of the bankruptcy proceeding that may favour certain creditors over others. These protections are found in Chapter 5 of the Bankruptcy Code. The most commonly used of these actions are:
- avoidance of preferential transfers, which enables an insolvent debtor, subject to certain defences, to avoid and recover payments based on antecedent debt made to creditors within the 90 days prior to the debtor’s filing for bankruptcy – up to one year for payments made to insiders of the debtor;
- avoidance of fraudulent transfers, which enables the debtor to avoid and recover transfers of property that were actually fraudulent or were made while the debtor was insolvent and for less than reasonably equivalent value; and
- avoidance of unperfected security interests, which enables a debtor to avoid liens on property if those liens were not perfected under the applicable non-bankruptcy law prior to the commencement of the bankruptcy case.
The goal of US insolvency law is to provide maximum return to the creditors (and, if possible, equity holders) of a debtor and, in that context, to reorganise rather than liquidate business debtors to preserve employment and to realise the ‘going concern surplus’ of reorganisation value over liquidation value. This is accomplished by reorganising a debtor corporation under the provisions of Chapter 11 of the Bankruptcy Code. However, if a reorganisation is not possible – or if it would not result in a maximisation of value for creditors – the debtor company can be liquidated either under Chapter 11 or Chapter 7 of the Bankruptcy Code. Chapter 7 transfers the control of the liquidation process from the debtor’s management, who are likely to have greater familiarity with the assets and their value, to a trustee appointed by the US Trustee or elected by the debtor’s creditors. Chapter 7 liquidations usually result in lower recoveries for creditors. Therefore, companies are more likely to be liquidated under Chapter 7 if there are not sufficient funds in the estate or available to the estate to run a Chapter 11 process.
iii Insolvency procedures
As discussed in Section I.ii, the Bankruptcy Code provides for two main types of insolvency proceedings available to businesses with assets in the United States: Chapter 7 and Chapter 11.
Chapter 7 is a trustee-controlled liquidation. The goal of Chapter 7 is to ensure the most efficient, expeditious and orderly liquidation of a debtor’s assets to be distributed to the creditors and equity holders. Companies cannot reorganise under Chapter 7.
The Chapter 7 liquidation procedure is administered by a Chapter 7 trustee who is selected either by the US Trustee or by an election conducted by certain creditors. The Chapter 7 trustee is responsible for realising upon all the property of the estate and coordinating the distribution of that property or the proceeds of sales of that property.
Chapter 11 provides for an insolvency proceeding in which the directors and management of the debtor company remain in control (the DIP) unless a trustee is appointed for cause. Chapter 11 proceedings allow for the reorganisation of a debtor’s operations and capital structure in the hope that the company will emerge from the bankruptcy process as a healthier, reorganised company. Chapter 11 gives the debtor the exclusive right to propose a plan of reorganisation for the first 120 days after commencement of the bankruptcy proceedings. This date may be extended until 18 months after the order for relief (the petition date of a voluntary case) if the debtor is making progress with a plan of reorganisation and can show cause why the court should extend the exclusivity period. The plan of reorganisation provides for how the debtor’s assets will be distributed among the classes of creditors and equity holders. It is also possible for a debtor to liquidate its assets through Chapter 11, which is typically a more structured liquidation than one under Chapter 7.
The culmination of a Chapter 11 proceeding is the filing of the plan of reorganisation. The Chapter 11 plan provides how creditors’ claims will be treated by the estate. Under the Chapter 11 plan, creditors and shareholders are divided into classes of holders sharing substantially similar claims or interests. Chapter 11 plans must meet certain standards to be confirmed. Even if a plan is accepted by the requisite vote of all impaired classes, it must be found by the court to be in ‘the best interests of creditors’ (providing each dissenting class member with at least what would have been recovered in a liquidation). As to a class that rejects the plan, the plan must satisfy the Bankruptcy Code’s ‘fair and equitable’ requirement (described in Section I.i).
The plan of reorganisation is submitted to a vote of the various creditor and shareholder classes. If at least one class that stands to receive less than their asserted claim (an impaired class) votes in support of confirmation, excluding insider ‘yes’ votes, the plan can be confirmed over the dissent of another impaired class. Dissenting classes can thus be crammed down so long as the plan is fair and equitable and does not discriminate among creditors in a similar situation. Once the plan is approved by the necessary stakeholders, a court can confirm a plan, so long as certain other prerequisites of Section 1129 of the Bankruptcy Code are satisfied.
Chapter 15 is the Bankruptcy Code’s codification of the United Nations Commission on International Trade Law (UNCITRAL) Model Law and allows a foreign debtor, through its ‘foreign representative’, to commence an ancillary proceeding in the United States to support its foreign insolvency proceeding.
iv Starting proceedings
As set forth in Section I.i, the US Bankruptcy Code provides for different types of insolvency proceedings, not all of which are available for all types of companies. Specifically, insurance companies and banking institutions cannot file for Chapter 7 or Chapter 11 bankruptcy; a railroad can be a debtor under Chapter 11 but not Chapter 7, and stockbrokers and commodity brokers can file for bankruptcy under Chapter 7 but not Chapter 11. Regardless of the type of bankruptcy case, under Section 301(a) of the Bankruptcy Code, a debtor voluntarily commences a plenary insolvency proceeding by filing a petition with the bankruptcy court.
A bankruptcy proceeding can also be commenced against a debtor company, which is known as an ‘involuntary’ bankruptcy case. An involuntary case is commenced upon the filing of a petition with the bankruptcy court by three or more holders of non-contingent, undisputed claims, and those claims aggregate at least US$15,775 more than the value of any lien on property of the debtor securing such claims. A bankruptcy court will order relief against the debtor in an involuntary case only if the debtor is generally not paying its debts as they become due, unless those debts are the subject of a bona fide dispute as to liability or amount, or if a custodian as described in Section 303(h)(2) of the Bankruptcy Code has been appointed.
A Chapter 15 case is commenced when the foreign representative of the debtor company files a petition for recognition of the foreign proceeding with the US bankruptcy court.
v Control of insolvency proceedings
Under Chapter 7, the insolvency proceeding is controlled by a trustee who is appointed by the US Trustee or elected by the debtor’s creditors to administer the debtor’s assets. The Chapter 7 Trustee is responsible for, among other things, ‘collect[ing] and reduc[ing] to money the property of the estate for which such trustee serves, and closes such estate as expeditiously as is compatible with the best interests of parties in interest’. Although the Chapter 7 Trustee can continue business operations for a short period if value is maximised by doing so, generally, once a Chapter 7 Trustee has been appointed, the debtor company is expeditiously liquidated.
Chapter 11 proceedings allow for a debtor’s existing management and directors to stay in place and operate the business during the bankruptcy case. For this reason, a debtor in a Chapter 11 proceeding is referred to as the ‘DIP’. The board of directors’ primary duties in connection with an insolvency proceeding are the same as they are outside bankruptcy – to maximise the value of the company. The key distinction is that when a company is insolvent, the creditors, not the shareholders, are the residual beneficiaries of the board’s fiduciary duties to the corporation and are, thus, able to bring actions for breach of fiduciary duty. If it is in the best interests of the estate and its creditors, a trustee may be appointed to replace the DIP and administer a Chapter 11 case.
During a Chapter 7 or Chapter 11 case, the DIP or trustee may take actions that are in the ordinary course of the debtor’s business without approval of the bankruptcy court. Actions after entry of the order for relief outside the ordinary course of business are subject to bankruptcy court approval.
Bankruptcy courts in the United States are courts of limited jurisdiction. This is because, unlike federal district and circuit courts, they were not created under Article III of the United States Constitution. Instead, Congress created the bankruptcy courts because they were ‘necessary and proper’ to effectuate Congress’s enumerated powers to enact bankruptcy law. For this reason, bankruptcy courts may only oversee matters that are ‘core’ to the bankruptcy case unless the parties knowingly and voluntarily consent to adjudication of a ‘non-core’ matter by the bankruptcy court. Without consent, matters that are not ‘core’ to the insolvency proceeding must be decided by a federal district court. Appeals of bankruptcy court decisions are generally heard, in the first instance, by the federal district court sitting in the same jurisdiction as the applicable bankruptcy court. Bankruptcy court jurisdiction is the subject of much debate under a series of recent Supreme Court cases.
Among other things, the bankruptcy court manages filing deadlines, hears evidence on contested issues and issues orders regarding requests for relief by the parties. Nevertheless, and despite the involvement of the court, many aspects of the bankruptcy process are negotiated by the parties outside the courtroom and the DIP or trustee is free to enter into settlement agreements, which are then subject to the approval of the bankruptcy court.
vi Special regimes
Securities broker-dealers are not eligible for relief under Chapter 11. Instead, insolvent broker-dealers may liquidate under Chapter 7 of the Bankruptcy Code, but are more likely to be resolved in a proceeding under the Securities Investor Protection Act of 1970 (SIPA). SIPA proceedings are liquidation proceedings, and upon commencement thereof, the broker-dealer will cease to conduct business as a broker-dealer, subject to certain limited exceptions. In SIPA proceedings, a trustee (the SIPA trustee) will take control of all property, premises, bank accounts, records, systems and other assets of the broker-dealer and displace management. The SIPA trustee’s primary duties are to marshal assets, recover and return customer property (including through effectuating bulk account transfers to a solvent broker-dealer) and liquidate the broker-dealer.
In SIPA proceedings, the provisions of Chapters 1, 3 and 5 and Subchapters I and II of Chapter 7 of the Bankruptcy Code will also apply, to the extent consistent with SIPA, and the SIPA trustee will generally be subject to the same duties as a trustee under Chapter 7 of the Bankruptcy Code, with certain limited exceptions regarding securities that are the property of customers of the broker-dealer. If the broker-dealer is a registered futures commission merchant under the Commodity Exchange Act of 1936, the SIPA trustee will have additional obligations under the Part 190 regulations promulgated by the Commodity Futures Trading Commission, with respect to any commodity customer accounts that have not been transferred to another futures commission merchant prior to the filing date.
Although bank holding companies can file for Chapter 11 relief, their subsidiary depository institutions are not eligible for relief under the Bankruptcy Code, and are typically resolved by the Federal Deposit Insurance Corporation (FDIC) under the Federal Deposit Insurance Act. The FDIC has the authority to market a failed depository institution for sale to another depository institution, or the FDIC can insert itself as a receiver, close the bank and liquidate its assets to pay off creditors. The powers of the FDIC as receiver are very similar to those of a trustee in bankruptcy.
Additionally, the Dodd–Frank Wall Street Reform and Consumer Protection Act established the Orderly Liquidation Authority (OLA), which provides that the FDIC may be appointed as receiver for a top-tier holding company of a failing financial institution that poses a systemic risk to financial stability in the United States. OLA sets forth the procedures that the federal government can take to cause the wind-down of financial institutions that were once considered ‘too big to fail’. Pursuant to OLA, the FDIC can exercise many of the same powers it has as a bank receiver to liquidate systemically risky financial institutions. Moreover, under the Dodd–Frank Act, institutions that may be subject to OLA must provide the FDIC with resolution plans (commonly known as living wills) to serve as road maps in the event that the financial institution requires resolution.
State law governs all regulation of insurance companies, including the resolution of insolvent insurance companies.
The Bankruptcy Code has mechanisms for dealing with the insolvency proceedings of corporate groups and there is no special regime to address these types of filings. If multiple affiliated companies in the same corporate group seek relief under the US Bankruptcy Code, they will file separate bankruptcy petitions but will often seek joint administration of the various bankruptcy proceedings, meaning that the bankruptcy cases of each member of the group will be overseen by the same judge, which provides for greater efficiency in the administration of the cases. Importantly, joint administration does not mean that the assets and liabilities of the group will be combined. Rather, corporate separateness will be observed despite the joint administration of the cases, unless there is cause to breach corporate separateness and ‘substantively consolidate’ the assets and liabilities of the debtor.
vii Cross-border issues
As part of the 2005 Bankruptcy Abuse and Consumer Protection Act, the United States enacted Chapter 15 of the Bankruptcy Code, which is based on the UNCITRAL Model Law on Cross-Border Insolvency (the Model Law). Chapter 15 governs how a US court should treat a foreign insolvency proceeding when no plenary proceedings have been commenced in the United States and provides a mechanism for the cooperation between the US court and the foreign court overseeing a debtor’s plenary insolvency proceeding. Generally, Chapter 15 allows for the commencement of an ancillary proceeding upon recognition of the debtor’s foreign proceeding. Once the foreign proceeding is recognised by the US bankruptcy court, the automatic stay applies to the debtor and the property of the debtor that is within the territorial jurisdiction of the United States and the debtor’s foreign representative enjoys certain powers and privileges under the Bankruptcy Code, such as the right to intervene in any court proceeding in the United States in which the foreign debtor is a party, the right to sue and be sued in the United States on the foreign debtor’s behalf, the authority to operate the debtor’s business and the authority to initiate avoidance actions in a case pending under another chapter of the Bankruptcy Code.
The bar for accessing plenary proceedings in the US bankruptcy courts is relatively low. A company can be eligible to commence a Chapter 11 proceeding in a US bankruptcy court so long as it is incorporated or has any property or operations in the United States. Because of the perceived debtor-friendliness of US bankruptcy courts and the courts’ vast experience in restructuring large multinational companies, many multinational companies are filing for Chapter 11, even if their principal place of business, or centre of main interest, is located outside the United States. This trend has been particularly prevalent in the shipping industry. For example, the Taiwan-based TMT Group opened an office in Houston only a few days before filing for Chapter 11 protection in the United States Bankruptcy Court for the Southern District of Texas.
Overview of restructuring and insolvency activity
Since the global financial crisis, when gross domestic product adjusted for inflation (real GDP) dropped by 2.8 per cent from 2008 to 2009, the US economy has experienced a period of slow growth. Real GDP increased in the fourth quarter of 2018 at an average annual rate of 2.2 per cent and at an average annual rate of 2.1 per cent in the second quarter of 2019. Furthermore, reported unemployment continues to abate: the rate for July 2019 was 3.7 per cent, down slightly from 3.9 per cent in July of the previous year and from its October 2009 high of 10 per cent.
Additionally, credit has been readily available to US businesses. In 2018, US corporations issued almost US$1.53 trillion in bonds, a decline from the US$1.81 trillion issued in 2017 but still more than the US$1.49 trillion issued in 2016. During the first five months of 2019, more than US$750 billion worth of bonds were issued. The 10-year Treasury rate has ranged between 1.52 per cent and 2.79 per cent in the current calendar year, while in 2018, the rate ranged between 2.44 per cent and 3.24 per cent.
US equity markets have remained robust during July 2019, though volatility has been increasing in recent months. Specifically, US equity and equity-related proceeds totalled US$213.3 billion on 898 deals in 2018, which represents a 3.4 per cent increase in proceeds compared to the US$206.2 billion raised in 2017, though the number of deals declined by approximately 1.8 per cent from the 914 in 2017. US equity and equity-related proceeds in 2017 were approximately 14.5 per cent more than the US$180 billion raised in 2016 and 7.5 per cent less than the US$229.3 billion raised in 2015. Similarly, the number of deals in 2018 was 25.4 per cent greater than the 716 in 2016 and 5.4 per cent more than the 852 in 2015.
US corporate default rates have fluctuated since 2018. Moody’s measured the US speculative-grade default rate in March 2019 at 2.4 per cent, compared to default rates of 2.8 per cent at the end of 2018 and 3.4 per cent at the end of 2017. Moody’s indicated that the leveraged loan default rate has held steady at 1.9 per cent from December 2018 to March 2019, compared with the March 2018 rate of 2.9 per cent and 2017 first quarter rate of 2.2 per cent.
The frequency of business bankruptcy filings remains well below its peak in 2010, and although many businesses continue to seek bankruptcy relief as a result of significant challenges in sectors of the US economy, 2018 marked a significant decrease in filings as compared to recent years: 58 public companies filed Chapter 7 or Chapter 11 bankruptcy proceedings, representing an 18.3 per cent decrease from 71 public companies in 2017. Aggregate pre-petition assets totalled approximately US$52.056 billion in 2018, down from 2017’s aggregate pre-petition assets of approximately US$106.931 billion. Following downturns in 2017, filings in the oil and gas/energy/mining sector and the retail industry represented seven of the top 10 public company Chapter 7 and Chapter 11 filings in 2018. As described in further detail in Section V.i, the energy/oil and gas and retail industries have continued to produce many of the most significant bankruptcies in the early part of 2019.
Ninety-eight companies commenced Chapter 15 proceedings in the 12 months ending on 31 March 2019, compared with the 64 Chapter 15 cases that were initiated during the 12 months ending on 30 June 2018. Further, tariffs and trade wars hang over the economy but have not yet materially affected filings.