Chapter 11 as Metaphor: The Financial Systems Restructuring Act of 2008?

posted by Dave Hoffman

Last week, when all that was on the table was the mere collapse of a few investment banks and one large insurance holding company, I posted Jonathan Lipson’s lucid analysis, identifying the “selective socialism” of A.I.G.’s bailout as a consequence of the Bankruptcy Amendments of 2005.

Now that we’re frying bigger fish, I wondered what Lipson would say. His comments follow:

There are many options for a bailout. One that has received surprisingly little (if any) attention in Washington is reorganization under Chapter 11 of the United States Bankruptcy Code.

Strictly speaking, Chapter 11—which governs business reorganizations—would not apply in any meaningful way to many of the entities that are concerned here. Nor should it. But its general approach may, by analogy, be instructive.

Chapter 11 is a response to the collective action problem presented by a company’s general default. It is designed to enable parties to work out—restructure—legal and economic relationships with a mix of market incentives and government oversight. Some features of that system might, by analogy, help to avoid the growing stalemate in Washington while also creating mechanisms that actually resolve the underlying financial problems.

What, then, might a Financial Systems Restructuring Act of 2008 modeled on Chapter 11 do?

Stay

The Bankruptcy Code provides that the commencement of a case creates a stay of collection actions. This is vital, since it enables a troubled business to focus on correcting underlying problems rather than responding in ad hoc fashion to large numbers of collection suits.

Here, a stay might temporarily halt foreclosures on homes and enforcement of the various instruments currently in private hands that are apparently in default (or about to default). It could temporarily stay collection on credit default swaps. It would only be temporary, while a more fulsome plan is developed (see below).

Financing

Simply freezing the market, without more, would be the disaster Paulson legitimately seeks to avert. So, the government must inject capital and acquire some distressed assets to revive the capital markets.

Bankruptcy reorganization contemplates this through what is known as “debtor in possession financing,” where banks or other financial institutions make short term (usually) high interest loans to finance the process of a company’s reorganization.

Here, the Fed may lead a syndicate of lenders to provide short term financing to keep capital markets functioning, with the understanding that this financing would have to be repaid. It might be repaid in whole or in part by the Federal government, but that would depend on the development of a more fulsome plan (see below).

Today, of course, we do not know how much is really needed to stabilize markets in the short term. Paulson wants $700 Bn. But, like the claim that Iraq had weapons of mass destruction, I have seen no credible evidence supporting this number. Paulson and Bernanke admit that it may be too much or too little.

There is likely to be some smaller number that would stabilize the markets until, say, after the election. I don’t know what that is. But I would certainly hope that it was something far south of $700 Bn.

Market Testing—Treasury as Stalking Horse

The reason Paulson and Bernanke can’t tell us the right number is because there has been a market failure. No one, apparently, wants to purchase the toxic paper. If the market is what a willing buyer would pay a willing seller then, strictly speaking, the paper has a value of $0.

But in the long run, that seems unrealistic. I am sure that many CDOs were issued with nothing but smoke and mirrors behind them. They probably are worthless. But I am equally sure that many MBS are backed by real mortgages that really are worth something. We need to develop some mechanism for assessing the value of these securities, for many reasons.

Reorganization under Chapter 11 offers a helpful analogy. It contemplates fairly quick sales with auction mechanisms designed, at least in theory, to maximize asset values.

Here, rather than simply buying securities wholesale in the opaque and unaccountable way proposed by Paulson, perhaps the Treasury should be the statutory stalking horse in a series of controlled auctions, buying only where no one else will. I don’t know what formula should be used to set the initial price, but suspect that if this is done in some reasonably transparent way, it would produce better values and help to revive the market.

Reorganization Plan

There has to be some larger plan about how to address the underlying problems. In Chapter 11, this is called a plan of reorganization, and becomes the contract between the debtor and its stakeholders if enough of them support it.

A reorganization plan takes time to develop, but is essentially a set of rules that define how the affected parties will behave going forward. I am of the (admittedly under informed) view that much of the trouble here was driven by investment bankers’ and hedge fund managers’ fee incentives to issue and buy as much paper as possible, and the credit rating agencies’ incentives to provide unrealistic ratings of that paper because they were paid by the sellers, not the buyers. If these were the problems, a plan should include rules that address these problems going forward.

It should also contain a funding mechanism. Here, the initial funding might come from Treasury. But it seems possible to establish various mechanisms for recouping or minimizing some of the costs, whether through the auctions described above or in the form of fees paid by the largest beneficiaries of the bailout, or equity in those entities, or new debt issued by them, and so on. Some of these proposals are already on the table.

One of the problems with the Paulson proposal—which the Senate response does not really address—is how to value whatever it is the government gets in the bargain. Everyone now agrees that the government should get something–an “equity interest” or maybe debt of firms whose toxic paper the government acquires. But how much equity? At what valuation? With what rights?

These questions are usually at the heart of the negotiations over a Chapter 11 reorganization plan. We can’t really answer these questions now, however, because we don’t know enough about the underlying values.

I suspect part of what concerns Congress and the taxpaying public is that Paulson’s proposal simply sounded like more “planning by opportunity,” which is really no plan at all. Congress has legitimate concerns, many of which could be addressed in an intelligent plan. But that takes time. Using a stay, short term financing and controlled auctions may buy the time and gain the information we need to better understand the real problem and develop a more lasting and effective response to it.

Governance

A central feature of Paulson’s plan was that it made no real effort to change the governance of financial institutions. Executives would keep their jobs. The Treasury would acquire bad assets, not bad firms (although one could argue that enough bad assets make for a bad firm). Congress has responded with a much more rigorous oversight program, which might help.

Part of the logic of Chapter 11—and what distinguishes it from many other bankruptcy systems—is that management gets to remain in possession and control of the troubled company. But, there is considerably more oversight, both by the government (in the form of a bankruptcy judge and the office of the United States Trustee) and stakeholders (in the form of committees of creditors and equity holders) than in the marketplace generally.

Here, governance would remain with companies that participate in the program. But, picking up on the Senate bill, oversight would be provided by an Emergency Oversight Board, or similar entity. It would review not simply the decisions of the Treasury Secretary but consider how those decisions affect all stakeholders, including taxpayers and financial institutions. It might function like a combination of a bankruptcy judge and creditors’ committee. And, its decisions, like the decisions of the Treasury Secretary under the Senate bill, would be subject to some administrative and judicial review.

Recoveries

There’s a great deal of discussion about how much Wall Street executives should be “punished” for this. That’s an understandable sentiment.

But this sort of talk is not likely to get executives excited about any plan. Among other problems, merely capping future compensation simply gives executives an incentive to do nothing. If they are terminated by a board that wants them to compromise and work with Treasury, they may well sue on their employment agreements and hope for the best.

I am frankly less concerned about executive compensation going forward than I am about recovering from those who caused the problems. It seems to me unlikely that capping John Thain’s future salary (were Merrill independent and seeking a bailout) is likely to do much good. But getting back the $57 million Stan O’Neill took away might be a good (if small) start.

How would that be possible? Bankruptcy incorporates a number of traditional legal mechanisms for avoiding transfers of property, or remedying other conduct, that might have harmed a debtor.

Here, this would mean that someone like the special inspector general (SIG) contemplated under the Senate proposal might be empowered to investigate the banks and hedge funds that played a major role in this crisis and to sue under recognized (albeit perhaps strengthened) principles of fraudulent conveyance, breach of fiduciary duty, professional negligence, etc, with the recoveries going to the Treasury, subject to appropriate oversight.

The SIG would have to be given explicit standing to sue on behalf of these entities. This won’t sit well with everyone, but those who have little to fear should have little to lose.

Questions

Using reorganization as a metaphor would obviously leave many questions. After all, the whole point of Paulson’s initial proposal was to avoid the equivalent of bankruptcy—taking banks over.

The political standoff at this point seems to reflect competing ideologies. The administration says “trust us” and the market will heal itself. The Democrats seem to want something much closer to the Resolution Trust Corporation which really did take over failed banks. Republicans don’t seem to know what they want—other than to be (re-)elected.

None of this seems promising.

Restructuring as contemplated by Chapter 11 of the Bankruptcy Code can be seen as a third way, a hybrid, that might give us time and information that would permit cooler heads to really figure out what’s going on without an unchecked giveaway or total system meltdown.

 September 23, 2008 at 5:57 pm   Posted in: Bankruptcy, Corporate Law, Current Events, Securities    Print This Post

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