The United States is about to enter year five of what has been aptly deemed “The Great Recession.” Bankruptcy advising is a cyclical business, and after a dearth of work in the heady financial years of the mid-2000s, expectations were high that in the downturn bankruptcy work would be abundant and steady.
But that has hardly proven to be so. Instead, such work has come in fits and starts, with months of doldrums, even in the midst of the worst economic downturn in decades. Bankruptcy filings, and especially Chapter 11s, significantly underrepresent the amount of distress in the market, especially in the mid-market. Why is that?
Here’s one theory: a single bankruptcy decision issued by the U.S. Supreme Court in 1999 has dramatically changed Chapter 11 practice — and may be the most important decision for the day-to-day practice since the advent of Chapter 11. In practical terms, the decision in Bank of America National Trust and Savings Association v. 203 North LaSalle Street Partnership established that every time a company files Chapter 11, the company is in play. This has had significant implications for the shape of bankruptcy proceedings, as well as the reduced velocity of Chapter 11 filings. Secondary and tertiary effects of the ruling on the bankruptcy market are just now becoming fully apparent.
LaSalle was a single-asset real estate (SARE) case involving an apartment complex located in Chicago that was worth substantially less than the secured lender’s debt. Like many SAREs, LaSalle’s Chapter 11 plan was predicated on reducing the lender’s debt to the current value of the property and turning the rest of the lender’s claim into an unsecured claim that would be paid at pennies on the dollar — a straightforward way to use bankruptcy to de-lever a property. LaSalle’s existing equity holders would have the exclusive right to keep their ownership interests by paying in “new value,” even though the company’s creditors were not being paid in full.
Throughout the 1980s and 1990s, standard practice in many Chapter 11s was to do exactly what LaSalle was attempting — for equity to control the bankruptcy and then make a contribution to buy back its ownership as part of the plan — and equity was routinely successful in this process. This happened in cases involving real estate, manufacturing, healthcare, and other industries of all stripes because the law was unsettled.
When the Chapter 11 plan in LaSalle
finally reached the U.S. Supreme Court on appeal, however, the justices issued a decision with implications that even they likely did not anticipate. The court held that when creditors are not paid in full and do not consent, the U.S. Bankruptcy Code prohibits equity from giving itself the exclusive right in a Chapter 11 plan to pay new value for ownership of the reorganized debtor. Instead, the right to purchase equity has to be subjected to a market valuation process, such as an equity auction or the right of creditors to propose a competing Chapter 11 plan.
Implications of LaSalle
Borrowers have since devised many ways to comply with LaSalle to confirm a Chapter 11 plan, so traditional in-court restructuring has hardly disappeared. However, LaSalle has rendered bankruptcy a riskier option for many debtors and their professionals, and has reshaped the practice in profound ways. A few trend lines are clear:
The Rise (and Predominance) of Sale Cases. Many commentators have lamented that Chapter 11 has simply become a method for companies to sell assets and is no longer primarily a reorganization process. In recent years, many debtors and their lenders have used the Section 363 sale process (so named for the Bankruptcy Code Section that governs it) as the basis to sell all of a debtor’s assets early in a bankruptcy case, sometimes in place of a plan. After the sale is approved and the assets sold, the debtor either converts the case to Chapter 7 or proposes a liquidating Chapter 11 plan that pays out the sale proceeds. By comparison, plans of reorganization are perceived to have become a rarity.
This trend is directly traceable to LaSalle, which makes it much more difficult for a debtor to simply file a bankruptcy, cram down the secured creditor’s claim, and then allow existing equity retain its stake in the reorganized company. Instead, under LaSalle the equity takes a bigger risk of losing the company in the process and spending a lot of money to do so. LaSalle has shifted the leverage. As a result of the case, equity ownership may change, which is hardly different from a sale.
The consequence is that debtors are less likely to file bankruptcy in the first place. They walk away and leave the assets to the lender, try to work out a palatable restructuring, file a Chapter 7, or negotiate a Chapter 11 filing with the support of their lender – which usually means that their assets are sold. A long-fought mid-market case by a company whose assets are fully encumbered by its lender is rare. Long-running reorganization cases in bankruptcy are now fewer and farther between.
The Rise of the Professional Fee Carve-Out. One of the requirements of confirming a Chapter 11 plan has always been payment of all expenses of the Chapter 11 process, including costs of the professionals involved. In the 1980s and 1990s, bankruptcy professionals knew that if the process was handled properly, their debtor clients were reasonably likely to be able to control the case and then confirm a new-value Chapter 11 reorganization plan. So, professionals knew that they had a high likelihood of being paid for their work, and they could file cases with small retainers and take a calculated risk of future payment.
After the LaSalle ruling, however, control in a Chapter 11 is more elusive, and the risk of an unconfirmed plan is higher. Therefore, the debtor’s professionals must be more cautious to ensure that they receive payment. A debtor needs a war chest of unencumbered cash to pay retainers and ongoing fees during its bankruptcy. If it does not have one or the likely prospect of a new debtor-in-possession (DIP) loan to pay fees, a debtor and its professionals often must negotiate for a “professional fee carve-out” before filing the bankruptcy. The debtor is forced to ask its lender to pay for the process and hope that the lender is incentivized to participate. Otherwise, Chapter 11 may be economically out of reach.
The Rise of “Extend, Amend, and Pretend.” During the Great Recession, lenders dealing with bad credits adopted a strategy disparaged as “extend, amend, and pretend.” They pushed the problem down the road by granting forbearance, seemingly pretending that a credit was not as bad as it might seem.
This made sense in an economy plagued by a financial sickness that emanated directly from the financial sector and credit markets, and characterized by broken lending institutions and the freezing of credit in a modern economy that relies on steady access to available money. For example, if a bank cannot afford to take the loss now on the sale of a bad loan, it waits, hoping that time is on its side and that its own financial wherewithal or that of its borrower will improve over time to the point that it can afford to deal with the financial reality of the loan later.
LaSalle had a lot to do with the emergence of extend, amend, and pretend. In the absence of LaSalle, many borrowers with commercial properties would file Chapter 11 to cram down the bank’s loan and de-lever their properties, or they would use the threat of Chapter 11 to arrange a sustainable long-term voluntary restructuring. The same is true for many manufacturing and other companies across industries in the mid-market.
LaSalle, though, has made borrowers less inclined to risk their fortunes on Chapter 11. And because they are sick themselves, lenders have been slower than usual over the last four years to push their commercial borrowers into foreclosure or loan resolution. It has created a situation in which neither party is inclined to move swiftly to resurrect assets that are underwater.
The result is that capital is not being reallocated quickly to the people who can use it or put it back into efficient application. The pain of reallocation is pushed into the future and with it the dynamic opportunity that reallocation brings. Efficient reallocation means that assets are again available to be used as collateral for new loans, creating new jobs and pouring new revenue streams into the economy.
Slow resolution, by comparison, means that the malaise continues. This is not because of the number of bankruptcies and the amount of insolvency. Indeed, it might be inversely proportional to it. The absence of Chapter 11s in the mid-market may well be contributing to the perpetuation of financial sickness and the length of The Great Recession.
The effect of all of these trends is fewer Chapter 11 filings, especially in the mid-market. Borrowers without unencumbered cash follow other paths — walking away, consenting to the sale plan, or agreeing to an extend, amend, and pretend restructuring, among other options.
Are these simply Malthusian musings on the fate of Chapter 11? Maybe, but maybe not. The author is actually optimistic about the future of Chapter 11 because it is impossible for other processes to replace bankruptcy in the United States. With limited exceptions, only the bankruptcy powers under the U.S. Constitution make it possible to modify a company’s obligations to its creditors against the wishes of those creditors.
Other processes, such as receiverships and assignments for the benefit of creditors (ABCs), will never replace Chapter 11 because they are merely liquidation tools. They also have a fatal flaw — a debtor can throw a wrench in the works by filing a designed Chapter 11 just before the successful receivership sale or during the administration of the ABC, creating havoc in the liquidation process. So, Chapter 11 still provides debtors with significant leverage.
As a result, Chapter 11 will always have a place in the economics of restructuring. But the bench and bar should take care, lest Chapter 11 become inaccessible as a result of LaSalle to all but the rare debtor. The prevailing view in the United States is that saving companies is the best way to promote high employment and, as a result, the United States through Chapter 11 leads the world as the major proponent of insolvency reorganizations instead of liquidations. LaSalle’s shift of the fragile balance in Chapter 11, however, has put this at risk, especially in the mid-market.
To be sure, other trends also have affected the practice of Chapter 11, such as the substantial amendments to the Bankruptcy Code that took effect in 2005. Those code changes included better protections for vendors and landlords and put an outer limit on the time that debtors can maintain the exclusive right to propose and confirm a plan (20 months). But at least in this author’s opinion, these changes pale in comparison to the long-term effects of LaSalle, which predated the amendments by six years.
Anecdotal evidence and the dearth of bankruptcies in an economy filled with commercial business distress supports this theory. It will be interesting to see what the future holds, whether a formal study to confirm the theory or changes to shift the balance of Chapter 11 back in the other direction. LaSalle and its implications seem ripe for study by academia and the think tanks that focus on the health of the U.S. financial market.
 526 U.S. 434 (1999).
 One more thought about the potential effect of LaSalle
on the broader economy: has it contributed to access to cheaper credit in the first decade of the 21st century? This seems a stretch, but basic economic theory (the correlation of risk and reward) would suggest some plausibility. Lenders loan at higher rates when their risk is higher. If lenders have had less risk of being crammed down in a bankruptcy, then their risk of loss would be lower and . . . their rates should have been, too, suggesting easy, cheap credit. Sound familiar?
 See, for example, 11 U.S.C. Section 542(d)(2), providing that a Bankruptcy Court shall not require a custodian to turn over records to the bankruptcy estate if the custodian was appointed or took possession more than 120 days before the filing of the bankruptcy case. So in theory, even a fully consensual ABC process is subject to disruption for up to 120 days. Accord, 11 U.S.C. Section 305 (court may dismiss or suspend bankruptcy proceedings if the interests of creditors and debtor better served by such dismissal); 28 U.S.C. Section 1334 (providing that bankruptcy court can abstain under appropriate circumstances). In practice, however, such dismissals or abstentions are generally rare.