Liquidation

Ruth Sarah Lee*

At its heart, Chapter 11 is supposed to be about giving struggling businesses a new beginning, predicated on the idea that “a failing business can be reshaped into a successful operation . . . a predictable creation from a people whose majority religion embraces the idea of life from death and whose central myth is the pioneer making a fresh start on the boundless prairie.”[1] However, major Chapter 11 cases filed in the past few months, and the subsequent discussions they provoked, raise a new question to peruse: how new should the new beginning be—how fresh the fresh start? When a corporation vows to change its business model in order to pay back its debts and become more successful, how much is it supposed to change? Can it morph into a completely different corporation after it emerges? Corporations like Borders Group, Inc. (“Borders”) or Blockbuster Inc. (“Blockbuster”) might be making Chapter 11 the fashionable, new way to metamorphose.

As far as large corporations are concerned, Chapter 11 should be about capturing, retaining, and protecting something that is of value. If a corporation has nothing of worth that can be preserved through reorganization, there are very few reasons why it should not be liquidated immediately, its parts dissembled and auctioned, whatever lifeblood leftover to be given to its creditors. All reorganization efforts “proceed in the shadow of the [liquidation] alternative…[r]eorganizations are designed and evaluated by comparison with the outcomes available” under liquidation.[2] What this means is that some corporations should file for Chapter 11 bankruptcy, while others should liquidate, depending on what they have to offer.

In practice, however, Congress created powerful incentives for all corporations to choose Chapter 11 in the past three decades.[3] Among these incentives are strong presumptions in favor of letting the debtor stay in control and the elimination of the insolvency requirement.[4] Related to this, legal academics have criticized reorganization procedures, regarding the system to be corrupt, due to forum-shopping, judicial irresponsibility, and competition.[5] But, these forces that guide corporations toward corruption are also steering companies into a new sort of reinvention bankruptcy—that is, a corporation that is popularly agreed to be not-viable nonetheless files for Chapter 11 with hopes of not only refinancing, re-designing, or changing its business model—by changing the entire business itself.

In reorganization, corporations need to have their reorganization plans confirmed by the bankruptcy judge, who, in turn needs to ascertain, inter alia, that confirmation “is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan.”[6] As a result, at least theoretically, corporations should come up with plans that sound at least potentially successful. Blockbuster, which recently put itself up for sale when its reorganization plan collapsed,[7] can hardly be mentioned without an obligatory nod to Netflix and Redbox, both often credited with putting Blockbuster out of business, and both often cited as reasons why Blockbuster should have just liquidated instead of putting up a fight.[8] Netflix and Redbox are Blockbuster’s more digital age savvy competitors, famous for cheaper by-mail and vending-kiosk movie rentals, respectively. But now, Blockbuster is planning on “closing old-fashioned stores, installing new kiosks, and diving into digital delivery.”[9] In other words, Blockbuster is trying to turn into Netflix.

Observers have noted similarities between Blockbuster’s Chapter 11 and Borders’ Chapter 11.[10] Both are companies victimized by the digitalization of media and burdened with chains of large physical stores.[11] Borders’ bankruptcy has been attributed to “its failure to establish a strong online sales operation and a slow embrace of electronic books.”[12] Like Blockbuster, Borders is playing the chameleon by changing its identity: shifting “the focus away from its physical presence” and at the same time “overhaul[ing] its website and introduc[ing] a digital book store.”[13]

Borders and Blockbuster are merely two examples of companies that seem somewhat antiquated to the electronic generation. And as they flounder around in Chapter 11, they both have their eyes on becoming digitized, unrecognizable from their former selves. It is one thing to do a balance-sheet reorganization, refinance, close unprofitable chain stores, and rethink a business model, but it is another thing entirely to turn yourself from a video rental store into an online streaming service; or from a physical bookstore into Amazon.com. Yet this is what these corporations are considering.

In one sense, this is the same old story we have all heard before, that a bankrupt corporation must find new ways to make profits. However, practically speaking, this means that the 11 U.S.C. § 1129 hurdle should be relatively easy to clear as long as a corporation is flexible enough about its future. Any out-of-date corporation can turn around, point its finger at a more successful, technologically fashionable company and say, “I am going to be like that!” It is true that a judge might be skeptical about the ability of the corporation to change, especially in light of its debts, but Blockbuster is an example that is very established in its ways, with almost $1 billion in debt at the time of filing.[14]

Furthermore, this is actually a radical shift in the essence of reorganizational bankruptcy: We are no longer considering a corporation that has any worth to preserve at the beginning of the reorganization, we are considering a corporation that wants to create worth by reinventing itself.[15] We are no longer dealing with a viable business that has fallen on hard times and needs some tweaking; we are dealing with businesses that are so admittedly unviable that they need to transform into a completely different business in order to convince the bankruptcy judges that they have a fighting chance at life.

Borders is transforming into Amazon.com. Blockbusters is transforming into Netflix. What is Chapter 11 reorganization transforming into? Perhaps—rebirth.

* J.D. Candidate, 2012, Harvard Law School. The author would like to thank Kevin Cooper, Jason Iuliano, Mike Patrone, and especially Emily Zand for their help with this Commentary; also Professor Lynn LoPucki and Professor Katherine Porter for inspiring her foray into the world of Bankruptcy Law. All errors remain my own.

[1] Elizabeth Warren & Jay Lawrence Westbrook, The Success of Chapter 11: A Challenge to the Critics, 107 Mich. L. Rev. 603, 604 (2009).

[2] See Elizabeth Warren, Business Bankruptcy 28 (1993).

[3] Michael Bradley & Michael Rosenzweig, The Untenable Case for Chapter 11, 101 Yale L.J. 1043, 1045 (1992) (noting that the “presumption favoring management’s continued control, when combined with other provisions of Chapter 11 affording the corporate debtor considerable latitude regarding its treatment of creditors,effectively gave managers powerful incentives to pursue bankruptcy reorganization.”).

[4] See 11 U.S.C. § 1107 (2006).

[5] See, e.g., Bradley & Rosenzweig, supra note 3; see also Lynn M. LoPucki & Joseph W. Doherty, Delaware Bankruptcy: Failure in the Ascendancy, 73 U. Chi. L. Rev. 1387 (2006); Lynn M. LoPucki & Sara D. Kalin, The Failure of Public Company Bankruptcies in Delaware and New York: Empirical Evidence of a ‘Race to the Bottom’, 54 Vand. L. Rev. 231 (2001).

[6] 11 U.S.C. §1129(a)(11) (2006).

[7] See Ben Fritz, Blockbuster To Put Itself Up For Sale, L.A. Times, Feb. 21, 2011, http://articles.latimes.com/2011/feb/21/business/la-fi-ct-blockbuster-20110222.

[8] See, e.g., The Feldman File, http://feldmanfile.blogspot.com/ (Mar. 1, 2011, 13:32 CST); Mae Anderson, Blockbuster, Creditors Agree on Sale Plan, Bloomberg Businessweek, Mar. 10, 2011, http://www.businessweek.com/ap/financialnews/D9LSLSVO0.htm; Scott Gordon, What is the Future of Blockbuster?, NBC Bus. News, July 9, 2010, http://www.nbcdfw.com/news/business/What-Is-the-Future-of-Blockbuster-98149184.html; Blockbuster Files for Chapter 11 Business Reorganization, Business First, Sept. 23, 2010, http://www.bizjournals.com/louisville/stories/2010/09/20/daily39.html (noting that Blockbuster “lost out because Netflix and RedBox gained ground quickly with new platforms, and Blockbuster moved too late . . . like the Captain of the Titanic [Keyes, Blockbuster’s CEO] got on the ship after it hit the iceberg. He has been trying to bail it out with a bucket.”)

[9] Gordon, supra note 8.

[10] Nathan Borney, Blockbuster’s Proposed Bankruptcy Sale is Uncomfortable Reminder for Borders, Ann.Arbor.com Business News, Feb. 22, 2011, http://www.annarbor.com/business-review/blockbusters-proposed-bankruptcy-sale-is-uncomfortable-reminder-for-borders/.

[11] Id.

[12] Id.

[13] Joseph Checkler, Borders Files for Chapter 11 Bankruptcy Protection, Wall St. J. Online, Feb. 17, 2011, http://online.wsj.com/article/SB10001424052748703373404576147922340434998.html.

[14] See Checkler, supra note 13.

[15] An argument that could be made is that the brand name itself (Borders or Blockbuster) is value worth preserving through Chapter 11, even if the companies themselves completely change into unrecognizably new companies. However, this departs from most of the traditional Chapter 11 discussions (which are mainly about preserving assets and jobs).

Preferred citation: Ruth Sarah Lee, Corporate Reorganization as Corporate Reinvention: Borders and Blockbuster in Chapter 11, 1 Harv. Bus. L. Rev. Online 53 (2011), https://www.hblr.org//?p=1002.

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Harvey R. Miller & Maurice Horwitz^*

On October 19, 2010, the FDIC published a proposed rule governing the implementation of Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).[1] Title II of Dodd-Frank creates an orderly liquidation authority for the resolution of systemically important financial institutions.[2] According to the FDIC’s Notice of Proposed Rulemaking Implementing Certain Orderly Liquidation Authority Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, “[t]he liquidation rules of Title II are designed to create parity in the treatment of creditors with the Bankruptcy Code and other normally applicable insolvency laws.”[3]

One of the criticisms of Title II, however, is that creditors lack the same degree of certainty with respect to their probable treatment under an FDIC receivership as compared with the bankruptcy process. The FDIC’s typical response to this concern is that the statute guarantees creditors no less than the amount they would have received if the covered financial company had been liquidated under chapter 7 of the Bankruptcy Code.[4]

This response is inherently flawed because it assumes that one could state objectively what a creditor’s probable recovery would be in a hypothetical chapter 7 case. All judgments of value are subjective, even if based to some extent on objective facts. It is for this reason that valuation disputes are among the most common forms of litigation in Bankruptcy Courts. However, Title II does not appear to provide any recourse to creditors who disagree with the FDIC’s determination of value in most contexts. What follow are some examples of how the subjective value determinations of the FDIC may affect creditor treatment under Title II. These examples demonstrate the lack of transparency and creditor rights that is a general issue with FDIC receiverships.

Bifurcation of Secured Claims. To the extent that the FDIC determines that a claim is undersecured, Title II gives the FDIC the authority to bifurcate claims and treat the undersecured portion as an unsecured claim.[5] The FDIC may make payments to a secured creditor pursuant to the disposition of its collateral, but is under no obligation to make any payment with respect to the undersecured portion of the claim.[6] One cannot imagine a more likely scenario for a valuation dispute. If the FDIC cannot dispose of a secured creditor’s collateral, then the FDIC will value the underlying security and determine to what extent the security is insufficient, and pay the secured creditor based on that valuation. Moreover, even if the FDIC disposes of a secured creditor’s collateral, secured creditors may wish to be involved in the development and administration of the sale process, as well as the determination of the price that the FDIC decides is acceptable. Creditors whose claims are secured by highly illiquid or distressed assets will be particularly disadvantaged, both by the FDIC’s absolute discretion in valuing or disposing of such assets and by its relative inexperience in managing such assets.

Transfer of Assets To A Bridge Financial Company. Title II gives the FDIC the ability to organize a “bridge financial company,”[7] and transfer any assets and liabilities of the covered financial company to the bridge financial company without assignment, consent, or obtaining any approval under federal or state law.[8] It is not clear, however, what sort of value a bridge financial company would be required to provide in exchange for such assets. The statute provides that a bridge financial company may either “assume” liabilities, or “purchase” assets of the covered financial company.[9] Presumably, therefore, Congress intended that the bridge financial company would provide some consideration for the transferred assets. But what consideration? This question will be crucial for those unsecured creditors whose liabilities are not assumed by the bridge financial institution, as they will be left to rely on the proceeds of such a transfer in the subsequent distribution of the remaining assets. Title II does not appear to provide any recourse for creditors who believe that the bridge financial institution has not paid fair value.

Adequate Protection for Priming Liens. Title II may also affect secured claims if the FDIC transfers encumbered assets to a bridge financial company. In these circumstances, the FDIC may authorize the bridge company to issue debt with first priority liens (i.e., “priming liens”) on such assets.[10] Fortunately, in such circumstances and unlike for other actions by the FDIC, a hearing is required before a federal district court: the FDIC must demonstrate to the court that secured creditors’ preexisting liens are adequately protected.[11] However, the statute does not define the nature of this process, even though it is an area likely to give rise to significant litigation over valuation of the collateral security and what would constitute adequate protection for the secured creditor.

Liquidation Analysis. Under Title II, the FDIC may favor certain creditors over others that are similarly situated, or pay certain creditors before others.[12] Similar results can be obtained in a chapter 11 case, but typically require creditor consent and court approval. Not so under Title II: the FDIC has complete discretion in making this decision. To allay creditor fears, the FDIC cites the statutory “guarantee” that creditors will receive no less, in any event, than they would have received in a chapter 7 liquidation. To ensure that this guarantee is met, however, will require a comparison of the distributions proposed by the FDIC in a Title II liquidation with the probable distributions that would be available to creditors in a chapter 7 liquidation. Who will make this comparison? Who will prepare the liquidation analysis to demonstrate that the FDIC has met its burden? The FDIC should craft rules not only to address these questions, but also to ensure that the liquidation analysis is credible—ideally, performed by an independent third party—and not dependent on the FDIC’s subjective view of an institution’s liquidation value.

If, through the rulemaking process, value determinations such as the foregoing can be placed in the hands of independent third party arbiters, Title II may yet achieve parity with the Bankruptcy Code. Meaningful dialogue on this subject will require the FDIC, industry executives, investors, and academics to recognize that any potential outcome for creditors under Title II, as it currently stands, depends disproportionately more on the subjective value determinations of a single party—the FDIC receiver—than would ever be the case in a chapter 7 bankruptcy

* Mr. Miller is a Partner, and Mr. Horwitz is an Associate, at Weil, Gotshal & Manges LLP.

[1] Pub. L. No. 111-203, 124 Stat. 1376 (2010) (to be codified at 15 U.S.C. § 78o-7).

[2] §§ 201–217.

[3] 75 Fed. Reg. 64,182, 64,175 (proposed Oct. 19, 2010) (to be codified at 12 C.F.R. pt. 380).

[4] See §§ 210(a)(7)(B), (d)(2)(B).

[5] See § 210(a)(3)(D)(ii).

[6] § 210(a)(2)(D).

[7] See § 210(h)(1)(A).

[8] See § 210(h)(5)(A), (D).

[9] See § 210(h)(1).

[10] See § 210(h)(16)(C).

[11] See § 210(h)(16)(C)(ii).

[12] See § 210(b)(4).

Preferred citation: Harvey Miller & Maurice Horwitz, One Way That Dodd-Frank’s Liquidation Authority Could Achieve Parity With The Bankruptcy Code, 1 Harv. Bus. L. Rev. Online 1 (2010), https://www.hblr.org//?p=350.

Liquidation

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