(2097)
ARTICLE
BANKRUPTCY’S IDENTITY CRISIS
DAVID SKE EL
†
e large companies that currently le for Chapter 11 look very dierent
from the typical Chapter 11 cases of the past. e liability side of debtors’ balance
sheets is much more complex and now consists primarily of secured rather than
unsecured obligations. Many rms that might once have borrowed on a secured basis
from a bank and on an unsecured basis from bondholders now have rst and second
liens instead. Leveraged loans have further contributed to the prevalence of secured
debt.
While these developments are benecial in many respects, they have
exacerbated two serious problems in Chap ter 11. e rst is the unusually high
variability in outcomes in large cases as lenders enter and exit the lending syndicates
and as debtors and creditors exploit loopholes in the credit documents through
“uptiering” and “dropdown” or “trapdoor” transactions. Second is a growing
perception that insiders benet from Chapter 11 and outsiders often do not. An
unfortunate irony is that eorts (such as restructuring support agreements) to reduce
the rst problem—uncertainty—often exacerbate the second—insider control.
Part I of the Article recounts the shift in debtors’ capital structure due to the
new nancing techniques, highlighting a surprising feature of the emergence of the
leveraged loan and CLO markets: women playing an unusually prominent role. Part
II explores the close, though partial, relationship between private equity funds and
these recent developments. e nal part considers a series of potential solutions and
interventions for addressing the downsides of the new nancing techniques. e Part
advocates an incrementalist approach while warning that, unless the perception that
†
S. Samuel Arsht Professor, University of Pennsylvania Carey Law School. Thanks to Ken
Ayotte, Jared Ellias, Victoria Ivashina, Dominique Mielle, Elizabeth Pollman, and Kate Waldock for
helpful comments and conversations; to Julia Raphael and Anna Statz for excellent research
assistance; and to the University of Pennsylvania Carey Law School for generous summer funding.
2098 University of Pennsylvania Law Review [Vol. 171: 2097
Chapter 11 is rigged in favor of insiders is addressed, pressure may build for more
radical reform.
I
NTRODUCTION ........................................................................... 2098
I. T
HE NEW COO RDINATION PROBLEMS.................................... 2102
A. Key Features of Lending and Capital Structure .............................. 2103
1. Leveraged Loans, CLOs, and Pioneering Women.............. 2103
2. Predominance of Secured Claims ......................................2106
3. Complexity....................................................................... 2107
B. Complexity in Action .................................................................2108
C. The Darkside of the New Regime................................................. 2110
II. I
S THIS A PRIVATE EQUIT Y P HENOMENON?.............................2113
III. S
OLUTIONS AND INTERVENTIONS ............................................21 16
A. Addressing Gaps by Contract........................................................2117
B. Imposing a Duty of Good Faith.................................................... 2118
C. Banning Signing Fees in RSAs ....................................................2120
D. Loosening the Sclerotic Market for Bankruptcy Financing................ 2122
E. Reg ulatory Restraints on Private Equity Fund s .............................. 2123
F. Reforming Non-Debtor Releases .................................................. 2125
C
ONCLUSION................................................................................ 2127
I
NTRODUCTION
Chapter 11 is experiencing an identity crisis. Current bankruptcy law
assumes that troubled corporations have substantial amounts of unsecured
debt held by widely scattered unsecured creditors, as does the standard
normative account of corporate bankruptcy.
1
This assumption, which once
mirrored reality, is reected in features such as the creation of an estate-
funded creditors’ committee in every substantial bankruptcy case to
1
The standard account is the “creditors’ bargain theory” formulated by Thomas Jackson and
Douglas Baird. See, e.g., T
HOMAS H. JACKSON, T HE LOGIC AND LIMITS OF BANKRUPTCY LAW
7-17 (1986) (describing the theory of creditors bargaining outside the bankruptcy process); Douglas
G. Baird & Thomas H. Jackson, Corporate Reorganizations and the Treatment of Diverse Ownership
Interests: A Comment on Adequate Protection of Secured Credi tors in Bankruptcy, 51 U.
CHI. L. REV. 97,
112-14 (1984) (explaining that interest holders strike bargains in acquiring rights to assets). Jackson
recounts the origins of the creditors’ bargain theory in a recent essay. See Thomas H. Jackson, A
Retrospective Look at Bankruptcy’s New Frontiers, 166 U. P
A. L. REV. 1867, 1867-68 (2018).
2023] Bankruptcy's Identity Crisis 2099
counteract collective-action problems that might impede coordination by
unsecured creditors.
2
The large companies that currently le for Chapter 11 look very dierent
from the typical Chapter 11 cases of the past. Although the operating
businesses that le for Chapter 11 are not necessarily dierent, their capital
structure is. The liability side of debtors’ balance sheets is much more
complex and now consists primarily of secured rather than unsecured
obligations.
3
These changes are part of the larger revolution in nancial engineering in
the past several decades. Many rms that might once have borrowed on a
secured basis from a bank or syndicate of banks and on an unsecured basis
from bondholders or other unsecured creditors now have rst and second
liens instead.
4
The emergence of the leveraged-loan market has further
contributed to the prevalence of secured debt.
5
Leveraged loans are secured
loans to troubled corporate debtors that are often packaged together in
securitized entities called collateralized loan obligations, or CLOs.
6
The
expansion of secured nancing has shifted the center of gravity in current
Chapter 11 cases. Secured creditors, not unsecured creditors, are now the
principal players.
7
These developments are in some respects quite benecial. By providing
access to credit for struggling companies, leveraged loans may sometimes
make bankruptcy unnecessary for a rm whose distress would have landed it
in Chapter 11 in an earlier era.
8
The novel nancing techniques (and parallel
developments) have also improved Chapter 11 in two important respects.
First, cases proceed much more quickly than they once did due to factors such
as milestones imposed by a debtor’s secured lenders.
9
In addition, the new
2
See 11 U.S.C. § 1102(a)(1). For a defense of creditors’ committees in response to contentions
that they should no longer be mandatory in large cases, see Christopher S. Sontchi & Bruce
Grohsgal, Should the Appointment of an Unsecured Creditors’ Committee Be Made Optional in Chapter
11?, A
M. BANKR. INST. J., Nov. 2019, at 12, 73-75.
3
These developments are chronicled in greater detail infra subsections I.A.2 (ubiquity of
secured debt) and I.A.3. (increasing complexity).
4
See, e.g., Kenneth Ayotte, Anthony J. Casey, & David A. Skeel, Jr., Bankruptcy on the Side, 112
N
W. U. L. REV. 255, 269-72 (2017) (describing RadioShack’s two groups of secured lenders).
5
The rise of the leveraged-loan market is described in Elisabeth de Fontenay, Do the Securities
Laws Matter? The Rise of the Leveraged Loan Market, 39 J.
CORP. L. 725, 739-42 (2014).
6
For discussion of leveraged loans and CLOs, see infra subsection I.A.1.
7
David A. Skeel, Jr. & George Triantis, Bankruptcy’s Uneasy Shift to a Contract Paradigm, 166 U.
P
A. L. REV. 1777, 1779 (2018).
8
See, e.g., Matt Grossman, Junk-Loan Market Shrugs O Economic Worries, WALL ST. J. (Feb.
13, 2023, 4:25 PM), https://www.wsj.com/articles/junk-loan-market-shrugs-o-economic-worries-
824b701b [https://perma.cc/MMF2-7WFD] (“The loan market helps keep cash-poor businesses
aoat and provides much of the funding for Wall Street’s mergers-and-acquisitions machine.”).
9
For evidence that cases proceed faster, see, for example, Foteini Teloni, Chapter 11 Duration,
Pre-Planned Cases, and Reling Rates: An Empirical Analysis in the Post-BAPCPA Era, 23 A
M. BANKR.
2100 University of Pennsylvania Law Review [Vol. 171: 2097
lending techniques may help break the monopoly a debtor’s pre-bankruptcy
lenders have over new nancing in bankruptcy as an unintended consequence
of the increased multiplicity and diversity of lenders.
10
Two or more of a
debtor’s current lenders may oer competing nancing bids, as in the recent
Neiman Marcus bankruptcy.
11
While the developments have been benecial overall, the nancing
revolution has exacerbated several of the biggest problems in current Chapter
11 practice. The rst is the unusually high variability in outcomes in large
cases as lenders enter and exit the lending syndicates and as debtors and
creditors exploit loopholes in the credit documents through strategies such as
“uptiering” (arranging with a subset of lenders for a loan that has priority
over existing senior lenders) and “dropdown” or “trapdoor” (transferring
assets to subsidiaries that are not restricted under the debtor’s loan
documents and using the assets as collateral for ne w loans).
12
The new
nancing techniques exacerbate this tendency by creating new coordination
issues. The coordination issues that bedevil current cases do not arise
naturally due to an inability or failure to coordinate, as did the collective-
action problems of the past. They arise from the terms of contracts the parties
negotiate with one another. For this reason, I sometimes will call them
“synthetic collective-action problems.”
Uncertainty—even uncertainty arising from coordination issues—is not
always pernicious. If creditors sometimes nd themselves on the losing side
of an uptiering or dropdown transaction and sometimes on the winning, the
variability of outcomes may not seem problematic. But even if the results
were a wash overall, the uncertainty invites unnecessary costs as creditors
jockey for inside position.
13
And some creditors may be systematically
disadvantaged as a result of the maneuvers, rarely being included in the
winning coalition.
14
INST. L. REV. 571, 592-93 (2015) (nding that the mean duration for traditional Chapter 11 cases
dropped from 634 to 430 days after 2005, and the mean for all cases (including prepackaged
bankruptcies) fell from 480 to 261 days after 2005).
10
This is a central theme of David A. Skeel, Jr., Pandemic Hope for Chapter 11 Financing, 131
YALE L.J.F. 315, 318 (2021) (“Although the new capital structure complexity has potential downsides,
it also has a signicant upside: it can provide a solution, or at least the beginning of a solution, to
the lack of competition for DIP nancing. ”).
11
See id. at 315 (“After Neiman Marcus, the luxury department store, led for Chapter 11 in
May 2020, two dierent groups of lenders vied to provide bankruptcy nancing.”).
12
These maneuvers, often associated with Serta and J.Crew, respectively, are described in more
detail infra Section II.B.
13
For a similar argument, see Kenneth Ayotte & Alex Zhicheng Huang, Standardizing and
Unbundling the Sub Rosa DIP Loan 21-22 (Dec. 27, 2022) (unpublished manuscript),
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4313279 [https:// perma.cc/E2CP-6KWK]
(discussing deadweight costs).
14
See, e.g., id. (“Anecdotally, CLOs are often the victims of priority-shifting tactics.”).
2023] Bankruptcy's Identity Crisis 2101
Although companies owned by private equity funds are not the only
companies that reect the new capital structure, private equity funds have
been especially aggressive in exploiting credit documents.
15
And private
equity sponsors are over-represented in large corporate bankruptcy cases
more generally. Roughly seventy percent of the companies that qualify as
distressed are owned by private equity funds.
16
In addition to enhanced uncertainty, the second problem in Chapter 11 is
a growing perception that insiders benet from Chapter 11 while outsiders
often do not. This perception stems in part from controversial cases largely
unrelated to the new nancing techniques, such as the Purdue Pharma opioid
case.
17
But insider control is especially prevalent in cases involving the new
nancing techniques.
An unfortunate irony of the current landscape is that eorts to solve the
rst problem—uncertainty—frequently exacerbate both the perception and
the reality of insider control. The most obvious illustration here is the now-
ubiquitous use of restructuring support agreements, or RSAs.
18
By
committing the parties to the terms of a potential reorganization plan, RSAs
help counteract an important source of uncertainty: the risk that a deal a
debtor reaches with some of its creditor s will fall apart if creditors sell their
claims and the new holders do not share their predecessors’ perspective.
19
But
RSAs are negotiated by insiders and usually benet the insiders by
compensating them in a variety of ways, such as paying them to “backstop”
the sale of new stock when a company emerges from Chapter 11.
20
The
15
Private equity funds are pools of investment capital their managers use to, among other
things, acquire companies, usually borrowing a substantial portion of the purchase price. The private
equity managers ordinarily run the company for a few years with the intention of later selling it or
taking it public again. For an analysis of the private equity industry by an unabashed booster, see
generally S
ACHIN KHAJURIA, TWO AND TWENTY: HOW THE MASTERS OF PRIVATE EQUITY
ALWAYS WIN (2022).
16
See Mayra Rodriguez Valladares, Over Half of Rated Company Defaulters Are Owned by Private
Equity Firms, F
ORBE S (July 16, 2020, 5:32 PM),
https://www.forbes.com/sites/mayrarodriguezvalladares/2020/07/16/over-half-of-rated-company-
defaulters-are-owned-by-private-equity-rms/?sh=33bd33d37b1c [https://perma.cc/KLC6-C75B].
17
See, e.g., Anthony J. Casey & Joshua C. Macey, In Defense of Chapter 11 for Mass Torts, 90 U.
CHI. L. REV. 973, 984-86 (2023) (describing the controversy over the Purdue Pharma case).
18
Casey, Tung, and Waldock document the rapid rise in use of RSAs. See generally Anthony J.
Casey, Frederick Tung & Katherine Waldock, Restructuring Support Agreements: An Empirical
Analysis (Jan. 2022) (unpublished manuscript) (on le with author).
19
See, e.g., David A. Skeel, Jr., Distorted Choice in Corporate Bankruptcy, 130 YALE L.J. 366, 370
(2020) (“The RSA commits its signatories to support a future reorganization plan that conforms to
the terms of the RSA, including the proposed payout to each creditor class.”).
20
A “backstop” is a promise for which the insiders are given a fee to purchase any stock that
remains unsold after the oering. For a description in a controversial case that upheld very lucrative
backstopping fees, see generally Ad Hoc Comm. of Non-Consenting Creditors v. Peabody Energy
Corp. (In re Peabody Energy Corp.), 933 F.3d 918 (8th Cir. 2019).
2102 University of Pennsylvania Law Review [Vol. 171: 2097
solution can be as dissatisfying as the problem, raising concerns that Chapter
11 no longer works as intended and may need to be rethought.
Part I of this Article recounts the shift in debtors’ capital structure due to
the new nancing techniques, highlighting a surprising feature of the
emergence of the leveraged-loan and CLO markets: women playing an
unusually prominent role. This Part chronicles the coordination problems
that have recently arisen, as reected in a handful of much-discussed recent
cases such as Serta, J.Crew, and RadioShack. These developments have
exacerbated two key problems in current bankruptcy practice: the uncertainty
of outcomes and the perception that insiders dominate Chapter 11.
Part II explores the close, though partial, relationship between private
equity funds and these recent developments. The frequent presence of private
equity funds in the most notorious cases raises two questions: whether the
problems have more to do with private equity than with the new nancing
techniques, and whether overrepresentation of private equity is likely to
endure. This Part concludes that the problems are not simply private equity
problems and that private equity–sponsored companies may not be quite as
ubiquitous in Chapter 11 in the future as they are now.
Part III considers a series of potential solutions and interventions that
have been or might be proposed for addressing the downsides of the new
nancing techniques. The analysis begins by considering the possibility that
the problems will be addressed by better contr act-drafting. This Part then
explores four potential correctives, ranging loosely from the least to the most
intrusive: using priming liens more frequently; barring signing fees for those
who commit to an RSA; imposing a good-faith duty for debt; and restricting
or banning the use of third-party releases. This Part advocates an
incrementalist approach while warning that, unless the perception that
Chapter 11 is rigged in favor of insiders is addressed, pressure may build for
more radical reform.
I. T
HE NEW COORDINATION PROBLEMS
The classic theory of bankruptcy is premised on a debtor with widely
scattered, unsecured creditors whose inability to coordinate could jeopardize
the continued existence of an otherwise viable rm, destroying its going
concern value.
21
Large corporate debtors in Chapter 11 now often look very
dierent from those envisioned by the classical theory. Their debt is nearly
all secured rather than unsecured, and the debtor and creditors seem to be in
21
See JACKSON, supra note 1, at 7-11.
2023] Bankruptcy's Identity Crisis 2103
a position to anticipate and plan for the possibility of bankruptcy.
22
Yet
serious coordination problems remain.
23
Because these problems emerge in
an environment where coordination is possible, and traditional collective
action problems do not exist, they are “synthetic” collective action problems.
The discussion of the new coordination problems in this Part proceeds in
three steps. The Part begins by exploring key features of the capital structure
of current large corporate debtors. Next, it briey describes the conicts that
have arisen in three much-discussed rece nt cases. In each case, the conicts
were made possible by gaps in the governing loan documents. The Part then
focuses on two key problems that have been exacerbated by these
developments—the uncertainty of recent cases and the perception that
insiders control the Chapter 11 process—and considers the relationship
between them.
A. Key Features of Lending and Capital Structure
1. Leveraged Loans, CLOs, and Pioneering Women
The rst key feature of current capital structure is the widespread use of
leveraged-loan borrowing. The term “leveraged loan” refers broadly (and
loosely) to any “type of loan made to borrowers who already have high levels
of debt and/or a low credit rating.”
24
Two decades ago, loans that t this
description comprised only a pittance of the debt markets—$100 billion in
volume.
25
Since then, the use of leveraged loans has grown exponentially. The
current volume of $1.5 trillion is compara ble to, and soon likely to exceed, the
volume of the traditional high-yield debt market.
26
22
See Skeel & Triantis, supra note 7, at 1779 (“Unsecured creditors are less likely to be the key
constituency in current cases than they were a generation ago, and the traditional collective action
problems are correspondingly less relevant in many cases. ”).
23
See, e.g., Kenneth Ayotte & Christina Scully, J. Crew, Nine West, and the Complexities of
Financial Distress, 131 Y
ALE L.J.F. 363, 363-66 (2021) (describing the complexity of current capital
structures).
24
U.S. Securities and Exchange Commission, Leveraged Loan Funds, INVESTOR.GOV,
https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-
funds-and-exchange-traded-0 [https://perma.cc/LA9G-CJXC] (last visited Feb. 8, 2023).
25
Leveraged Lending and Corporate Borrowing: Increased Reliance on Capital Markets, with
Important Bank Links, FDIC
Q., 2019, at 44 (citation omitted) (“The leveraged loan market has
grown dramatically over the past 20 years from about $100 billion outstanding in 2000 to almost $1.2
trillion in 2019.”).
26
Matt Wirz, Junk-Loan Defaults Worry Wall Street Investors, WALL ST. J. (Sept. 6, 2022, 5:30
AM), https://www.wsj.com/articles/junk-loan-defaults-worry-wall-street-investors-11662429632
[https://perma.cc/Y85C-9MHE] (showing that the leveraged-loan market is $1.5 trillion); America’s
High-Yield Debt Is on Ever-Shakier Foundations, E
CONOMIST (June 17, 2021),
https://www.economist.com/nance-and-economics/2021/06/17/americas-high-yield-debt-is-on-
2104 University of Pennsylvania Law Review [Vol. 171: 2097
Securitization in the form of collateralized loan obligation structures, or
CLOs, has been a key engine for the growth of the leveraged-loan market.
Before the advent of CLOs, a leveraged loan was little more than a very risky
loan to a struggling company. To create a CLO, the organizer purchases
numerous leveraged loans and packages them into a CLO, selling intere sts in
the CLO to various tranches of investors.
27
Much as securitization did with
mortgages, CLOs vastly expanded the market for leveraged loans.
A striking feature of the emergence of the leveraged-loan and CLO
markets is the greater role women seem to have played here than in other
precincts of Wall Street, such as the mortgage bond markets.
28
A recent story
speculated about the reason for this phenomenon:
The strong female cadre in CLOs traces back to gender discrimination at
banks in the late 1980s, when Wall Street still outshone Silicon Valley as the
destination of choice for the U.S.’s top university graduates . . . . Banks had
just started hiring more women with nance and technical degrees but rarely
placed them in high-prole—and high-paying—roles like trading bonds or
chasing merger deals. . . . Instead, women trainees were often assigned to
commercial lending, the less-glamorous business of making loans to
corporations. While bond traders like Michael Milken and corporate raiders
like Carl Icahn monopolized the limelight, women were often crunching the
numbers behind their big leveraged buyouts.
29
Dominique Mielle, who rose to partnership at the hedge fund Canyon
Capital Advisors, oers a dierent perspective. To the extent a
disproportionate percentage of CLO pioneers were indeed women—a
question that awaits empirical verication , Mielle notes
30
—women may have
benetted from an inherent gender neutrality:
ever-shakier-foundations [https://perma.cc/E2RY-8YY7] (describing the high-yield bond market as
being worth $1.7 trillion).
27
For a more detailed overview of CLOs, see, for example, Jennifer Johnson, Collateralized
Loan Obligations (CLOs) Primer, NAIC:
CAP. MKTS. BUREA U,
https://content.naic.org/sites/default/les/capital-markets-primer-collateralized-loan-
obligations.pdf [https://perma.cc/Y8NC-LECS].
28
The prevalence of men, especially of Italian descent, in Morgan Stanley’s pioneering
mortgage bond department is a recurring theme of M
ICHAEL LEWIS, LIAR’S POKER: RISING
THROUGH THE WRECKAGE ON WALL STREET (1989).
29
Matt Wirz, Women Claim New Turf on Wall Street, WALL ST. J. (Feb. 2, 2019, 7:00 AM),
https://www.wsj.com/articles/women-claim-new-turf-on-wall-street-11549108800
[https://perma.cc/6DDV-QM3P]. According to some evidence, CLOs structured by women also
perform somewhat better than CLOs assembled by men. See Matt Wirz, Female CLO Managers Tend
to Outperform Men, W
ALL ST. J. (Feb. 8, 2019, 8:00 AM), https://www.wsj.com/articles/female-clo-
managers-tend-to-outperform-men-11549630802 [https://perma.cc/RT5T-4Z7F].
30
Interview with Dominique Mielle (Oct. 12, 2022).
2023] Bankruptcy's Identity Crisis 2105
The CLO structure is . . . pretty transparent and pretty measurable. You have
vintages of CLOs, and they play in the same sandbox, right? You have the
same set of loans that you have to choose from and optimize your portfolio
and issue your debt at the optimal cost as well. Then, you look at the return
on equity, and it’s all tracked by either analysts or rating agencies. And so, it’s
much more transparent who is good and who is not good.
31
This gender neutrality in CLOs is notable when compared to hedge
funds, which “started at dierent times; they have dierent strategies,
dierent growth paths, et ce tera.”
32
The same qualities Mielle identies as creating opportunities for women
suggest that leverag ed loans and CLOs are not inherently problematic. Their
transparency makes them easier to track than many other investments. It may
or may not be coincidental that these CLOs, whose transparency stands in
striking contrast to many hedge and pr ivate equity fund investments,
33
often
appear to be on the losing side of the aggressive creditor tactics discussed
below.
34
The rise of the leveraged-loan market has vastly increased the liquidity
available to struggling mid-size and large corporations. For many rms, this
phenomenon may enable them to avoid a default or bankruptcy that might
have been inevitable in an earlier era.
35
Spurred by the success of leveraged loans, a new private capital industry
has emerged in which non-bank lenders make direct loans to companies with
the same no n-investment grade prole. Lenders such as HPS, Ares,
Blackstone, Centerbridge, and Oak Tree are major sources of these direct
loans, and many of the largest private equity funds also now have a private
capital dimension.
36
The ipside of the benets of these loans—that they provide additional
liquidity for companies that might not otherwise have access to credit—is
31
Id.
32
Id. Mielle chronicles her own experience in a thoughtful and entertaining recent book. See
D
OMINIQUE MIELLE, DAMSEL IN DISTRESSED: MY LIFE IN THE GOLDEN AGE OF HEDGE
FUNDS (2021).
33
See generally, e.g., Ayotte & Huang, supra note 1 3 (arguing for standardization of DIP
nancing agreement terms to remove lenders’ ability to include lucrative and opaque terms, such as
backstopping fees).
34
See, e.g., id. at 21 (identifying CLOs as losers in these skirmishes). The aggressive tactics are
discussed infra Section I.B.
35
See, e.g., Grossman, supra note 8 (discussing how the leveraged-loan market has helped keep
some struggling business aoat).
36
See, e.g., Brian DeChesare, Private Equity Strategies: Growth, Buyouts, Credit, Turnarounds, and
Toll Roads to Nowhere, M
ERGERS & INQUISITIONS (July 29, 2020),
https://mergersandinquisitions.com/private-equity-strategies/ [https://perma.cc/94ZZ-PNMC]
(listing major players in direct lending).
2106 University of Pennsylvania Law Review [Vol. 171: 2097
that the borrowers pose a high risk of default.
37
Moreover, because the
originators of the loans often quickly transfer them to CLOs whose trustees
have weaker oversight incentives than a traditional bank, they may not be
monitored as eectively as traditional loans—though the evidence on this
point is mixed.
38
If they do le for bankruptcy, they may be in worse condition
than a company that led for bankruptcy earlier in its cycle of decline.
2. Predominance of Secured Claims
The second key feature of the typical large corporate debtor’s nancial
distress is a predominance of secured debt. Struggling businesses have always
taken on considerable secured debt prior to a default or bankruptcy,
39
but the
current environment has magnied this trend in several respects. The rst is
access to sources of secured debt that did not exist in the past. The leveraged
loans we encountered in the last subsection are a prime example.
The shift in this regard is vividly illustrated by the capital structure of
companies acquired by private equity funds. In the 1980s, when they were
known as leveraged buyout or LBO rms, private equity funds nanced
acquisitions primarily with unsecured junk bonds.
40
If the company fell into
distress and led for bankruptcy, it t the traditional paradigm of a relatively
small amount of secured senior debt and a substantial amount of unsecured
debt. Private equity funds currently use leveraged loans to nance
acquisitions far more than in the past, which has tilted the capital structure
balance toward secured rather than unsecured debt.
41
37
See, e.g., Grossman, supra note 8 (“Some investors have worried that the added pressure on
already shaky balance sheets could spark a wave of missed payments or bankruptcies.”).
38
McClane nds less intervention to police covenant violations with loans included in CLOs
than those that are not put into CLOs. See Jeremy McClane, Reconsidering Creditor Governance in a
Time of Financial Alchemy, 2020 C
OLUM. BUS. L. REV. 192, 259-61. Mitchell Berlin, Greg Nini, and
Edison Yu conclude, by contrast, that monitoring does not appreciably decline because many
borrowers have traditional loans as well as leveraged loans. See Mitchell Berlin, Greg Nini & Edison
G. Yu, Concentration of Control Rights in Leveraged Loan Syndicates, 137 J.
FIN. ECON. 249, 250 (2020).
39
See, e.g., Steven L. Schwarcz, The Easy Case for the Priority of Secured Claims in Bankruptcy, 47
D
UKE L.J. 425, 429 (1997) (describing the value of having the option to borrow on a secured basis
at a time of stress).
40
A considerable amount of popular literature recounts the rise of takeovers nanced by junk
bonds, a strategy pioneered by Michael Milken at Drexel Burnham. One of the best accounts is
C
ONNIE BRUCK, THE PREDATORS’ BALL: THE INSIDE STORY OF DREXEL BURNHAM AN D THE
RISE OF THE JUNK BOND RAIDERS (1988).
41
The use of leveraged loans has declined recently due to interest rate increases. See, e.g., Chris
Cumming, Private Equity Turns to Direct Lenders as Leveraged Loans Dry Up, W
ALL ST. J. (June 8,
2022, 6:00 AM), https://www.wsj.com/articles/private-equity-turns-to-direct-lenders-as-leveraged-
loans-dry-up-11654682400 [https://perma.cc/AB5B-FTJF] (“Buyout rms are increasingly looking
to private lenders to nance their deals, as the once robust ow of junk bonds and leveraged loans
has dwindled to a trickle.”). But the direct loans that private equity funds have turned to are also
secured. See, e.g., O
AKTREE INSIGHTS, DIRECT LENDING: BENEFITS, RISKS AND
2023] Bankruptcy's Identity Crisis 2107
The second, overlapping development is the increased use of rst-and-
second-lien arrangements—overlapping in the sense that rst- or second-lien
loans may be purchased for CLOs, just as leveraged loans are. In a rst-and-
second-lien arrangement, the rst liens have senior liens on the collateral and
the second liens junior.
42
The second liens occupy a similar position to the
unsecured bonds issued by companies with bonds and often are used by
companies for whom bonds would be too costly or dicult to issue. The
dierence is that second liens, unlike bonds, are secured.
The predominance of secured debt is reected in the location of the
residual claimant or “fulcrum security” of Chapter 11 debtors. The fulcr um
security is the rst class of claims of a debtor that cannot realistically be paid
in full. These are the creditors that will benet most from an eective
Chapter 11 process and suer from an inecient one.
43
The Bankruptcy Code
appears to envision that the fulcrum security will be a class of widely scattered
unsecured claims.
44
It provides, for instance, for an estate-funded unsecured
creditors committee in every substantial case.
45
Current cases often do not t
this paradigm. In many recent cases, the second liens are the fulcrum security,
because so much of the capital structure consists of secured debt.
46
3. Complexity
A nal noteworthy feature of current capital structure is complexity,
which has had ironic implications: although the evolution of nance has
magnied the parties’ ability to coordinate—thus rendering traditional
OPPORTUNITIES 3 (2021), https://www.oaktreecapital.com/docs/default-source/default-document-
library/direct-lending.pdf?sfvrsn=347d7e66_4 [https://perma.cc/G3HU-JQ9C] (describing direct
lending and noting, as a benet of direct loans, that “[t]hese loans typically oer strong downside
protection because they are collateralized and high in the capital structure”).
42
See, e.g., Ayotte et al., supra note 4, at 269-70 (describing rst-and-second-lien arrangements
for RadioShack). Unitranche loans often have a similar structure, except that the arrangement
technically has a single lien with senior and junior cashow rights. For a good overview of
Unitranche nancing, see McCarthy M. Shelton, Turning the Middle Market Upside Down:
Unitranche Financing in U.S. Middle-Market Leveraged Buyouts 17-20 (2017) (B.A. thesis,
Appalachian State University), https://case.edu/law/sites/case.edu.law/les/2020-
02/Shelton%2C%20Mac%20Spring%202017%20Turning%20the%20Middle%20Market%20Upside%
20Down%20%2843%20p.%29.pdf [https://perma.cc/HV6B-MLJ8].
43
See generally David A. Skeel, Jr., The Nature and Eect of Corporate Voting in Chapter 11
Reorganization Cases, 78 V
A. L. REV. 461 (1992) (describing bankruptcy provisions that enhance
authority of the residual creditors and assuming these are unsecured creditors).
44
See, e.g., id. at 479-85 (explaining how the voting process concentrates authority in the
residual class).
45
See 11 U.S.C. § 1102(a)(1).
46
See generally Douglas G. Baird & Robert K. Rasmussen, Antibankruptcy, 119 YALE L.J. 648,
675 (2010) (“If the second lien position is the fulcrum security—the security which is in the money,
but not being paid in full—then the reorganization is being run for the second lien lender s’ benet
and they should pay for it.”).
2108 University of Pennsylvania Law Review [Vol. 171: 2097
collective-action problems obsolete for most rms—the greater ability to
contract has not eliminated coordination problems. Their complexity has
introduced new coordination problems.
One form of complexity arises from the use of separate entities within a
corporate enterprise. In recent work, Ken Ayotte shows that debtors can
exploit lenders’ diering valuations of the debtor’s assets by creating new
subsidiaries.
47
If a debtor has two potential lenders, one of whom places an
optimistic valuation on one of the debtor’s assets and the other lender on
another asset, the debtor can exploit their optimism by putting the assets in
separate subsidiaries and borrowing in each case from the more op timistic
lender.
Additional complexity may arise from the eorts of sophisticated parties
to anticipate, or to exploit, gaps in a lending agreement. “Substantive choices
of contract terms are path dependent and aected by the law rm that
provides the rst draft,” Ayotte and Christina Scully point out, “not just the
economics of the transaction.”
48
Rather than reducing complexity, the
presence of sophisticated parties “magnies the impact of a contract’s
inevitable aws”:
49
Sophisticated parties use these aws to reallocate value from one coalition to
another. Restructuring transactions add complexity to capital structures due
to new layers of debt and legal entities, as well as the prospect of costly
litigation exploiting ambiguous provisions in law and contract. Capital
structure changes that occur in such scenarios . . . are workarounds of the
contractual and legal constraints on the ground when the restructuring
happens.
50
Somewhat counterintuitively, several nance scholars have found that so-
called “covenant-lite” loans—that is, loans with weak lender protections—
may be more complex than traditional loans.
51
B. Complexity in Action
The ingredients of current capital structure have proven to be unusually
combustible, giving rise to contested bankruptcies and restructurings that
47
See generally Kenneth Ayotte, Disagreement and Capital Structure Complexity, 49 J. LEGAL
STUD. 1 (2020).
48
Ayotte & Scully, supra note 23, at 365.
49
Id. at 366.
50
Id.
51
See Victoria Ivashina & Boris Vallée, Complexity in Loan Contracts 4 (May 6, 2022)
(unpublished manuscript), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3218631
[https://perma.cc/DDR5-L9FH] (“Complexity is positively correlated with well-known measures
of contract weakness in the literature such as ‘cov-lite’ provisions.”).
2023] Bankruptcy's Identity Crisis 2109
scholars have referred to as “bankruptcy hardball”
52
and “hostile
restructurings.”
53
Similarly vivid terms have crept into the practitioner
literature, which warns about “lender-on-lender violence”
54
and “predatory
priming.”
55
The fallout can be seen both in debtors’ eorts to avoid
bankruptcy and in the bankr uptcy context.
Two recent cases are emblematic of the principal strategies debtors have
employed in an eort to postpone a potential default or bankruptcy. In
Serta,
56
the rst case, the sponsor employed an aggressive though plausible
interpretation of its loan documents to justify a new loan from a subgroup of
its existing lenders that eec tively enjoyed seniority over its existing secured
creditors.
57
The Serta strategy, which was also employed in Boardriders
58
and
TriMark,
59
is often referred to as “uptiering” or an “uptier exchange.”
60
In
each case, the exploitation of apparent gaps in existing lending agreements
facilitated additional secured borrowing and prompted a battle in bankruptcy.
The second strategy is exemplied by J.Crew.
61
Taking advantage of a gap
in its principal credit agreement, J.Crew transferred assets (in this case,
52
See, e.g., Jared A. Ellias & Robert J. Stark, Bankruptcy Hardball, 108 CALIF. L. REV. 745
(2020).
53
See, e.g., Diane Lourdes Dick, Hostile Restructurings, 96 WASH. L. REV. 1333 (2021).
54
See, e.g., Jennifer Selendy, Max Siegel & Samuel Kwak, Improved T&C May Avoid Lender-
on-Lender Violence, S
ELENDY GAY (Aug. 26, 2022),
https://www.selendygay.com/news/publications/2022-08-26-improved-tc-may-avoid-lender-on-
lender-violence [https://perma.cc/72G8-FEKC].
55
See, e.g., Je Norton, John J. Rapisardi, Evan M. Jones & Adam J. Longenbach, Predatory
Priming: How Can Investors Protect Their Priority?, O’M
ELVENY (Sept. 9, 2020),
https://www.omm.com/resources/alerts-and-publications/publications/predatory-priming-how-can-
in vestors-protect-their-priority/ [https://perma.cc/WD78-ZBZF].
56
N. Star Debt Holdings, L.P. v. Serta Simmons Bedding, LLC, No. 652243/2020, 2020 WL
3411267 (N.Y. Sup. Ct. June 19, 2020).
57
The bankruptcy judge in the Serta case drew a stronger conclusion, stating from the bench
that “there simply is no ambiguity in my mind” that it was permitted by the loan documents. See
Serta Debtors Win Summary Judgment that 2020 Uptier Exchange Was Permitted as Open-Market
Purchase Under 2016 Credit Agreement, R
EORG: AMS. CORE CREDIT (Mar. 28, 2023, 4:52 PM).
The bankruptcy judge initially withheld judgment as to whether the transaction violated the implied
covenant of good faith and fair dealing, but he subsequently ruled that it did not. See In re Serta
Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820 (S.D. Tex. June 6, 2023); see also Amelia
Pollard, Mattress Company’s Infamous Debt Deal Gets Court Blessing, B
LOOMBERG (June 7, 2023, 8:52
AM), https://www.bloomberg.com/news/articles/2023-06-07/infamous-serta-debt-deal-deemed-in-
good-faith-by-federal-judge [https://perma.cc/RJ8X-4BCM] (summarizing the ruling).
58
ICG Glob. Fund 1 DAC v. Boardriders, Inc., No. 655174/2020, 2022 WL 10085886 (N.Y. Sup.
Ct. Oct. 17, 2020).
59
Audax Credit Opportunities Oshore Ltd. v. TMK Hawk Parent, Corp., No. 565123/2020,
2021 WL 3671541 (N.Y. Sup. Ct. Aug. 16, 2021); see Ayotte & Scully, supra note 23, at 372 (noting the
use of “uptiering” in both Boardriders and TriMark).
60
See Jackson Skeen, Uptier Exchange Transactions: Lawful Innovation or Lender-on-Lender
Violence?, 40 Y
ALE J. ON REGUL. 408, 410 (2023).
61
Eaton Vance Mgmt. v. Wilmington Sav. Fund Soc’y, FSB, 171 A.D.3d 626 (N.Y. Sup. Ct.
2019).
2110 University of Pennsylvania Law Review [Vol. 171: 2097
intellectual property) to a subsidiary that was not restricted from borrowing
by the credit agreement and then used the assets as collateral for a new loan.
62
This maneuver has become known as a “dropdown” or “trapdoor”
transaction.
63
In other cases, proble ms do not emerge until after a debtor les for
bankruptcy. RadioShack
64
is a particularly baroque illustration.
65
RadioShack
had two major groups of secured lenders, the ABL group and SCP, which had
overlapping interests in the same collateral. The ABL group was divided into
“rst-out” lenders and “second-out” lenders, with the rst-out group entitled
to be paid rst. The various entanglements threatened to derail the case after
Standard General, one of the second-out ABL lenders, oered to buy many
of RadioShack’s stores.
The Standard General proposal precipitated a shifting set of allegiances
both between and within the two loan facilities. ABL rst-out lenders
attempted to use the ABL agreement to block the bid, and an SCP creditor
invoked the intercreditor agreement to the same eect. Cerberus, another
SCP creditor, initially consented to the objection but then threw its support
behind the Standard General bid. The cour t nally cut through the confusion
by hinting that it would not let the rst-out ABL lenders block the bid and
ruling that the intercreditor agreement did not preclude Standard General’ s
bid. But it could easily have held that the bid was preempted by one or both
contracts.
66
Traditional collective-action problems—the inability of widely scattered
unsecured creditors to coordinate—are nowhere to be found in these cases.
The disputes involve secured creditors and the new coordination problems—
problems that arise from ga ps and uncertainties in the parties’ contracts.
C. The Darkside of the New Regime
Navigating nancial distress has always been uncertain, of course, but
outcomes are unusually unpredictable in the current environment. In
RadioShack, a broad reading of the contr acts would have precluded a
potentially attractive oer for RadioShack stores, sharply diminishing the
value of this asset. In the Caesars bankruptcy, which involved asset sales
loosely analogous to J.Crew’s dropdown transaction, the two private equity
sponsors seemed likely to retain nearly all of the equity under a proposed
62
Ayotte & Scully, supra note 23, at 368-69.
63
Id.
64
In re RadioShack Corp., 550 B.R. 700 (Bankr. D. Del 2016).
65
The developments summarized below are discussed in detail in Ayotte et al., supra note 4,
at 269-71.
66
Id. at 271.
2023] Bankruptcy's Identity Crisis 2111
reorganization plan pursued by Caesars’s nancial advisor.
67
The plan was
derailed by an examiner’s report nding a high likelihood that the transfers
could be successfully challenged as fraudulent conveyances and on related
grounds.
68
The court eventually conrmed a plan that gave Apollo and TPG,
the private equity funds, a much smaller share of the reorganized company’s
equity than they initially expected.
69
In the bankruptcy of Nine West,
skirmishing over contract terms generated fees that consumed “23% of the
$600 million enterprise-value estimate.”
70
The Nine West battle highlights a key cost of the current uncertainty.
Even if any given creditor will sometimes be on the winning side of the
jockeying for advantage and other times lose, thus ending up even overall, the
skirmishes generate considerable deadweight costs.
71
And it is likely that
some groups of creditors, such as CLOs, are systematically disadvantaged.
72
A second key feature of Chapter 11 is the dominance of insiders. As with
unpredictability, insider dominance is not a new phenomenon, but it has
escalated. The complexity of companies’ capital structures and of the
bankruptcy process has magnied the advantage enjoyed by repeat players—
a small group of bankruptcy lawyers and nancial advisors cycling through
the big Chapter 11 cases. The insiders are the only ones with the sophistication
and familiarity needed to navigate the system.
The prevalence of insiders is no t invariably problematic. Indeed, in a new
book, Douglas Baird identies the “unwritten rules” developed, transmitted,
and honored by insiders as the chief reason for the success of American
bankruptcy law.
73
“The law of corporate reorganizations works as well as it
does,” Baird writes, “because its practitioners, like its judges, enjoy a shared
understanding of its past.”
74
They know the unwritten rules: that modest
67
The asset sales are chronicled in MAX FRUMES & SUJEET INDAP, THE CAESARS PALACE
COUP: HOW A BILLIONAIRE BRAWL OVER THE FAMOUS CASINO EXPOSED THE POWER AND
GREED OF WALL STREET 63-90 (2021).
68
The report concluded that the potential damages claims challenging the transactions that
the examiner deemed either “reasonable” or “strong” were $3.6 to $5.1 billion. Id. at 228-29.
69
See FRUMES & INDAP, supra note 67, at 284-85 (stating that Apollo gave up all the equity
in the parent company and retained only 14% of the reorganized operating company); see also John
Tamny, Books: When Apollo Took on Debtholders of a Portfolio Company, and Lost, F
ORBE S (Nov. 17,
2021, 4:00 PM), https://www.forbes.com/sites/johntamny/2021/11/17/books-when-apollo-took-on-
debtholders-of-a-portfolio-company-and-lost/ [https://perma.cc/UWN2-P7DA] (“While the junior
debtholders [were originally] oered .9 cents on the dollar, they ultimately got .66 cents. The
creditors (senior and junior) would also own 2/3rds of the new Caesars in the settlement.”).
70
Ayotte & Scully, supra note 23, at 380.
71
See supra note 13 and accompanying text.
72
See supra note 14 and accompanying text.
73
See generally DOUGLAS G. BAIRD, THE UNWRITTEN LAW OF CORPORATE
REORGANIZA TIONS (2022).
74
Id. at 183.
2112 University of Pennsylvania Law Review [Vol. 171: 2097
“tips” to pacify objecting parties are permissible, for instance, but “side-deals”
are not. “When well-represented, well-informed parties compete on a level
eld, the judge allows them to play on. Interventions should come only when
the dynamics of the negotiations fail to account for the interests of the various
constituencies and the stakes are large enough to make the game worth the
candle.”
75
But insider dominance also carries considerable costs. Some of the costs
are optical. A system that is perceived to be dominated by insiders may lose
credibility among those outside the insider circle.
76
In the 1930s, the
perception that the Wall Street bankers who dominated corporate
reorganization sought “business patronage” and that their Wall Street lawyers
were “charging all the trac will bear,”
77
as William Douglas put it in a
famously scathing speech, spurred Congress to gut the existing reorganization
framework and usher out the Wall Street bankers and lawyers who had served
as gatekeepers to the big corporate reorganizations of the era.
78
Even if the
complaints are exaggerated, as they sometimes were in the 1930s, these
perceptions can corrode the functioning of the system.
Underlying th e perceptions of insider dominance are more tangible costs.
While insiders and their clients benet, other constituencies may not. As
Vincent Buccola has pointed out, legacy creditors who will not have a role
with the reorganized company (“the odd ones out,” in his account) often will
be the losers.
79
Although some can perhaps anticipate this status and adjust
the terms of contracts or loans to the debtor accordingly, others cannot.
80
And
the maneuvering by insiders to put their favored resolution strategy in place
will generate deadweight costs.
81
It is of course possible that an insider-
oriented system is desirable even with these costs, but the costs are real
nonetheless.
Parties have devised contractual strategies for reducing the uncertainty of
the Chapter 11 process. When a debtor’s existing lenders provide new
75
Id. at 182. Although this Article highlights concerns about insider dominance, I have
provided a generally sympathetic account of the role insiders played in the emergence of modern
corporate reorganization in other work. See generally D
AVID A. SKEEL, JR., DEBT’S DOMINION: A
HISTORY OF BANKRUPTCY LAW IN AMERICA (2001).
76
Melissa Jacoby has written about the costs of perceived unfairness in the related context of
representation of ordinary citizens and small creditors in the bankruptcy process. See, e.g., Melissa
B. Jacoby , Federalism Form and Function in the Detroit Bankruptcy, 33 Y
ALE J. ON REGUL. 55, 70-71
(2016) (discussing the underrepresentation of city residents and small creditors in the city of
Detroit’s bankruptcy ling).
77
SKEEL, supra note 75, at 111.
78
Id. at 112-13.
79
See Vincent S.J. Buccola, Unwritten Law and the Odd Ones Out, 131 YALE L.J. 1559, 1563 (2022)
(stating this argument about the “odd ones out”).
80
Id. at 1579-80.
81
Id. at 1580.
2023] Bankruptcy's Identity Crisis 2113
nancing for bankruptcies, they often include “milestones” that dictate the
direction of the case rather than leave it to negotiations after the bankruptcy
ling.
82
In a restructuring support agreement, the parties commit to the terms
of a potential reorganization plan.
83
Like DIP nancing agreements, RSAs
usually have milestones, and RSAs also require that any creditor who
purchases the claim of a signatory to the RSA must itself commit to the terms
of the RSA.
84
This removes the risk that a tentative agreement will unravel
after some of the signatories se ll their claims to other investors.
85
Although DIP nancing agreements and RSAs can be problematic when
they are linked, each can benecially reduce the uncertainty of Chapter 11.
They streamline the restructuring process and once they are in place can
reduce jockeying among the parties to participate in the favored transaction.
86
But they also increase insider dominance. Insiders invariably arrange the
RSA, for instance, and they often receive a fee for participating, either
directly or in connection with transactions such as the debtor’s exit
nancing.
87
Those outside the inner circle do not receive the fees.
II. I
S THIS A PRIVATE EQUITY PHENOMENON?
One of the most remarkable features of the distressed debt market is
captured in a simple statistic: roughly seventy percent of the companies on
Moody’s list of potentially distressed businesses are owned by private equity
fund sponsors.
88
Not surprisingly, given that distressed businesses are the
logical candidates for Chapter 11, private equity sponsors are a familiar
presence in Chapter 11.
89
It is possible that the concerns discussed thus far are
primarily a function of the prevalence of private equity–sponsored debtors in
bankruptcy. This part asks why private equity funds have become so
82
See, e.g., Frederick Tung, Financing Failure: Bankruptcy Lending, Credit Market Conditions, and
the Financial Crisis, 37 Y
ALE J. ON REGUL. 651, 672 (2020) (dening milestones).
83
See, e.g., Skeel, supra note 19, at 370 (dening an RSA).
84
Id. at 385.
85
Id.
86
Edward Morrison defended RSAs in similar terms in the Inaugural Harvey R. Miller
Lecture at Columbia Law School in April 2022. Columbia Law School, Harvey’s Legacy: How to
Think About Restructuring Support Agreements and Other Tools that ‘Distort’ the Bankruptcy Process,
V
IMEO (Apr. 25, 2022), https://vimeo.com/708639990 [https://perma.cc/D8X8-B4ZV].
87
The most widely discussed recent example is chronicled in In re Peabody Energy Corp., 933
F.3d 918, 928 (8th Cir. 2019), which approved extremely generous fees for the insiders in the case.
88
Vallad ares, supra note 16 (identifying this statistic).
89
See generally Luisa Beltran, The Year in Bankruptcy Isn’t Just an FTX Story. What’s Next Could
Be Even Bigger, F
ORTUNE (Dec. 29, 2022, 2:12 PM), https://fortune.com/2022/12/29/the-year-in-
bankruptcy-isnt-just-an-ftx-story-whats-next-could-be-even-bigger/ [https://perma.cc/B22Q-
XTSW] (nding that there were forty-nine private equity–sponsored company bankruptcies in
2022).
2114 University of Pennsylvania Law Review [Vol. 171: 2097
prominent in Chapter 11, what implications this has, and whether the trend
will continue.
One obvious reason for the rise of private equity is the liquidity generated
by leveraged loans and CLOs, which are central to private equity acquisitions.
The growing market for leveraged loans provides the funding private equity
funds need for new transactions. In addition, private equity funds have
themselves been highly attractive investments for investors in an
environment where returns to other investments are re latively low.
90
As of
2020, roughly thirty-ve percent of the investment in private equity funds
came from public pensions for precisely this reason.
91
With considerable
funding for their own stake in acquisitions and access to leveraged loans for
the additional funds they need, private equity funds have been unusually
active.
The diminished attractiveness of publicly held companies may be an
additional, though perhaps less central, factor. After the corporate scandals
involving Enron, WorldCom, and other companies, Congress passed the
Sarbanes-Oxley Act in 2002. Sarbanes-Oxley requires publicly he ld
companies to establish internal control systems and gives the company’s chief
executive ocer and accounting rm responsibility for certifying the ecacy
of the internal controls.
92
Some have attributed the decline in the number of
publicly held rms to the added regulatory costs created by the Act, while
others have attributed this phenomenon to other factors.
93
Either way, the
shift appears to have aected private equity acquisitions as well. Rather than
taking most of the companies they acquire public after a few years as they had
in the past, private equity funds hold them longer or sell them privately,
including to other private equity funds.
94
Private equity fund ownership is
thus less temporary than it was in the past.
90
See, e.g., Heather Gillers, Calpers’ Investment Chief Highlights Lagging Returns, ‘Lost Decade’ for
Private Equity, W
ALL ST. J. (Sept. 20, 2022, 8:30 AM), https://www.wsj.com/articles/calpers-
investment-chief-highlights-lagging-returns-lost-decade-for-private-equity-11663677010
[https://perma.cc/W9WV-S4RB] (noting the California pension fund attributed its lagging returns
to a failure to put substantial investment in provide equity, which other funds “have relied on heavily
in recent year s to amp up returns”).
91
PREQIN, 2020 PREQIN GLOBAL PRIVATE EQUITY & VENTURE CAPITAL REPORT 42
(2020) (stating that public pensions hold thirty-ve percent of investment in private equity).
92
For a brief overview of the Sarbanes-Oxley Act, see George S. Georgiev, The Breakdown of
the Public–Private Divide in Securities Law: Causes, Consequences, and Reforms, 18 N. Y.U.
J.L. & BUS.
221, 258-60 (2021).
93
For a critique of the overregulation thesis and an argument that this thesis prompted
deregulatory measures that increased the ease of capital-raising by private companies, see id . at 260-
63.
94
See Elisabeth de Fontenay, The Deregulation of Private Capital and the Decline of the Public
Company, 68 H
ASTINGS L.J. 466, 471 (2017) (“[T]he decline of IPOs has left private company
2023] Bankruptcy's Identity Crisis 2115
It is possible that the ubiquity of private equity–sponsored Chapter 11
debtors is more a temporary aberration than a permanent change. Before and
during the COVID-19 pandemic, an extremely low–interest rate environment
put pressure on pension funds and other institutional investors to search for
higher returns, since even the more scally responsible pension funds assume
at least a six percent return.
95
This made pr ivate equity, with its robust
returns, especially attractive. Rising interest rates could reduce the
comparative advantage private equity had enjoyed over other investments.
96
In addition, the growth of the market for private capital—direct loans to
struggling businesses—could provide an alternative to private equity
acquisitions.
97
Even if the high market share private equity–sponsored companies
currently have in Chapter 11 proves to be the apex of the trend, the lure of
private equity as an investment and the funds’ access to nancing are likely
to endure. A non-trivial number of the companies the funds acquire will
default, which means that private equity sponsors will remain a major
presence in Chapter 11. Given that “sponsor-owned companies are
responsible for almost every hardball priming transaction,”
98
as one scholar
notes, the brinkmanship—and attendant uncertainty—of current Chapter 11
practice will likely continue.
The predominance of sponsor-owned Chapter 11 debtors exacerbates both
the appearance and the reality of insider dominance in Chapter 11. When a
traditional publicly held company les for bankruptcy, the grip of its old
managers and shareholders may be loosened considerably. If a majority of its
directors are independent, they are likely to focus more on resolving its
nancial distress than on protecting the incumbent decisionmakers. By the
in vestors such as founders, venture capital and private equity funds, and employees with only
mergers and acquisitions as a ready means of exit.”).
95
See, e.g., Oliver Giesecke & Joshua Rauh, Trends in State and Local Pension Funds, 15 ANN.
REV. FIN. ECON. (forthcoming 2023) (manuscript at 2),
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4258469 [https://perma.cc/XH56-HN6T]
(nding liability weighted average discount rate of 6.76%).
96
See, e.g., Heather Gillers & Dion Rabouin, Pensions Brace for Private-Equity Losses, WALL ST.
J. (Sept. 24, 2022, 5:30 AM), https://www.wsj.com/articles/pensions-brace-for-private-equity-losses-
1166398524 0 [https://perma.cc/QTA6-4EZP].
97
The largest private equity funds now have their own pr ivate capital branches, so they may
be the ones making some of these loans. See, e.g., Lisa Lee & Olivia Raimonde, Private Equity Firms
Are Cutting Out Banks and Funding LBOs Themselves, B
LOOMBERG (Aug. 11, 2021, 7:00 AM),
https://www.bloomberg.com/news/articles/2021-08-11/blackstone-ares-are-turning-into-banks-for-
lbo-nancing [https://perma.cc/Q3R4-K98T] (“More and more, private equity rms looking to
nance big leveraged buyouts are cutting out the Wall Street banks, and borrowing money from
each other or from direct lenders. ”).
98
Vincent S.J. Buccola, Sponsor Control: A New Paradigm for Corporate Reorganization, 90 U.
CHI. L. REV. 1, 6 (2023).
2116 University of Pennsylvania Law Review [Vol. 171: 2097
time the company nears default, it may ha ve looked to new or existing lenders
for liquidity who may force the replacement of existing manager s.
Sponsor-owned companies are dierent. They typically have a small
board of directors that is tightly controlled by the sponsor–owner.
99
Sponsors
often negotiate for releases absolving themselves of potential liability for pre-
bankruptcy misbehavior in connection with RSAs that shape the
reorganization process.
100
The sponsor’s continued inuence raises concerns
that the debtor, among other things, will not vigorously challenge problematic
transactions that the company may have engag ed in prior to bankruptcy. This
feeds the perception that Chapter 11 is rigged in favor of insiders and their
professionals.
To counter this perception, pr ivate equity funds often appoint a new
board of directors shortly before the company les for bankruptcy. Whether
the ostensibly independent directors are genuinely independent is debatable.
Many are repeat players, having served for the same law rms in multiple
cases.
101
The private equity sponsors are represented by insider lawyers and
nancial analysts, and the boards of sponsor-owned Chapter 11 companies
often had insider directors.
III. SOLUTIONS AN D INT ERVENTIONS
The shift in the capital structure of Chapter 11 debtors and the dominant
role played by private equity funds has contributed to an identity crisis in
Chapter 11. The traditional collective-action problems of bankruptcy theory
are much less salient, having been replaced by coordination problems arising
from gaps and uncertainties in the parties’ contracts.
The problems this Article has focused on—highly uncertain outcomes and
insider control—are a perennial feature of corporate reorganizatio n in the
United States. The irony that eorts to reduce uncertainty tend to exacerbate
the inuence of insiders could easily be traced back through bankruptcy
history, for instance.
102
But they have taken a distinctive form in the current
era.
99
See id. at 22-23 (explaining the close relationship a sponsor will have with a company’s
board).
100
Id. at 39-42.
101
See Jared A. Ellias, Ehud Kumar, & Kobi Kastier, The Rise of Bankruptcy Directors, 95 S. CAL.
L. REV. 1083, 1098 (2022) (“Private equity sponsors are repeat players that can appoint individuals
to many boards.”).
102
Earlier corporate reorganization stars such as Paul Cravath touted their inside knowledge
as essential to the smooth functioning of reorganization practice. “The provisions of the modern
reorganization agreement,” Cravath observed, “are the result of the experience and prophetic vision
of a great many able lawyers.” See Paul Cravath, The Reorganization of Corporations; Bondholders’ and
Stockholders’ Protective Committees; Reorganization Committees; and the Voluntary Recapitalization of
2023] Bankruptcy's Identity Crisis 2117
This Part co nsiders a series of potential solutions and interventions that
have been or might be proposed. It starts with measures the parties
themselves might pursue, moves to potential duties imposed by bankruptcy
judges, and concludes with possible legislative correctives.
A. Addressing Gaps by Contract
Since the most aggressive stratagems have exploited gaps in the debtor’s
loan documents, the rst line of defense is contrac t-drafting. If lenders
altered lending contracts to remove the possibility of uptier or dropdown
transactions, some of the maneuver s that have characterized recent cases
might prove transitory.
In one respect, the early evidence about improved contracting in this
context is encouraging. A rich contracts literature shows that problematic
terms in contracts tend to be ineciently sticky. After a surprising
interpretation of the pari passu clause in sovereign debt contracts, for instance,
many sovereign-debt contracts continued to include the troublesome clause
without clarifying its meaning.
103
A new study of the provisions that were
construed to permit Serta-style uptiering, by contrast, nds that the loophole
has been closed in many of the new contracts.
104
Far fewer, however, have
been amended to remove the risk of J.Crew-style dropdown or trapdoor
transactions. This could suggest either that stickiness is sometimes but not
always an issue or that the provisions that leave a crack open for dropdowns
may be benecial overall, despite their opportunis tic use in some cases.
Even if provisions that egregiously misre are likely to be corrected,
improved drafting is unlikely to be more than a partial remedy for the
uncertainty engendered by current capital structure. Given that contract
drafting is often path-dependent rather than vigilant and objective, and
sophisticated parties have an incentive to nd gaps when a company faces
nancial distress,
105
coordination issues will not be removed by ex post xes
to the problems that have emerged thus far.
Corporations, in SOME LEGAL PHASES OF CORPORATE FINANCING, REORGANIZA TION, AND
REGULATION 153, 178 (1917).
103
See MITU GULATI & ROBERT E. SCOTT, THE THREE AND A HALF MINUTE
TRANSACTION: BOILERPLATE AND THE LIMITS OF CONTRACT DESIGN 2 (2013) (describing how
contracts continued to use a clause without clarication after a “heretical interpretation” of it).
104
Vincent S.J. Buccola & Greg Nini, The Loan Market Response to Dropdown and Uptier
Transactions 42-43 (June 2022) (unpublished manuscript),
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4143928 [https://perma.cc/8JDM-KHNS]
(explaining how lenders have since updated their views on the subject).
105
Ayotte & Scully, supra note 23, at 366 (“The prospect of interaction between contracts when
there is not enough money to go around creates a search for loopholes and other creative
strategies. ”).
2118 University of Pennsyl vania Law Review [Vol. 171: 2097
B. Imposing a Duty of Good Faith
The standard response to a worrisome residual of opportunism is to invite
courts to impose a duty of good faith.
106
While corporate directors owe duties
of care and loyalty to shareholders, Delaware, the leading source of corporate
law, has been hesitant to extend similar protection to bondholders and other
creditors, especially while the company is solvent.
107
If the debtor falls into
nancial distress, creditors may be permitted to sue the directors for alleged
misbehavior, but the suit must be brought derivatively on behalf of all, rather
than directly.
108
In response to the aggressive tactics of sponsor-owned companies, several
scholars have advocated that courts provide more robust protection for
creditors. “Importantly,” one scholar and a prominent practitioner write, “we
believe that management would be restrained if they knew they would be
forced to justify their conduct under a judiciary inquiry with more bite. While
a more aggressive application of the business judgment rule would not
eliminate control opportunism, it would likely deter the most egregious
cases.”
109
Sounding a similar theme, another scholar urges “all courts to
approach disputes arising out of loan restructurings with a renewed emphasis
on existing legal and equitable principles, such as the implied covenant of
good faith and fair dealing,” pointing out that “under basic principles of state
contract law, the implied covenant is generally understood to mean that
parties to contracts should behave honestly and work to uphold the spir it of
the agreement.”
110
106
This is the principal proposed solution to the related problem of coercive bond
restructuring transactions, for instance. See, e.g., William W. Bratton & Adam J. Levitin, The New
Bond Workouts, 166 U.
PA. L.REV. 1597, 1604 (2018) (“We suggest that the intercreditor duty of good
faith . . . would provide an eective solution to any resulting problems.”). William Bratton and Mitu
Gulati have advocated use of a similar approach with sovereign debt. See, e.g., William W. Bratton
& G. Mitu Gulati, Sovereign Debt Reform and the Best Interest of Creditors, 57 V
AND. L. REV. 1, 8
(2004) (“Resolution of [sovereign debt] disputes, therefore, requires a robust good faith principle.”).
107
See, e.g., Katz v. Oak Indus. Inc., 508 A.2d 873, 880 (Del. Ch. 1986) (stating that
bondholders are protected only if a transaction is “wrongfully coercive”).
108
See, e.g., N. Am. Cath. Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 103
(Del. 2007) (“[I]ndividual creditors of an insolvent corporation have no right to assert direct claims for
breach of duciary duty against corporate directors. Creditors may nonetheless . . . bring[]
derivative claims . . . .”).
109
Ellias & Stark, supra note 52, at 785.
110
Dick, supra note 53, at 1384. Eric Talley and Sneha Pandya oer an intriguing, though
somewhat speculative, historical account of Delaware courts’ reluctance to look beyond the terms of
bonds and other lending contracts and to police the parties’ good faith. They too advocate for
enhanced scrutiny of good faith. See Sneha Pandya & Eric L. Talley, Debt Textualism and Creditor-
on-Creditor Violence: A Modest Plea to Keep the Faith 3-4 (EGI Working Paper Series in L., Working
Paper No. 673/2023 2023), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4317353
[https://perma.cc/4R35-P XAM].
2023] Bankruptcy's Identity Crisis 2119
Although the prospect of a judicial eye over the parties’ shoulders is
attractive, it is important to register several cautions (each consistent with
points made by the scholars just quoted). First, adding a robust new good-
faith duty would step in precisely the opposite direction than where Delaware
courts have tended, even with their tradition al (shareholder-oriented)
duciary duties. In the past several decades, Delaware has increasingly
proceduralized its duciary duties in the corporate law context, diminishing
the focus on subjective factors.
111
The proceduralization is most pronounced
with publicly held corporations, and it does not preclude careful review,
112
but
it is a noticeable shift in Delaware law. To the extent this reects diculties
in applying subjective factors, advocates for a robust good-faith duty may be
expecting too much from the bankruptcy judges who would be applying the
duty.
113
Second, the traditional view that duciary duty–like protections are
more essential for shareholders than for creditors given the open-ended
nature of shareholders’ commitment to the rm
114
is, in my view, still
compelling, and cautions against giving courts a roving commission to
intervene on behalf of creditors on good-faith or related grounds. Finally,
aggressive intervention might chill legitimate behavior or serve as an
attractive nuisance to creditors’ committees or other parties after the fact,
inviting them to challenge even defensible transactions.
This does not mean that imposing a good-faith duty is a bad idea. But it
should only be wielded in egregious cases. Caesars would have been a close
call in that regard, perhaps justifying intervention due to the magnitude of,
and questionable consideration for, the transfers made by the pr ivate equity
111
This is reected in the deference given to approval by disinterested directors and
shareholders in contexts such as self-dealing transactions and corporate freezeouts that previously
would have been subject to entire fairness review. See, e.g., Kahn v. M&F Worldwide Corp., 88 A.3d
635, 645-46 (Del. 2014) (detailing the new business judgment standard of review in a case about
freezeouts).
112
In Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), for instance, the Delaware Supreme
Court held that simply complying with federal Food and Drug Administration regulation was not
sucient to satisfy a board’s oversight obligations, given the importance of food safety to an ice
cream manufacturer.
113
Jared Ellias and Elisabeth de Fontenay draw a somewhat dierent conclusion, contending
that Delaware courts are attentive to substantive considerations. But they too are skeptical of “a
revival and extension” of good-faith doctrine, worrying that judges may not be well-positioned to
“mak[e] such determinations in the extraordinarily complex and fast-moving world of debt
transactions.” See Jared A. Ellias & Elisabeth de Fontenay, Law and Courts in an Age of Debt, 171 U.
PA. L. REV. (forthcoming 2023) (manuscript at 34),
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4387437 [https://perma.cc/2C7S-AYZZ].
114
The classic ex position came from Nobel-prize winning economist Oliver Williamson. See
generally Oliver Williamson, Corporate Governance, 93 Y
ALE L.J. 1197 (1984).
2120 University of Pennsylvania Law Review [Vol. 171: 2097
sponsors prior to the bankruptcy.
115
But this is the domain of fraudulent
conveyance;
116
it’s not clear that a good-faith duty would be needed.
117
Serta was perhaps the most compelling of the recent cases for good faith
intervention. Uptier transactions are designed to exploit the minority of the
current lenders that are not oered an opportunity to participate in the new
loan transaction. Unless the minority were invited to participate and declined,
the transactions are hard to justify. But even here, the case for intervening in
the future was weaker, given that contracting parties are awar e of the issue
and many have addressed it in their contracts.
118
C. Banning Signing Fees in RSAs
As discussed earlier, an increasingly standard technique for reducing the
uncertainty of current cases is for the debtor and some of its creditors to
negotiate a restructuring support agreement prior to ling for bankruptcy.
119
This commits both the parties and subsequent purchasers of the claims of
signatories to the terms of a future reorganization plan consistent with the
RSA. While they curb uncertainty, RSAs frequently benet the insiders who
negotiate them by providing a signing bonus or other fees.
While acknowledging that RSAs can serve a valuable coordination
function, several scholars have advocated that courts ban signing fees. RSAs
with signing fees should be prohibited altogether,
120
they suggest, “even if this
puts ultimate conrmation at risk.”
121
They worry that RSAs interfere with
the Chapter 11 disclosure and voting processes and that signing fees
eectively give signatories compensation that other creditors in their class do
115
The transfers of key real estate assets by the operating company prior to bankruptcy are
chronicled in F
RUMES & INDAP, supra note 67, at 77-90.
116
As noted earlier, the examiner valued the claims at $3.6 to $5.1 billion. The parties ultimately
settled. See Tamny, supra note 69.
117
This point echoes the ndings of Laura Lin’ s classic empirical study of cases around the
time of Delaware’s famous Credit Lyonnais dicta suggesting the directors owed a duty to creditors
when a rm is in the vicinity of insolvency. See Laura Lin, Shift of Fiduciary Duty Upon Corporate
Insolvency: Proper Scope of Directors’ Duty to Creditors, 46 V
AND. L. REV. 1485, 1487 n.7 (1993).
118
See Buccola & Nini, supra note 98, at 42-43. (“Splitting lender classes via uptier transactions
will be very uncommon, however, as the vast majority of new contracts will prohibit borrowers from
subordinating existing loans without unanimous or aected-lender consent.”).
119
See supra notes 82–85 and accompanying text.
120
See Edward J. Janger & Adam J. Levitin, The Proceduralist Intervention—A Response to Skeel,
130 Y
ALE L.J.F. 335, 346, 349 (2020) [hereinafter Proceduralist Intervention] (noting rst that “[i]n an
earlier article we took the position that entitlement-distorting RSAs ought to be proscribed” and
subsequently stating that their response was intended “not only to defend our position, but to esh
it out”); Edward J. Janger & Adam J. Levitin, Badges of Opportunism: Principles for Policing
Restructuring Support Agreements, 13 B
ROOK. J. CORP. FIN. & COM. L. 169, 186 (2018) (calling
payments to signatories “badges of opportunism”).
121
Proceduralist Intervention, supra note 120, at 344.
2023] Bankruptcy's Identity Crisis 2121
not receive. Absent a formal court ruling that the signatories provided a
benet to the estate, they conclude, signing fees should never be permitted.
122
RSAs undeniably do sidestep Chapter 11 disclosure and voting rules,
which preclude the debtor and creditors from soliciting vote s on a
reorganization plan before the court has approved a disclosure statement.
123
An RSA is invariably negotiated long before the debtor les the disclosure
statement. The parties that negotiate RSAs are bankruptcy insiders, and the
signing fees may give an extra recovery to those insiders. A ban would
vindicate the formal voting rules and curb the favoritism of insiders. A ban is
also hard to beat for ease of enforcement.
But the cost of a ban would be considerable. As even their critics
acknowledge, RSAs enable the parties to coordinate, thus reducing the
uncertainty of the Chapter 11 process. The prospect of an RSA may also
induce some companies—especially those owned by private equity
sponsors—to le a Chapter 11 case they would otherwise delay.
124
Although
creditors sometimes might be willing to commit to an RSA without receiving
a signing fee, often they would not. The creditors who negotiate the RSA
incur signicant expenses—both direct expenses and the cost of forgoing the
opportunity to buy or sell claims during the negotiation process.
125
In
negotiating a deal that benets all creditors, the participants provide a public
good, for which payment is appropriate.
126
As with the good-faith duty, this does not mean that bankruptcy courts
should approve every RSA that comes before them. Courts should assess
whether the fees associated with an RSA are appropriate, much as they do
with lockup provisions in merger transactions in corporate law.
127
If the fees
are egregious, they should not be permitted. The recent Peabody Energy case
128
was a missed opportunity to signal that courts will not approve an RSA that
gives insiders far more than reasonable compensation for their involvement
in the negotiations. In that case, RSA participants were promised fees for
122
See id. at 347 (“[J]ust as the coercive aspects of the plan process all come with procedural
protections associated with the vote, administrative expense priority should only be granted to a
creditor upon a nding of benet to the estate.”).
123
See 11 U.S.C. § 1125(b) (2018) (prohibiting solicitation before disclosure statement is
approved).
124
See Buccola, supra note 98, at 39-42.
125
See Skeel, supra note 19, at 403-04 (describing these two costs to creditors).
126
See id. at 401 (“The creditors who negotiate the terms of an RSA—and thus the terms of a
potential reorganization plan—provide a public good, since reorganization may be valuable for
everyone, and they also forgo the opportunity to trade during the negotiations.”).
127
See id. at 420 (“Absent a presumption against rights oerings as part of a PSA, a court needs
to determine whether the entitlement coercion is excessive, as well as the related question of whether
plan proponents are receiving excessive compensation for the public good they have supplied.”); see
also id. at 416-21 (illustrating this point).
128
In re Peabody Energy Corp., 933 F.3d 918 (8th Cir. 2019).
2122 University of Pennsylvania Law Review [Vol. 171: 2097
backstopping Peabody’s exit nancing that objectors claimed to be as high as
$1.4 billion.
129
By refusing to approve the RSA, the court could have
discouraged insider abuse of RSAs.
D. Loosening the Sclerotic Market for Bankruptcy Financing
One of Chapter 11’s great innovations was its inclusion of a provision
giving bankruptcy courts broad discretion to authorize so called “debtor in
possession” or “D IP” nancing—nancing for its operations in bankruptcy.
130
The cour t can authorize nancing on an unsecured basis, as an administrative
claim, on a secured basi s, or even on a secured basis with priority over existing
security creditors.
131
This last option is known as a “priming lien.” The DIP-
nancing provision makes it far more likely that a potentially viable debtor
can obtain nancing than might otherwise be the case.
Although DIP nancing is essential, and DIP-nancing agreements have
long been used to curb some the problems that emerged in the early years of
the bankruptcy code,
132
several serious problems have emerged, each
magnifying the inuence of insiders. The rst and most longstanding is the
diculty of obtaining nancing from anyone other than the debtor’s existing
lenders. Because the inside lenders invariably have liens on most or all of a
debtor’s assets, those lenders would be the principal beneciary of the
proceeds of a new lender’s loan. As a result, new lenders are reluctant to
provide nancing; the market is costly and uncompetitive.
133
The obstacle to
outside nancing could be surmounted by giving new lenders priority: a
priming lien. But courts have been very reluctant to give serious
consideration to outside loans, which would require a valuation hearing and
a nding that the existing lenders are “adequately protected.”
134
129
See Skeel, supra note 19, at 420.
130
See 11 U.S.C. § 364.
131
Id.
132
See, e.g., Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 STAN. L.
REV. 751, 785 (2002) (“These revolving credit facilities and the practical control they give lenders
over a rm are some of the most striking changes in Chapter 11 practice over the last twenty years.”);
David A. Skeel, Jr., Creditors’ Ball: The “New” New Corpor ate Governance in Chapter 11, 152 U.
PA. L.
REV. 917, 919 (2003) (explaining that there has been an increasing use of DIP-nancing agreements).
133
For empirical evidence conrming this, see B. Espen Eckbo, Kai Li & Wei Wang, Loans to
Chapter 11 Firms: Contract Design, Repayment Risk, and Pricing, 66 J.L.
& ECON. (forthcoming 2023)
(manuscript at 4), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3384389
[https://perma.cc/QG2U-UXBB] (citing evidence that eighty percent of bankruptcy nancing
comes from the debtor’s current lenders); Frederick Tung, Financing Failure: Bankruptcy Lending,
Credit Market Conditions, and the Financial Crisis, 37 Y
ALE J. ON REG. 651, 655 n.13 (2020) (noting
that in a sample data set of debtor-in-possession loans, seventy-ve percent of bankruptcy nancing
came from debtors’ current lenders).
134
See Skeel, supra note 10, at 327-28.
2023] Bankruptcy's Identity Crisis 2123
Second, and relatedly, the debtor and inside creditors often link their
DIP-nancing agreement to an RSA. In the Neiman Marcus bankruptcy, for
instance, signatories to the RSA would receive generous fees for participating
in the DIP nancing and backstopping $75 million of exit nancing.
135
But
the RSA precluded signatories from oering alternative nancing, which
meant that they would sacrice the fees if they made a competing oer for
nancing.
136
Bankruptcy courts could loosen the sclerosis, and insider dominance, of
the bankruptcy-nancing market with several simple interventions. The most
obvious is simply to adopt a more hospitable stance toward priming liens.
137
Inside lenders invariably fend o a potential priming lien by warning that
considering nancing from outside lenders, or from non-favored current
lenders, would require a costly valuation hearing and that the outsiders could
not demonstrate that the insiders are adequately protected. The market might
thaw if a few bankruptcy judges called the insiders’ blu and held the hearing.
Courts should also decline to enforce provisions that cut o access to
potential funding from outside lenders. First-and-second-lien agreements
sometimes preclude second lien holders from oering new nancing.
138
As
discussed above, RSAs may similarly constrain their signatories.
139
The
leading bankruptcy courts have sometimes adopted local rules indicating that
they will not allow, or will rarely allow, problematic provisions.
140
They could
do the same with provisions that discourage outside lenders from providing
nancing.
E. Regulatory Restraints on Private Equity Funds
Since the uncertainty and insider dominance of current Chapter 11
practice are intertwined with private equity funds, another possible strategy
135
Id. at 332.
136
See id. at 333.
137
See id. at 328 (“A thawing of this reluctance [towards priming liens] is essential to the
emergence of a competitive lending market, given the debt-overhang issues that discourage new
lenders from making loans without an assurance of priority.”).
138
See id. at 328 (“One standard term gives rst lienholders the exclusive right to enforce the
parties’ rights in their collateral.”).
139
See id. at 332-33 (describing the ways in which an RSA may constrain its signatories using
the example of Neiman Marcus).
140
Provisions that the Southern District of New York and Delaware have warned against and
require prominent disclosure of include cross-collateral provisions (provisions that secure a pre-
bankruptcy obligation with the lien given for new bankruptcy nancing) and DIP-nancing
agreements that give the lender a security interest in avoidance actions. See Bankr. S.D.N.Y. R. 4001-
2, https://www.nysb.uscourts.gov/rule-4001-2 [https://perma.cc/R78C-HE33]; Bankr. D. Del.
R. 4001-2, http://www.deb.uscourts.gov/content/rule-4001-2-cash-collateral-and-nancing-orders
[https://perma.cc/M35X-EHWB].
2124 University of Pennsylvania Law Review [Vol. 171: 2097
is regulatory reform of private equity. Senator Elizabeth Warren and other
progressives are the principal advocates of this approach.
141
“For far too long,”
she has complained, “Washington has looked the other way whil e pr ivate
equity rms take over companies, load them with debt, strip them of their
wealth, and walk away scot-free—leaving workers, consumers, and whole
communities to pick up the pieces.”
142
In 2019, Warren and several other progressives introduced the Stop Wall
Street Looting Act, which would impose new restrictions on private equity.
143
The legislation was reintroduced in 2021.
144
The Stop Wall Street Looting
Act would hold the funds personally responsible for debt and other
obligations incurred by companies they acquire, thus removing the shield of
limited liability.
145
Acquired companies would not be permitted to make
dividends or other distributions for two years after the acquisition,
146
and
private equity would lose the favorable tax treatment currently given to
“carried interest.”
147
The proposed legislation would also amend bankruptcy
law to enhance the treatment of employees and take away the authority of
“sham” pr ivate equity directors to determine whether or not to sue managers
and other insiders of the company.
148
The most spectacular provisions, which would hold private equity funds
personally liable for the obligations of the companies they acquire, might be
defended as discouraging the funds from gambling with a company’s future.
The funds would be more careful if the managers shared in the risk of
failure.
149
In practice, however, the provisions would do far more. By
141
See Press Release, Senator Elizabeth Warren, Warren, Balding, Brown, Pocan, Jayapal,
Colleagues Unveil Bold Legislation to Fundamentally Reform the Private Equity Industry;
Comprehensive Bill Would Ensure Private Investment Funds Have Skin in the Game; Reforms
Would Empower Workers, Safeguard the Financial System, and Protect Investors (July 18, 2019),
https://www.warren.senate.gov/newsroom/press-releases/warren-baldwin-brown-pocan-jayapal-
colleagues-unveil-bold-legislation-to-fundamentally-reform-the-private-equity-industry
[https://perma.cc/L7CU-275M].
142
Id.
143
See id.; Stop Wall Street Looting Act, S. 2155, 116th Cong. (2019).
144
See id.; Stop Wall Street Looting Act, S. 3022, 117th Cong. (2021). For a detailed but
accessible section-by-section summary of the legislation, see Senator Elizabeth Warren, The Stop
Wall Street Looting Act of 2021: Section-by-Section, E
LIZABETH WARREN,
https://www.warren.senate.gov/imo/media/doc/The%20Stop%20Wall%20Street%20Looting%20Ac
t%20of%202021%20Section%20by%20Section%20Final.pdf [https://perma.cc/LU6P-CG HS] (last
visited Feb. 14, 2023).
145
Stop Wall Street Looting Act, S. 3022, 117th Cong. §§ 101–102 (2021).
146
Id. § 201.
147
Id. § 403.
148
Id. § 202.
149
See, e.g., Press Release, supra note 141 (“Firms will share responsibility for the liabilities of
companies under their control including debt, legal judgments and pension-related obligations to
better align the incentives of private equity rms and the companies they own.”).
2023] Bankruptcy's Identity Crisis 2125
imposing liability for any default, regardless of the reason, they would destroy
the pr ivate equity model, just as the bankruptcy reforms of the New Deal
destroyed large-scale corporate reorganization practice.
150
Eectively banning
private equity is unwarranted, given the benets that private equity–style
acquisitions can bring.
At least one of the minor reforms—the sham-director provision—
warrants closer consideration, however.
151
Whereas the directors of a Chapter
11 debtor, serving as “debtor-in-posse ssion,” are ordinarily the ones who bring
causes of action for pre-bankruptcy misbehavior, this provision would vest
the authority in a representative of the creditors’ committee.
152
Creditors’
committee control is an imperfect solution. In many current cases, the
unsecured creditors who are represented by the creditors’ committee are out
of the money. This creates a risk that the committee would be motivated more
by the holdup-power control of the litigation gave it than a cost–benet
analysis of whether litigation would be benecial to the estate. But private
equity sponsors’ installment of new “independent” directors has rightly
generated considerable skepticism.
153
Shifting control over this litigation to a
more disinterested party would red uce the perception, and possibly the
reality, of insider control in bankruptcy.
F. Reforming Non-Debtor Releases
Controversial mass tort cases such as the Purdue Pharma bankruptcy are
starkly dierent in most respects than cases with the sponsor-owned debtors
that are a focus of this Article. But they do have a key feature in common:
third-party releases. Although the Sacklers, the family that owned Purdue
Pharma, did not themselves le for bankruptcy, their liability would be
released in return for a contr ibution to the bankruptcy case. Similarly, most
or all Chapter 11 cases with sponsor- owned debtors release the private equity
fund and its partners.
154
150
For a description of how the Chandler Act of 1938 destroyed the corporate reorganization
practice in the New Deal, see Skeel, supra note 75, at 123-27.
151
Ellias, Kumar, and Kastier reach a similar conclusion, although they advocate a somewhat
dierent approach. See Ellias et al., supr a note 101, at 1089 (proposing that bankruptcy judges
consider whether creditors overwhelmingly support the private equity directors).
152
See H.R. 5648, 117th Cong. § 202(e) (2021) (“[I]f a debtor in possession is serving in a case
under this title, a committee of creditors appointed under section 1102 of this title shall have the
exclusive right of a trustee serving in a case under this chapter to bring or settle on behalf of the
estate . . . .”).
153
See, e.g., Ellias et al., supra note 101.
154
Buccola argues that the non-debtor release is a key feature of these cases for the funds.
Buccola, supra note 98, at 6.
2126 University of Pennsylvania Law Review [Vol. 171: 2097
The ability to discharge the obligations of non-debtor insiders further
contributes to the perception of insider control in bankruptcy. Because courts
are more willing to permit non-debtor releases in some circuits than others,
debtors and inside creditors forum-shop to bankruptcy courts that are willing
to grant non-debtor releases.
155
Purdue Pharma established a mailing address
and led for Chapter 11 in White Plains, New York, knowing it would get a
particular bankruptcy judge.
156
The private equity funds that owned Caesars
led its case in Chicago, because Seventh Circuit caselaw is congenial to
third-party releases.
157
The existential question with non-debtor releases is whether they should
be banned altogether. A prohibition (other than in asbestos cases, where non-
debtor releases are authorized by statute)
158
could be justied on both legal
and policy grounds. Legally, bankruptcy courts do not have obvious statutory
authority to grant a discharge to non-debtors, and these releases have been
challenged constitutionally as well.
159
Although the Second Circuit recently
upheld the non-debtor releases in the Purdue Pharma opioid bankruptcy, the
circuits are split on these issues, and the Supreme Court agreed to review the
Purdue Pharma ruling shortly before this Article went to press.
160
The
inrmity of non-debtor releases on policy grounds, from the perspective of
critics, is that they give the benets of bankruptcy to parties who have not
subjected themselves to the requirements of bankruptcy law by ling for
bankruptcy.
Defenders of non-debtor releases point out that it may be impossible to
achieve a truly global resolution of a company’s nancial distress if the related
claims against major shareholders or insurance companies are not addressed
in the bankruptcy.
161
The litigation would simply continue after bankruptcy.
Defenders also emphasize that victims may receive larger and more equitable
recoveries when non-debtors make contributions in return for non-debtor
155
For highly critical discussions these and related issues, see Adam J. Levitin, Purdue’s Poison
Pill: The Breakdown of Chapter 11’s Checks and Balances, 100 T
EX. L. REV. 1079 (2022), and Lynn M.
LoPucki, Chapter 11’s Descent into Lawlessness, 96 A
M. BANKR. L.J. 247 (2022).
156
See Levitin, supra note 155, at 1131-35.
157
See, e.g., FRUMES & INDAP, supra note 67, at 167 (describing creditors’ attorney’s accusation
that Caesars led in Chicago because of the caselaw on third-party releases).
158
See 11 U.S.C. § 524(g).
159
The classic challenge to the legality of third-party releases is Ralph Brubaker, Bankruptcy
Injunctions and Complex Litigation: A Critical Reappraisal of Non-Debtor Releases in Chapter 11
Reorganizations, 1997 U.
ILL. L. REV. 959.
160
In re Purdue Pharma, 69 F.4th 45, 73-74 (2d Cir. 2023) (surveying the divide between
circuits that have held that non-debtor releases are not permissible and those that have upheld the
releases), cert. granted, Harrington v. Purdue Pharma, L.P., Nos. 23-124, 23A87, 2023 WL 5116031
(U.S. Aug. 10, 2023) (granting certiorari).
161
Tony Casey has stressed this point. See Anthony J. Casey, Chapter 11’s Renegotiation
Framework and the Purpose of Corporate Bankruptcy, 120 C
OLUM. L. REV. 1709, 1749-50 (2020).
2023] Bankruptcy's Identity Crisis 2127
releases than they would outside of bankruptcy.
162
In the private equity
context, the funds might be more reluctant to le for Chapter 11 and might
wait too long if Chapter 11 did not oer the prospect of a non-debtor
release.
163
From this perspective, the non-debtor release is an inducement for
private equity sponsors, just as deviations from absolute priority are
sometimes thought to entice managers to le for Chapter 11,
164
and lockups
in corporate law may encourage the directors of a target company to agree to
a change in control transactions.
165
Whether these benets justify allowing non-debtor releases is quite
debatable. The risk to non-debtors of post-bankruptcy exposure could have a
benecial disciplining eect. And the benets of a global resolution of
nancial distress are much less obvious with private equity–sponsored
Chapter 11 cases than with mass torts, which may involve thousands of
victims. Perhaps the best approach would be to permit non-debtor releases in
mass tort cases—that is, expand current bankruptcy law to encompass all mass
torts, not just asbestos—and prohibit releases in other contexts with respect
to any creditor that has not consented.
166
C
ONCLUSION
This Article has oered an initial assessment of the bankruptcy
implications of the shift in large corporate debtors’ capital structures and the
dramatic increase in private equity–owned debtors in Chapter 11. The Article
described key features of the shift and considered the extent to which it is a
private equity phenomenon. It identied uncertainty and the enhanced
dominance of insiders, which create a perception of unfairne ss and increase
the deadweight costs of bankruptcy, as the dark side of these developments.
162
With Purdue Pharma, the Sacklers threatened to interpose serious defenses to actions to
recover, among other things, distributions they received, and it would be dicult to reach assets the
Sacklers hold in oshore trusts. See Geo Mulvihill, Legal shield for Purdue Pharma Owner Is at Heart
of Appeals, S
EATTLE TIMES (Sept. 4, 2021, 7:34 AM), https://www.seattletimes.com/business/legal-
shield-for-purdue-pharma-owners-is-at-heart-of-appeals/ [https://perma.cc/89YQ-RT9Q].
163
This is a central theme of Buccola, supra note 98.
164
See Douglas G. Baird, The Initiation Problem in Bankruptcy, 11 INT’L REV. L. & ECON. 223,
230 (1991).
165
See David A. Skeel, Jr., Lockups and Delaware Venue in Corporate Law and Bankruptcy, 68 U.
CIN. L. REV. 1243, 1256-57 (2000).
166
To the extent third-party releases continue to be permitted, at least in some contexts, courts
should impose some of the disclosure and transparency obligations that would apply if the third
party had itself led for bankruptcy. Courts should assess the third party’s capacity and
responsibility to pay and consider whether creditors would likely recover more outside of bankruptcy
if the release were not allowed. Lindsey Simon makes this case at length in Lindsey D. Simon,
Bankruptcy Grifters, 131 Y
ALE L.J. 1154 (2022).
2128 University of Pennsylvania Law Review [Vol. 171: 2097
The Article then considered a variety of correctives that scholars have
proposed or that might be proposed.
The response that has emerged is incrementalist. The most dramatic
possible correctives, such as banning RSA-signing fees or imposing an
aggressive good-faith duty, do not seem warranted. Modest adjustments such
as bankruptcy courts’ willingness to strike down egregious RSA fees and to
grant priming liens to outside lenders would diminish the perception that
Chapter 11 is rigged in favor of insiders and fails to adequately protect the
interests of victims and other outsiders.
It is possible that a true overhaul of Chapter 11 is needed, given the
dramatic shifts in debtors’ capital structure, and that it is simply not yet
apparent what that alternative framework might look like. But it seems more
likely that limited adjustments to existing Chapter 11 are preferable and
sucient.
