An important battle about the place of secured lending in the United States economy is set to begin. When the battle ends, fundamental assumptions about the expected recovery rates for defaulted secured loans may change.
On December 8, 2014, the American Bankruptcy Institute is set to release its proposals to reform and overhaul to Chapter 11 of the United States Bankruptcy Code.1 The proposals are the result of three years of study into areas of friction between Chapter 11 and modern corporate ﬁnance by the ABI Commission to Study the Reform of Chapter 11 (the “ABI Commission”). The report embodying the proposals is expected to exceed 400 pages and contain 100 recommendations about 13 topics that the ABI Commission will make to Congress and the federal courts.2
Of critical importance are the ABI Commission’s study and proposals relating to secured lending and debtor in possession ﬁnancing. The ABI Commission, along with other academics and professionals, have debated whether the evolution of a large and liquid secured lending market has caused recoveries for unsecured creditors to decrease over time, and therefore whether the growth of secured lending has disadvantaged unsecured creditor constituencies (employees, landlords, bondholders, vendors, etc.)
We expect that the ABI Commission will conclude that the increased availability of secured loans to below-investment-grade borrowers has caused borrowers to favor capital structures dominated by secured loans. The argument follows that when borrowers with such capital structures default, they have little freedom to choose a form of reorganization and few, if any, viable restructuring alternatives that are not controlled by the secured lenders. The result, some claim, is that secured lenders then use their superior collateral rights under the Bankruptcy Code to force a quick sale of the borrower’s assets or to convert their secured debt into equity of the reorganized borrower.3 Because unsecured creditors may be “out of the money” in such capital structures, the argument concludes that unless secured lending recoveries are reduced and secured lenders are restrained, little can be done to help repay unsecured creditors or continue the debtor’s existence as a viable post-reorganization entity – two purported goals of Chapter 11.
Most importantly, some bankruptcy professionals wishing to curtail secured lending have called for a statutory redistribution of a portion of a secured lender’s return on collateral to unsecured constituencies.
COULD THE PROPOSED REFORMS CHANGE “RECOVERY EXPECTATIONS” FOR SECURED LENDERS?
The Bankruptcy Code informs the structure and framework of all commercial transactions and implicitly sets recovery expectations for creditors throughout the United States. At the highest policy levels, the Bankruptcy Code reﬂects a multitude of hard-fought compromises between conﬂicting forces that seek to (i) promptly rehabilitate a debtor as a going concern, (ii) maximize and fairly distribute a debtor’s remaining assets to its creditors and stakeholders, and (iii) provide secured lenders with a right to “full repayment” from their collateral through the absolute priority rule. Because commercial transactions are structured and priced based upon the existing Bankruptcy Code framework (and the balancing of conﬂicting views embedded therein), changes to the bedrock concepts and goals of bankruptcy proceedings will materially impact secured lending.
If the ABI Commission’s proposals result in secured lenders being surcharged as a result of the bankruptcy process so as to upset the absolute priority rule, loss given default (“LGD”) calculations based on the current Bankruptcy framework will not accurately predict losses for secured lenders after borrower defaults. The result is that lenders will need to adjust current LGD calculations in a manner that will increase borrowing rates. Any uncertainty or judicial discretion with respect to a surcharge may cause LGD assumptions to increase borrowing rates in an inefﬁcient manner. We would expect these costs ultimately will be paid by borrowers and potentially passed along to consumers and employees.
HOW WILL SECURED LENDERS RESPOND TO THE COMMISSION’S PROPOSALS?
We expect a robust response from secured lenders to the proposals of the ABI Commission. The Loan Syndications and Trading Association, Inc. (the “LSTA”) has invested substantial time and effort to track the progress of the ABI Commission’s work for the beneﬁt of its institutional members, many of which are active participants in the global leveraged loan markets and therefore have a vital stake in participating in any debate about Chapter 11 reform. We believe that the LSTA will continue to carry the laboring oar in charting the response of secured lenders to the ABI Commission’s report. They will be hosting a webinar on this topic on Thursday, December 11, 2014, at noon (EST).
Private equity sponsors will also need to defend secured lending by actively lobbying for, and describing the beneﬁts of, low cost capital for below-investment-grade borrowers. The borrowers of secured loans are in a good position to make the case that secured lending enables economic growth and job creation within local communities.
We will all have a ringside seat at the upcoming debate over the conﬂicting policies and economic considerations that will ultimately determine a “reformed” bankruptcy framework and the shape of bankruptcy proceedings in the future. Secured lenders joining the debate will be required to justify and defend their reliance on the absolute priority rule and the LGD calculations derived therefrom to efﬁciently price loans in the leveraged loan market. Participants throughout the leveraged loan market should prepare to be heard on these important issues.