1. Class 1 Bankruptcy, Spring, 2009 Case Initiation & Property of the Estate Randal C. Picker Leffmann Professor of Commercial Law The Law School The University of Chicago 773.702.0864/r-picker@uchicago.edu Copyright © 2005-09 Randal C. Picker. All Rights Reserved.

2. September 23, 2015Copyright © 2005-09 Randal C. Picker2 The Dark Side of Bankruptcy? n The Hypo u Zero real rate of interest u Project requires $100 cash investment u Firm want outside financing u 10% of the time the project yields $50 u 90% of the time the project yields $V > 50

3. September 23, 2015Copyright © 2005-09 Randal C. Picker3 Social Q: Do We Want This Project? n Expected Value of the Project u.1*50 +.9*V – 100 u Want the project undertaken if V > 105.55

4. September 23, 2015Copyright © 2005-09 Randal C. Picker4 Outside Funding of the Project n Assume lending market is competitive n Funding decision, with zero interest rate, requires recovery of $100 investment n Let D be the amount of debt to be owed to the lender u Then we need 100 = 0.1*50 + 0.9*D u D = 105.55

5. September 23, 2015Copyright © 2005-09 Randal C. Picker5 Take Stock n Social Incentives = Private Incentives u Want project undertaken if V > 105.55 u Lender will finance with D = 105.55 u Lender will finance if and only if project is socially useful

6. September 23, 2015Copyright © 2005-09 Randal C. Picker6 Introduce Bankruptcy n If project fails ($50 value of project results) u Assume mechanism exists that will enable firm to undertake new investment project u With project, invest $50 u 90% of the time get nothing, 10% of the time get $300

7. September 23, 2015Copyright © 2005-09 Randal C. Picker7 Social Q: Do We Want This Project (and this Mechanism)? n Expected Value of the Project u.9*0 +.1*300 – 50 = -20 n Bad Investment!

8. September 23, 2015Copyright © 2005-09 Randal C. Picker8 What will the Firm Do? n With D = 105.55 u On failure with $50, firm keeps nothing (Lender owed 105.55 is entitled to all of the money) u But if Firm undertakes new investment w.9*0 +.1*(300-105.55) = 19.45 w Firm will undertake bad project if allowed to do so

9. September 23, 2015Copyright © 2005-09 Randal C. Picker9 What will the Firm Do? w Lender gets.9*105.55 +.1*(.9*0 +.1*105.55) = 96.05

10. September 23, 2015Copyright © 2005-09 Randal C. Picker10 How will Lender Respond? n Needs new debt amount upfront, call it F, where F needs to satisfy u.9*F +.1*(.9*0 +.1*F) = 100 u.91*F = 100 u F = 109.89

11. September 23, 2015Copyright © 2005-09 Randal C. Picker11 What Does This Mean? n Is Lender Harmed by this Mechanism that Allows the Bad Investment when Firm Fails? u Not in this example u Lender takes into account ex ante anticipated bad investment when Firm fails u Lender raises debt amount from 105.55 to 109.89

12. September 23, 2015Copyright © 2005-09 Randal C. Picker12 What Does This Mean? n Is Firm Harmed by this Mechanism? u Yes u Firm can’t fool Lender u Firm loses ability to finance projects where 105.55 < V < 109.89 n Is Society Harmed? u Yes, in exactly the same way

13. September 23, 2015Copyright © 2005-09 Randal C. Picker13 More Meaning n Possible Downside of Bankruptcy u If bankruptcy makes it possible for firm to undertake bad investments, lenders will anticipate that and adjust lending accordingly u Good upfront investments will be lost u We would be better off without bankruptcy or if we allowed firms to waive access to bankruptcy

14. September 23, 2015Copyright © 2005-09 Randal C. Picker14 Other People’s Money n Investment Incentives with Debt u Firm is willing to undertake bad project because it isn’t spending its own money u Presence of debt changes investment incentives

15. September 23, 2015Copyright © 2005-09 Randal C. Picker15 Other People’s Money n Bankruptcy Rules Matter u If bankruptcy rules facilitate bad in- bankruptcy investments, rules matter u Creditors will adjust but we will lose socially valuable investments upfront n Is this a Fair Characterization of Bankruptcy?

16. September 23, 2015Copyright © 2005-09 Randal C. Picker16 Initiating a Case: Statutes n 109 u Eligibility Rules n 301 u Voluntary Petitions: Mechanics and Consequences n 303 u Involuntary Petitions

17. September 23, 2015Copyright © 2005-09 Randal C. Picker17 Initiating a Case: Statutes n 305 u Abstention w When may the bankruptcy court decline to exercise jurisdiction over a case within its power?

18. September 23, 2015Copyright © 2005-09 Randal C. Picker18 109: Relation to the U.S n Who may be a debtor u (a) Notwithstanding any other provision of this section, only a person that resides or has a domicile, a place of business, or property in the United States, or a municipality, may be a debtor under this title.

19. September 23, 2015Copyright © 2005-09 Randal C. Picker19 109: Chapter 7 Eligiblity n Who may be a debtor (cont.) u (b) A person may be a debtor under chapter 7 of this title only if such person is not— w (1) a railroad; w (2) a domestic insurance company, bank, savings bank, cooperative bank, savings and loan association, building and loan association […]; or

20. September 23, 2015Copyright © 2005-09 Randal C. Picker20 109 (cont.) n Who may be a debtor (cont.) w (3)(A) a foreign insurance company, engaged in such business in the United States; or w (B) a foreign bank, savings bank, cooperative bank, savings and loan association, building and loan association, homestead association, or credit union, that has a branch or agency … in the United States.

21. September 23, 2015Copyright © 2005-09 Randal C. Picker21 109: Chapter 9 Eligibility n Who may be a debtor (cont.) u (c) An entity may be a debtor under chapter 9 of this title if and only if such entity-- w (1) is a municipality; w (2) [omitted]; w (3) is insolvent; w (4) desires to effect a plan to adjust such debts; w […]

22. September 23, 2015Copyright © 2005-09 Randal C. Picker22 109: Chapter 11 Eligibility n Who may be a debtor (cont.) u (d) Only a railroad, a person that may be a debtor under chapter 7 of this title (except a stockbroker or a commodity broker), and an uninsured State member bank, or a … may be a debtor under chapter 11 of this title.

23. September 23, 2015Copyright © 2005-09 Randal C. Picker23 109: Chapter 13 Eligibility n Who may be a debtor (cont.) u (e) Only an individual with regular income that owes, on the date of the filing of the petition, noncontingent, liquidated, unsecured debts of less than $336,900 and noncontingent, liquidated, secured debts of less than $1,010,650

24. September 23, 2015Copyright © 2005-09 Randal C. Picker24 109 (cont.) n Who may be a debtor (cont.) w or an individual with regular income and such individual's spouse, except a stockbroker or a commodity broker, that owe, on the date of the filing of the petition, noncontingent, liquidated, unsecured debts that aggregate less than $336,900 and noncontingent, liquidated, secured debts of less than $1,010,650 u may be a debtor under chapter 13 of this title.

25. September 23, 2015Copyright © 2005-09 Randal C. Picker25 109: Chapter 12 Eligibility n Who may be a debtor (cont.) u (f) Only a family farmer or family fisherman with regular annual income may be a debtor under chapter 12 of this title.

26. September 23, 2015Copyright © 2005-09 Randal C. Picker26 109: Serial Filings Limit n Who may be a debtor (cont.) u (g) Notwithstanding any other provision of this section, no individual or family farmer may be a debtor under this title who has been a debtor in a case pending under this title at any time in the preceding 180 days if—

27. September 23, 2015Copyright © 2005-09 Randal C. Picker27 109 (cont.) n Who may be a debtor (cont.) w (1) the case was dismissed by the court for willful failure of the debtor to abide by orders of the court, or to appear before the court in proper prosecution of the case; or w (2) the debtor requested and obtained the voluntary dismissal of the case following the filing of a request for relief from the automatic stay provided by section 362 of this title.

28. 109 (cont.) n 2005 Amendments on Prepetition Counseling u See 109(h) September 23, 2015Copyright © 2005-09 Randal C. Picker28

29. September 23, 2015Copyright © 2005-09 Randal C. Picker29 301: Commencing A Voluntary Case n Voluntary Cases u (a) A voluntary case under a chapter of this title is commenced by the filing with the bankruptcy court of a petition under such chapter by an entity that may be a debtor under such chapter. u (b) The commencement of a voluntary case under a chapter of this title constitutes an order for relief under such chapter.

30. September 23, 2015Copyright © 2005-09 Randal C. Picker30 Bankruptcy Forms n Go to u http://www.uscourts.gov/bkforms/bankruptc y_forms.html http://www.uscourts.gov/bkforms/bankruptc y_forms.html n Voluntary Petition Form Voluntary Petition Form

31. September 23, 2015Copyright © 2005-09 Randal C. Picker31 303: Involuntary Cases: Eligibility n Involuntary Cases u (a) An involuntary case may be commenced only under chapter 7 or 11 of this title, and only against a person, except a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial corporation, that may be a debtor under the chapter under which such case is commenced.

32. September 23, 2015Copyright © 2005-09 Randal C. Picker32 303: Dollar Amounts and Numbers n Involuntary Cases (cont.) u (b) An involuntary case against a person is commenced by the filing with the bankruptcy court of a petition under chapter 7 or 11 of this title - w (1) by three or more entities, each of which is either a holder of a claim against such person that is not contingent as to liability or the subject of a bona fide dispute, or an indenture trustee representing such a holder, if such claims aggregate at least $13,475 more than the value of any lien on property of the debtor securing such claims held by the holders of such claims;

33. September 23, 2015Copyright © 2005-09 Randal C. Picker33 303 (cont.) n Involuntary Cases (cont.) u (b)(2) if there are fewer than 12 such holders, excluding any employee or insider of such person and any transferee of a transfer that is voidable under section 544, 545, 547, 548, 549, or 724(a) of this title, by one or more of such holders that hold in the aggregate at least $13,475 of such claims;

34. September 23, 2015Copyright © 2005-09 Randal C. Picker34 303: Substantive Standard for Involuntary Petition n Involuntary Cases u (h) If the petition is not timely controverted, the court shall order relief against the debtor in an involuntary case under the chapter under which the petition was filed. Otherwise, after trial, the court shall order relief against the debtor in an involuntary case under the chapter under which the petition was filed, only if - w (1) the debtor is generally not paying such debtor’s debts as such debts become due unless such debts are the subject of a bona fide dispute; or …

35. September 23, 2015Copyright © 2005-09 Randal C. Picker35 305: Abstention n Abstention u (a) The court, after notice and a hearing, may dismiss a case under this title, or may suspend all proceedings in a case under this title, at any time if w (1) the interests of creditors and the debtor would be better served by such dismissal or suspension; or …

36. September 23, 2015Copyright © 2005-09 Randal C. Picker36 More Ways to Make the Case Go Away n 707 u Dismiss the case for “cause” n 1112 u Dismiss or convert the case (to another chapter) for cause

37. September 23, 2015Copyright © 2005-09 Randal C. Picker37 Shawmut Bank Equipment Trust Eastern $500MM Sale and Leaseback Trust Certificates 1 st Priority Secured $200MM 2 nd Priority Secured $200MM 3 rd Priority Secured $100MM 1. How should we characterize this transaction? 2. Why does it matter? I 1 --- I N

38. September 23, 2015Copyright © 2005-09 Randal C. Picker38 Two Characterizations n Transaction Between Trust and Eastern u Nominally a sale and leaseback u That means title to the planes leaves Eastern and comes to the Trust u If Eastern files for bankruptcy, planes won’t be part of the bankruptcy estate created when Eastern files a bankruptcy petition

39. September 23, 2015Copyright © 2005-09 Randal C. Picker39 Two Characterizations n Status of the Trust u What kind of entity is the trust? u Is it bankruptcy eligible or is it “bankruptcy remote”?

40. September 23, 2015Copyright © 2005-09 Randal C. Picker40 Sale and Leaseback as Secured Transaction n Parties Agree Deal is Secured Transaction u Implications w Trust makes loan to Eastern and is a creditor of Eastern w Title to Assets Remain with Eastern and assets will be part of Eastern bankruptcy w Trust as secured creditor will have priority over other creditors as to the planes

41. September 23, 2015Copyright © 2005-09 Randal C. Picker41 Sale and Leaseback as Secured Transaction n Why? u Historically, parties seek to use form to control results in deals u Law frequently looks through form to underlying substance

42. September 23, 2015Copyright © 2005-09 Randal C. Picker42 The Eastern Bankruptcy n Follow the Airplanes u 3/9/89: Eastern files Chapter 11 (official name of the bankruptcy “In re Ionsophere Clubs”) u 1/23/91: Eastern cuts deal with collateral trustee to turnover planes and $230MM in cash from sales of planes

43. September 23, 2015Copyright © 2005-09 Randal C. Picker43 Why File? n Why was an involuntary bankruptcy petition filed against the Trust?

44. September 23, 2015Copyright © 2005-09 Randal C. Picker44 Why the Filing? n Conf Call April 5, 1991: David Sherman, a vice president of Charter National Life Insurance Company u MR. SHERMAN: [One reason for the filing is that the First Series certificate holders are seeking payment of] interest on interest and redemption premium if entitled to it. And they have been very strongful [sic ] with that way. And as a result if that were to happen there would be no cash left in the estate for the Second or the Thirds to take care of their planes and generate asset sales or even help upkeep their lease requirements. …

45. September 23, 2015Copyright © 2005-09 Randal C. Picker45 Why the Filing? u Two, the structure between the Indenture Trustees and the Collateral Trustee, as Barbara has experienced, is horrible. The Collateral Trustee really won't do anything if he can avoid it because he is afraid of getting sued. And the Indenture Trustees say we think you should do this but we're not going to instruct you. So no one... nothing ever gets done. If Northwest or some other firm came to the Collateral Trustee and said we can sell you, we can sell 20 planes tomorrow, we'll buy them, but it's a one week offer and you have to decide, the Collateral Trustee would say "Gee, I don't know. What should I do.“

46. September 23, 2015Copyright © 2005-09 Randal C. Picker46 Why the Filing? u The Firsts would say "We don't care as long as we can get our cash out." The Seconds would probably say "as long as it's relatively reasonable price we should do this because we could hopefully get our cash out." The Thirds would be objecting because they won't be satisfied in today's market prices because, you know, they figure they get wiped out.