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Taking Control Rights Seriously

The Bankruptcy Code deals first and foremost with the cash flow rights of the debtor’s various investors. The immediate cause of most corporate bankruptcy filings is a company’s pending inability to pay off its obligations that are becoming due. The firm has made promises to pay various parties, and it does not have the financial wherewithal to live up to those obligations. It lacks the liquidity necessary to continue to service its debt and has either defaulted on its obligations or faces imminent default. In short, there is a mismatch between the company’s capital structure and its future revenues.

Restructuring the business’s balance sheet under Chapter 11 is designed to address this mismatch between obligations and available resources. The goal is to create a capital structure that better reflects the future revenues of the firm. The heart of Chapter 11 is the absolute priority rule. It sets forth the conditions that must be met for an investor to see her cash flow rights changed over her objection. Those holding secured debt can see their principal reduced, the interest rates on the debt trimmed, and the term of the loan extended. Unsecured debt can be reduced, paid off at pennies to the dollar, or converted to equity. Equity can be drastically diluted or even wiped out in full. Specifying the extent to which the various parties’ rights can be adjusted over their objection structures the bargaining process that leads to a plan of reorganization.

Over the decades, much ink has been spilled over the extent to which there are deviations from absolute priority in practice and the extent to which other mechanisms could be implemented that would vindicate the rule. Recently, there has been serious questioning of the wisdom of the Code’s strict adherence to absolute priority, with the suggestion that we return to the world of relative priority. Regardless of which flavor of priority one prefers, in every reorganization case the central issue that is the focus of reorganization law is how cash flow rights are adjusted—what claims will the prebankruptcy investors have against the restructured company?

The Code deals with cash flow rights in other ways besides adjusting investors’ rights to cash flow at the end of the proceeding via a plan of reorganization. For example, all rights to receive payments based on prepetition debts are stayed by the filing of a bankruptcy petition. Some transfers of money made on the eve of bankruptcy can be undone. Transactions of the last few years can be scrutinized to see whether the debtor received an adequate return for property that it has transferred to others. The debtor can decide whether to continue with transactions in progress. All of these situations adjust outside parties’ legal rights to receive money from the debtor.

Bankruptcy law, in contrast, has little to say about control rights over the running of the business. It by and large allows the existing management to remain in charge of the debtor. State law vests the ultimate authority over a company’s operations with the firm’s board of directors, and bankruptcy law leaves that structure in place. Boards, in turn, delegate the running of the company to the CEO and the executive team, and the Code takes this allocation of authority as the baseline for operating the debtor, both during the case and afterwards.