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University of California, Hastings School of Law
Ellias, Jared A.



Financial distress v. Economic distress

Financial distress: created when a profitable business with going- concern value has an inadequate capital structure.

Bankruptcy law can help solve this problem.
E.g. A widget company. Expense=$100, Revenue=$200. 50% margin. Assume borrowed $20 from the bank, 10 yrs, 10% interest yearly. Incurred $200. When strip the financial problem this is a good company. à financial distress only.
Liquidation value usually < going concern value.

Economic distress created when a business experiences a lack of customer demand.

BKC law has less to offer in these cases, but economic distress can often be solved by discharging debt and transforming a business.


Detroit: financial + economic distress
GM: Business model failed. Agreement w/union paying union even w/t production. BKC can renegotiate the contact. Financial + economic Distress.
Trump Atlantic City: Casino borrows and build when bad and filed bkc for Debt- to- equity swap.
Blockbusters: PURE ECONOMIC DISTRESS. BKC can do little in the case of pure economic distress, but provide for an orderly liquidation.

Types of Secured Debts


Security interests in personal property ( UCC article 9)
Mortgage interests in real property ( governed by state law)


Judgment liens
Execution liens
Statutory liens (e.g. Mechanic Liens)

Unsecured creditors can gain the same rights as secured creditors by obtaining liens( usually judgment or execution liens) on the D’s property.

Basic Mechanics of Secured Debts:

Elements of security interest (SI): attachments and perfections.
Attachment: A SI attaches to property if, among other things, it is evidenced by a writing ( a security agreement) or the property is possessed by the creditor.
Perfection: a security interest is perfected if (i) attached and (ii) notice has been given to the world. Notice is usually given by the filing of a financing statement (usually with Secretary of State of state where debtor is located) or by possession of the property by the creditor.

Attachment: SI is enforceable against the D.
Perfection: SI is enforceable against third parties and the Debtors.

Basic Mechanics of Secured Debt: Non-consensual case

An unsecured creditor can obtain priority t particular assists by obtaining a “lien” on these assets. This is typically by

(1) Obtaining a judgment
(2) Docketing the judgment, providing notice to the world, in most state, this creates a “judgment lien” on real property.
(3) Obtaining a writ if execution from the court clerk.
In most states, the creditor obtains an “ execution lien” as of the date of the Sheriff’s Levy.
A creditor who goes through these steps is called a “ lien creditor.” Under the BKC Code, both execution and judgment liens are called “ judgment liens.”



Cash flow insolvency is more serious than Balance sheet insolvency.

Unsecured creditors: Bondholders, noteholders, debenture holders, suppliers.

Bondholders are usually unsecured.

Secured creditors: Banks, lienholders, mortgagee.
Indenture Trustee; Reps for noteholders/bondholders.

United State Trustee: §109(h)(3) – armed of Department of Justice. DOJ special rule watch dog for bkc code.

In some cases, Sub A may borrow from Bank who cross-collateralizes the loan by requiring Parent to also pledge the assets of Sub B as collateral for the Sub A loan. àThus: If Sub A defaults, Bank can foreclose on Sub B’s assets.

Blanket Lien or Blanket Mortgage: A lien on substantially all of the assets.

Lien on going-concern- value of the company

Cross-default: Each loan had a cross-default clause, which means that a default by a sibling subsidiary triggers default by all other subs, even if those subs are current on their loans

GGP’s individual subsidiaries borrowed to finance their projects.
If GGP defaults mall3 ( which the bank has no interest in mall 3), the bank has the right to foreclose mall 2 ( the bank has interest in mall 3).

Worried about mall 3’s value was stripped away.
An indicator that the Borrower has problem.

Letter of Credit: Document issued by an institution (usually a bank) promising to pay the debts of a third party (like a guarantee).
Cash collateral: It is cash that is subject to a security interest. A debtor in bankruptcy cannot use this cash without creditor consent or judicial approval notwithstanding lack of consent.
Syndicated Loans: Banks group together making loans.
Public Unsecured Bonds:

Corporate who wants to borrow hire Investment Banks ( indenture trustee), to borrow from Public Bond Market.
Public Unsecured Bonds:

Pension Funds
Mutual Funds
Rich ppl

Consider a Failing Company has a Single Creditors:

Suppose Blockbuster has assets worth 100, but debt equal to 150. It is balance-sheet insolvent. All of the debt is held by a single creditor, ABC Bank.

When Blockbuster becomes distressed, it defaults on regular payments owed to ABC. It is cash flow-insolvent. What are ABC’s options?
Option 1: Sue, obtain a judgment, liquidate the firm, collect $100 million immediately.

Because only one creditor, ABC gets everything.

Option 2: Wait for repayment in the future (“forbearance”).

Forbearance. Wait for repayment in the future. After default when creditor waits to receive judicial remedy.

Contrast to Apple, with great assets, creditor will probably wait.
Kodak, liquidation value TODAY. (liquidation v. forbearance option)

Consider a Failing Company with Multiple Creditors

Suppose Blockbuster has 10 creditors, each owed 15. Total debt is still 150. The liquidation value of the assets is still 100.

Assume that, if kept alive, Blockbuster will generate cash flows to creditors with a present value equal to $120 million.
The firm has “going concern surplus” because the going concern value (120) exceeds the liquidation value of the assets (100).

Which option will XYZ choose?

Option 1: Even if firm is worth more alive than dead, XYZ’s payoff from waiting (12) is less than payoff from being first to sue (15).
This is a collective action problem (“prisoners’ dilemma”): it is socially efficient to keep the firm alive, but individually rational for each creditor to immediately seek payment.
First to sueà obtain Judgment Lien à XYZ’ll get 15.
Because EV ( suing) > EV ( Forbearance)
Race to the Court room Problemà cause the Going-concern value gets lost.


Though balance sheet insolvent, the Going concern Value >>> Liquidation value à the court REORG instead of LIQUIDATE.

The bankruptcy Judge as Gatekeeper.

Cloudeeva (blackboard); Integrated Telecom, Should the BKC judges dismiss cases when the D appear to be abusing BKC Law?
GGP, should bkc judges dismiss cases when creditors tried to keep collateral out of bkc court?
Colonial Ford When does a D’s pre-bkc consent to a debt restricting deal preclude renegotiating the bargain in Chapter 11.

Ex Ante Costs of financial distress

A distressed firm may UNDERinvest in efficient projects

Even if the firm has valuable projects, it may be unable to finance them,
Suppose, for example, Citibank is asked to fund a project proposed by IT, which is insolvent. If the project succeeds, the payoff is shared with other creditors. If project fails, Citibank will not be repaid. Citibank won’t invest.
This is called the “debt overhang” problem à unable to invest valuable project due to the debt from yesterday.

A distress firm may OVERinvest in inefficient projects

If the firm is organized as a corporation, the SSH do not bear the downside of risky projects. The worst that can happen is that the value of their equity is wiped out. They will not be personally liable.
Thus, as a firm enters distress, shareholders are attracted to risky projects, even projects with negative expected payoffs. A gamble with a 1% chance of success (a roulette wheel) is better than a certainty of receiving nothing in liquidation.
This is known as the “asset substitution” or “risk-shifting” problem.
Implies when firm does well, it does not take excess risks. E.g. GM and Google.

Chapters of the US Bankruptcy Codes:

Chapter 7

Business is liquidated. Debts are discharged.
Individual’s debts are discharged in exchange for giving up non-exempt assets.

Chapter 11

Reorganization: Debt burdens are reduced to a level compatible with the firm’s ability to pay.
Sensible only for firms in financial distress (but not in economic distress).

Chapter 13

Individual’s Debts are discharged in exchange for giving up a disposable income for three to five years

Other Bargains.

Chapter 12 (cross between chapters 11 and 13 for family farmers and fishermen;
Chapter 9 ( municipal bkc);
Chapter 15 (procedure for international cooperation)

WHO should be eligible?

Financial distress
Multiple creditors
Firm could benefit from the process

Not economically distressed; has going-concern value surplus.
A Non-viable firm, but orderly liquidation in bkc will conserve collection costs and avoids fire-sales of assets.

Eligibility under Chapter 11

Start with Section 109(d) – Railroad ( not chapter 8, b/c railroad can’t be separated), a person who is eligible for Chapter 7, and certain others.

Eligibility under Chapter 7

§109(b)- Any person, but not a Railroad, commercial bank( has its own provision), or insurance company.
Define “ person” – §101(41)
Define “ Partnership”à not defined à GO TO STATE LAW
Define “Business trust” à not defined à GO TO STATE LAW.

The Butner Principle

“ Congress has generally left the det

nkruptcy purposes,” even in the face of evidence of bad faith forum shopping.

But the Judge might appoint a trustee if management seems incompetent

Bankruptcy v. Workouts

Workout: An out-of-court adjustment of a D’s capital structure – a loan renegotiation, essentially.

Advantages of workouts: cheaper; reduced adverse publicity, reduced dislocations business.
No need for attorney

Advantages of BKC:

Can bind dissenting creditors, no need for unanimous consent.
Can get out of bad K, break promises and treat similarly situated creditors similarly.

In general, workouts are preferred

General Growth Properties

GGP is a parent (holding) company with about 750 subsidiaries. Most subs own a single piece of real estate. The holding company is the “brain” of the business, offering “centralized leasing, marketing, management, cash management, property maintenance and construction management.” Project-level finance – finance at sub leval. Usually commercial realty collateral= malls à when comes due à refinance.
“GGP [attempted] to renegotiate the debt, but the lenders were unwilling to consent to additional forbearance, which in turn led to defaults and cross-defaults.”

Cross-default: GGP’s individual subsidiaries borrowed to finance their projects. Each loan had a cross-default clause, which means that a default by a sibling subsidiary triggers default by all other subs, even if those subs are current on their loans.

Subs are separate legal entities with governance provisions designed to achieve “bankruptcy remoteness:” by (1) Lender appointed board member +(2) unanimous BKC filing requirement. The collateral stay away from the court because BKC remote à because BKC is not convenient for secured creditors when the collaterals are trapped.

prohibiting consolidation of GGP’s various special purpose entities (defined below)
restricting mergers and asset sales
requiring arms-length transactions between related entities
prohibiting one affiliate from guaranteeing debts of another
requiring two “independent” directors

“Many of the GGP Group’s mortgage loans were financed in the commercial mortgage-backed securities (“CMBS”) market.”

Instead of borrowing funds through a secured loan, debtor (D) conveys assets (collateral) to a legal entity (corporation or trust) that has been created solely for the purpose of owning the assets. àThe corporation is called a “special purpose entity” (SPE) or “special purpose vehicle” (SPV). The debtor usually owns the SPE (it is a subsidiary). The assets are typically mortgages, leases, or other long-lived assets that produce regular cash payments.
The SPE borrows from banks (loans) or issues bonds. In either case, the claims are secured by the SPE’s assets. Proceeds from borrowing are used by SPE to pay the debtor for the assets.
In this way, the debtor obtains funds by “selling” assets to a related entity.

Movants argue that the SPE or bankruptcy-remote structure of the project-level Debtors requires that each Debtor’s financial distress be analyzed exclusively from its perspective”

We will see that the automatic stay applies to all property of the debtor’s “estate.”àThus, if a creditor wants to prevent collateral from being “sucked” into a bankruptcy case, it must keep the property out of the estate àOne simple way to do this is to create an SPE and have the debtor (here, GGP) convey the property to the SPE. Because it is a separate legal entity, the SPE’s assets cannot be “sucked” into a filing by GGP.
The SPE typically has bylaws that limit the parent’s control over the SPE and ensure that all transactions with the parent are done on an arms-length basis
In this case, the lender appoints two directors to the board and the SPE’s corporate by-laws specify that unanimous director consent is needed for a bankruptcy filing
The two lender directors are given the simple charge of voting “no” to a bankruptcy filing – thus, keeping the collateral out of bankruptcy
Hence, the structure is “bankruptcy remote”