A controversial proposal to reform the bankruptcy code would shift the balance of power between debtors and creditors, resulting in extensive — but difficult to forecast — changes to the banking industry.

The American Bankruptcy Institute proposed a wide-ranging series of reforms that, taken together, would be the most significant changes to the bankruptcy code since it was written nearly 40 years ago. The ABI, an educational trade group for bankruptcy professionals, says Chapter 11 needs to be modernized to improve the odds of successful turnarounds for troubled companies, particularly small businesses.

The group proposed more than 200 changes, and it's impossible to predict the cumulative impact they would have on the banking industry if implemented. The ABI has no power to enact changes on its own, and bankruptcy reform is likely to take years to get through Congress, if it happens at all.

Yet creditors have already sounded the alarm. On the whole, observers — especially those in the financial-services industry — say the reforms would shift power away from banks and other secured lenders, which could reduce what they can recover through the courts. This could have the side effect of increasing the cost of funding, critics argue. 

"We are concerned that the report could lead to changes in the bankruptcy code that hurt secured creditors, which could lead to disruptions to secured lending, especially at the first signs of corporate distress," Jaret Seiberg, an analyst at Guggenheim Securities, wrote in a note to clients. "There is a serious effort underfoot to change the rules of the bankruptcy game."

The proposed reforms are intended to align the bankruptcy process with modern financial products and corporate structures, and to reduce the costs of bankruptcy, which the ABI argues make Chapter 11 impractical for small companies.

"The bankruptcy code was not originally designed to rehabilitate companies efficaciously in this complex environment," the group's report said. Reform would help preserve viable companies, and hence jobs and local economies, by reducing the barriers to filing for Chapter 11 protection, the ABI claimed.

Even reform opponents acknowledge that the 400-page report, the product of nearly five years of work by some 250 professionals, represents an authoritative study of the state of Chapter 11 — perhaps the most detailed commentary on the process ever produced.

As such, the report is likely to set the terms of the debate over Chapter 11, even if reform is years away.

Most observers see the proposals as an effort to balance the interests of all the parties in a Chapter 11 case — a "grand bargain," as a group of Davis Polk lawyers wrote, that seeks "to form a coherent and analytically consistent set of rights and remedies for secured creditors" in Chapter 11 cases.

Not all analysts think the proposals would achieve this balance. Fitch Ratings, for instance, said the proposed reforms "could adversely alter recovery prospects of first-lien debt claim holders."

Bob Keach, co-chair of the commission that produced the report, disagrees with Fitch's conclusion. Keach said he is "highly confident that the proposed changes would not affect secured creditor returns."

The proposals could even increase banks' recoveries by streamlining the process, reducing costs, and making it more difficult for unsecured creditors to block plans they don't like, Keach said.

"For the traditional commercial banking industry, including community banks, there's a lot of things that they'll like in the report," he said. "I think that, at the end of the day, it will increase rather than decrease returns for them."

Many of the proposals are aimed at rebalancing power among secured creditors, bankrupt companies and unsecured investors. Each party would get some perks and make some concessions, and analysts disagree about who would benefit most from the changes.

For instance, companies would have more power to force creditors to accept a restructuring plan that doesn't pay them in full. The proposals would also make it much easier for bankrupt companies to get debtor-in-possession loans, which could reduce creditors' leverage.

The reforms would alter the so-called absolute priority rule, which requires that junior creditors don't get paid anything until senior creditors are paid in full. In some cases, senior lenders would be required to pay junior lenders the value of the option to buy the bankrupt company at an impaired price — a change that would hurt secured lenders, said David Hillman, a lawyer at Schulte, Roth & Zabel.

"These proposals would be a significant shift of leverage away from the senior creditors in the capital structure to the debtors and out-of-the-money stakeholders," Hillman said.

Other changes could benefit banks. One key proposal would eliminate a rule that requires the consent of at least one group of unsecured lenders that takes a haircut on any restructuring plan. This could give secured lenders more leverage and reduce the legal wrangling over confirming a restructuring plan.

Keach thinks eliminating this rule would be an important win for banks and other secured lenders.

"When cases get held up by unsecured creditors who are otherwise out of the money, they often are able to they extract a tip from the bank to let this plan go forward," he said. "That shouldn't be a payment they extort, it should be a share in the future value of the business, if there is one."

Reducing the cost of Chapter 11 cases is another huge focus of the reforms. Troubled companies would benefit the most from cheaper bankruptcies, but banks, whose returns are reduced by protracted legislation, could also benefit. The ABI recommends that in some cases bankruptcy professionals be paid by contingent or flat fees, rather than hourly.

Most importantly, perhaps, the report proposes an alternative bankruptcy process for small and midsize companies, which have trouble making it through the complex and expensive Chapter 11 system intact, the ABI said.

"We wanted to get away from the phenomenon of small cases lingering in Chapter 11 because they were stuck there from deficiencies in the code," Keach said.

Smaller companies represent, by far, the majority of bankruptcy filings. Businesses with less than $10 million in annual revenue accounted for 92% of all bankruptcy filings last year, the report said.

For these companies, the proposal would eliminate the automatic creation of creditor committees. Such committees incur professional costs that are paid by the estate.  Rather, an independent bankruptcy adviser would offer free consultation. Owners of small companies would also be able to retain control of their companies through bankruptcy by paying their creditors the market value of the business, rather than the full face value of their debt.

Critics doubt, however, that the cumulative effect of the reforms would make bankruptcy cheaper. Elliot Ganz, general counsel of the Loan Syndications and Trading Association, a lobbying group, argues that the current system works well, and that the proposed reforms would make Chapter 11 more complicated and drawn out.

"The commission is adding all kinds of complexity to a simple system that works very, very well," he said.

Ganz said he backs some of the ABI's proposals, but thinks that others would constrain credit.

"If these proposals were implemented, the price of credit would have to change," Ganz said. "This has real market ramifications, which is why it has to be taken so seriously, and why we're not happy with some of these proposals."

Unlike Ganz's group, which represents buyers and sellers of loans, banking trade groups did not publicly fire back against the proposed reforms, though they are wary of them.

"These recommendations expose creditors of small businesses to much greater risk," a spokesman for the American Bankers Association wrote in an emailed response to questions on the proposals. "Some proposals would undo long-standing creditor rights for small and medium-sized businesses and would inevitably lead to less credit and higher borrowing costs, which will hurt the economy and threaten continued job growth."

Chris Cole, senior regulatory counsel for the Independent Community Bankers of America, said he thinks the report is an impressive attempt to address problems with Chapter 11, but is worried that it could shift Congress' attention away from the ICBA's legislative priorities, like regulatory relief and reforming the Dodd-Frank Act, in the coming year.

"I do think that it's a serious report that should be looked at, but I'd hate to see it morph into something bigger and become a distraction," Cole said.

Cole said he is also concerned that if Congress takes up bankruptcy reform, it could go far beyond what the ABI proposed, and ultimately could have negative consequences for secured lenders.

"There are so many moving parts to it that if you change one thing, there could be unintended consequences," he said. "You never know what the outcome is going to be when you start the process of reform."

The ABI plans to present the reform proposals to the judiciary committees of the House and Senate. From there, the process is largely out of the group's hands. The ABI does not lobby, and it will be up to other organizations to help shape reform and shepherd it through Congress, Keach said.

More than 100 of the proposals are "noncontroversial" reforms that Congress could conceivably enact without much controversy, Keach said. He hopes the more substantive — and divisive — recommendations help guide the coming conversation about Chapter 11 reform, even if they don't become law as proposed.

"It ought to be discussed and debated thoroughly," Keach said. "We'll see. If I could predict how things go when you put them in front of Congress, I would be making far more money than I am now."

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