Commercial Awareness Update – W/C 3rd April 2023

THE TEXAS TWO-STEP: DANCING OUT OF A $400BN BANKRUPTCY

The “Texas two-step” is a legal strategy large corporations employ to reduce liabilities from mass torts.

Facing potential liabilities more significant than its market capitalisation, Johnson and Johnson (J&J) has recently attempted the two-step, but an appellate court of the US Courts of Appeals halted the music. In the wake of this decision, law firms must conceive creative ways to execute the Texas two-step.

How to dance the two-step

When a US company faces potentially unpayable mass tort damages, it could split into two; transfer assets to one and liabilities to the other, thereby bankrupting the parent company.

In preparation, the company moves from its registered state to Texas.

Then, the first step: it undergoes a “divisive merger”, a de facto division that is legally a merger. Thanks to this corporation-friendly conflation, the company freely redistributes its balance sheet: assets go to GoodCo, and liabilities (including mass tort damages) go to BadCo.

The second step: management places BadCo into Chapter 11 Bankruptcy, intended for good-faith corporate reorganisation. For the appearance of acting in good faith, GoodCo and BadCo enter into mutual funding agreements. So, if BadCo cannot repay its creditors, GoodCo would pay the difference.

The result is that claimants may not be made whole. They cannot sue GoodCo, because the liabilities of GoodCo are liabilities of BadCo which is now bankrupt. They may not recover the full amount from zero-cash BadCo, because funding agreements are enforced by GoodCo’s management which controls both companies.

The case of J&J

Over 26,000 claimants against J&J allege that its baby powder has caused ovarian cancer. J&J had previously been ordered to pay around $7bn in damages, including $4.7bn, to twenty-two women in Missouri. If each claimant succeeds in recovering what these twenty-two women did, J&J will face liabilities larger than $5tn.

In October 2021, a J&J subsidiary executed the Texas two-step, creating LTL Management (BadCo) and New JJCI (GoodCo). LTL was given all J&J’s liabilities related to baby powder and $2bn in cash, meant to be expended as tort damages. Moreover, J&J agreed to indemnify LTL up to $61.5bn.

However, in January 2023, the Third Circuit (a federal court of appeals) ruled that LTL, funded by J&J, is not in financial distress and thus does not express the “proper purpose under the bankruptcy code”. Commenting on his ruling, Judge Thomas Ambro wrote, “LTL has a funding backstop, not unlike an ATM disguised as a contract, that it can draw on to pay its liabilities.”

Legal arguments and commercial implications

So, is the Texas two-step a brilliant legal tactic or two steps towards devious practice?

The Texas two-step has been criticised as being a fraudulent transfer and a bad-faith bankruptcy: the two-stepper intends to hinder or delay repayment to creditors, and it moves assets with the sole purpose of bankruptcy when it assumes no such intention. Moreover, the two-stepper assumes the court’s function, assigning damages and replacing litigation with funding agreements.

In defence, J&J argued that using the two-step is more efficient than civil litigation in satisfying claimants. Possibly lasting for decades, litigation could drain J&J’s balance and reduce the eventual damages recovered.

The recent ruling by the Third Circuit could have far-reaching legal and commercial implications, affecting companies hoping to use the two-step to minimise litigation and settlement costs.

A Thompson Coburn article describes the companies attempting the two-step as facing a “Catch-22” situation. That is, if BadCo holds sufficient assets (for the divisive merger to look legitimate), the court will find BadCo to be in no financial distress, dismissing the bankruptcy. But if BadCo is truly insolvent (and qualifies for bankruptcy), the “divisive merger” could be deemed a fraudulent transaction.

However, the two-step might still be viable. Whilst the Third Circuit dismissed J&J’s bankruptcy, Judge Amrbo left the door open for what he called “creative crafting” to pass the financial distress test.

This suggests that law firms are left with some wiggle room to devise new legal strategies to meet the twin standard of legitimate transaction and good-faith bankruptcy.

Article written by David Zheng

WHY HAVE BONDS LOST THEIR STATUS AS SAFE FINANCIAL INSTRUMENTS?

The past few weeks have seen the collapse and eventual sale of two prominent banks. The first is the Silicon Valley Bank (SVB), a commercial bank servicing mostly tech startups. The second is Credit Suisse, a global investment bank and financial services firm. Although both banks have different business models, one thing they have in common is the impact of their collapse on the bond market.

For contextual clarity, please see as follows:

Bonds: These are a type of financial instrument representing a loan made by an investor to a borrower. The borrower can be a government or a company. When an investor purchases a bond, they essentially lend money to the borrower for a specified period, and in exchange for that loan, the borrower promises to pay the investor back the principal amount of the loan (known as the face value) plus interest.

Treasury bonds: These are bonds issued by the US government. The equivalent of this in the UK is known as gilts.

Additional tier 1 bonds: Additional tier 1 (AT1) bonds or contingent convertibles (CoCos) are a bank equity and debt hybrid. Usually, they act as regular bonds and offer a higher rate of return for the purchasers. However, when a bank is in financial distress, the AT1 bonds are designed to convert to equity or can be written down to zero.

What happened to Silicon Valley Bank and Credit Suisse?

The main reason why SVB collapsed is that it used its deposits to predominantly invest in treasury bonds. Treasury bonds are relatively low-risk financial instruments if a low-interest rate is maintained.

However, due to the increase of interest rates by the Federal Reserve to tame inflation, the treasury bonds held by SVB became risky. This is because since investors could purchase new bonds at the new high-interest rates (which will lead to greater returns), the old long-term treasury bonds held by SVB at low-interest rates (low returns) declined in value. After SVB announced a loss of $1.8 billion on its bond portfolio, they were met with multiple withdrawal requests from its depositors. A total of $42 billion in withdrawal requests were attempted. As a result, SVB was shut down by federal regulators. The First Citizens Bank bought all deposits and loans from the failed bank, and the UK arm of SVB was sold to HSBC for £1.

On the other hand, the collapse of Credit Suisse can be attributed to the bank being plagued by a series of scandals, changes in management and significant losses in recent years. The final straw was when Credit Suisse announced plans to borrow $54 billion to increase liquidity. Still, Credit Suisse’s top investor, the Saudi National Bank, said it would not provide money due to regulatory issues.

As a result, Swiss regulators orchestrated the purchase of Credit Suisse by UBS for $3.3 billion. Shareholders will receive the price of their shares. However, the value of the AT1 bonds was written to zero, and therefore, the holders of the bonds will not get anything.

Implications on the bond market

In the US, the two-year and ten-year treasury yields fell due to the collapse of SVB. The view that treasury bonds are no longer safe investments due to the continuous increase in interest rates may lead to a reduction in the purchase of treasury bonds. It may also lead to the value of existing treasury bonds decreasing owing to the holders’ sale attempts.

Regarding Credit Suisse, the decision to write down the AT1 bonds has reduced the value of AT1 bonds issued by other banks. This is due to investors’ fears about the status of their AT1 bonds. They feel that if the AT1 bonds at Credit Suisse could be written off, the same could happen to their bonds. This may also make investors cautious about buying AT1 bonds in the future, making it more difficult for banks to raise money.

Due to the increased risk of AT1 bonds, banks may have to issue new bonds at a high coupon rate to continue attracting more investors. Coupon rates for AT1 bonds are currently in the single digits. However, there are fears that it may increase to double digits.

Implications for the legal industry

The investors of the AT1 bonds have been speaking to law firms regarding bringing a possible litigation claim. This is because debt typically ranks above equity in a restructuring. However, in the case of Credit Suisse, the Swiss financial regulator FINMA overturned this order of priority by giving shareholders the money and wiping out AT1 bondholders.

The decision to rank shareholders above the AT1 bondholders may lead to a challenge in court. It is still being determined if the challenge will hold up in court because FINMA has argued that the AT1 bonds contractually allowed for a complete write-down in a viability event and if extraordinary government support is granted. In the case of Credit Suisse, this support became evident when it was given extraordinary liquidity assistance loans secured by a federal default guarantee. Regardless of the outcome, the case will increase bondholders’ litigation claims, thereby increasing the demand for litigation lawyers.

Furthermore, if investors no longer trust bonds as a safe investment, it may reduce the sale of bonds. As a result, there may be a reduced need for capital market lawyers in structuring and negotiating bond issuance. Companies that have mainly invested in treasury and AT1 bonds may see the value of their investment reduce. Similar to the case of SVB, this may lead to insolvency. As a result, the demand for insolvency lawyers will increase.

Regardless of the impact, recent events have reminded investors that investing solely in this kind of financial instrument is never safe. Each has a level of risk attached to it, a risk which may be increased by external forces at any moment.

Article written by Ifeoluwa Bayo-Oluyamo

AI SHOWDOWN: TECH LEADERS CALL FOR CONTROL

An open letter, endorsed by hundreds of prominent figures in the tech industry, including Elon Musk and Steve Wozniak, has called on leading artificial intelligence labs to halt the development of increasingly powerful systems for six months. The signatories express concern that recent advances in AI pose “profound risks to society and humanity.”

In this article, we will discuss the potential threats associated with AI that prompted these tech giants to voice their concerns.

Loss of control

This letter emerged just two weeks after OpenAI introduced GPT-4, the most advanced AI system to date. Since the debut of Chat GPT last year, tech companies have been engaged in a competitive race to develop AI capabilities. Google unveiled their own AI bot, Bard, while Microsoft launched a chatbot for the Bing browser.

The rapid pace of AI development is at the heart of the signatories’ concerns. The letter states, “Regrettably, this level of planning and management is absent, despite recent months witnessing AI labs engaged in an unchecked race to create and deploy increasingly powerful digital minds that are beyond the comprehension, prediction, or reliable control of even their creators.”

Human redundancy

The fear of job loss due to AI is not a novel concern. However, recent discourse suggests that employees across various industries and sectors increasingly worry about job security. The letter emphasises that “AI systems with human-competitive intelligence pose significant risks to society and humanity.” This fear is widespread among tech companies. While previous technology advancements targeted blue-collar jobs, emerging AI models also threaten white-collar positions. McKinsey estimates that 50% of tasks in 50% of jobs could be rendered obsolete by AI.

As the Financial Times noted, “The accelerating pace of development and public deployment has alarmed some AI researchers and tech ethicists regarding the potential effects on employment, public discourse, and—ultimately—humanity’s ability to keep pace.”

What’s next?

On Wednesday, March 29th, the UK government is expected to release a white paper requesting existing regulators to develop a consistent approach to AI use in their respective industries. However, without legislation and regulation, there is little the government can do to enforce such requests. Meanwhile, the European Union is preparing its legislation to govern AI use within Europe, with fines anticipated for companies that violate EU regulations.

This story is developing as quickly as AI, so it is crucial to keep up to date!

Article written by Avishai Marcus

COMMERCIAL REAL ESTATE SECTOR UNDER THREAT

Rising interest rates and increased borrowing costs have sparked concern among investors that the commercial property sector is under threat.

George Gatch, chief executive of JPMorgan Asset Management, has identified commercial real estate as an area of particular risk in global markets following recent interest rate increases.

During the firm’s European Media Summit on 21^st March, Gatch stated, “when the Federal Reserve hits the brakes, something goes through the windshield.” He went on to say that “commercial real estate is an area of concern. We have higher interest rates for property developers, how does that impact the real estate market and lenders in that space?”

Explanation

Recent interest rate rises mean that borrowing costs for those in the commercial real estate sector has increased. In March, the Bank of England raised interest rates to between 4.25% and 5%, the European Central Bank to 3%, and the US Federal Reserve also raised theirs. These increased borrowing costs mean fewer transactions are taking place, causing a downturn in activity within the industry.

Recent turmoil in the banking sector after the collapses of Silicon Valley Bank and Signature Bank and the UBS takeover of Credit Suisse could worsen the issue as banks may reduce lending to the industry, preferring to hold on to deposits while uncertainty remains. This, coupled with high borrowing costs, makes it difficult for investors to transact, causing property prices to fall.

These issues pose a particular threat to the market for office spaces, which has already suffered due to the increase in hybrid working following the Covid-19 pandemic. According to Remit Consulting, pre-pandemic office occupancy rates on weekdays in the UK were 60%-80%, but in 2023 this rate has dropped to just 29%.

This doesn’t affect the space requirements for all businesses, as many will still need offices available for those workers who don’t choose to work from home. However, many smaller businesses have decided to ditch permanent offices altogether, realising they can save money by allowing employees to always work from home. This means there is less demand for office space, causing prices for this type of commercial property to drop.

Implications

These issues within the commercial real estate sector indicate a more extensive problem across the global financial system. According to a survey conducted by Bank of America, the threat of a credit crunch is now the biggest concern for investors. A credit crunch could have serious economic consequences, including reduced economic growth, increased unemployment, and decreased consumer spending.

A slump in activity within the commercial property industry may result in a reduced workload for real estate lawyers. This is because fewer transactions occur, resulting in fewer contracts, negotiations, and disputes that require the expertise of real estate lawyers. With fewer transactions and less legal work available, real estate lawyers may have to compete more aggressively for the remaining work, potentially reducing their fees and revenue.

Article written by Olivia Mathieson