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Practice Opportunities In Chapter 11

Serving those in distress

Despite a strong economy, business bankruptcies are on the increase, especially in the retail industry. Management, creditors, shareholders, and other interested parties look to their accountants to assist in development of important financial reports and advise them on the critical financial questions that arise during the pendency of the case. Given the financial complexities of these cases, accountants are uniquely positioned to advise both companies in Chapter 11 and their creditors.

Chapter 11 of the United States Bankruptcy Code enables a company to seek protection from creditors as it attempts to develop a reorganization plan to address conditions that led to the bankruptcy filing. Debtor's management, creditors, shareholders, and other interested parties regularly seek assistance from accountants as they address important financial and strategic issues as the case proceeds through the process. The accountant may lend financial expertise to development of the debtor's financial projections, assist in the preparation of many of the financial reports required to be submitted for review, and provide on-going accounting, audit, and tax assistance. Creditors rely on accountants to advise them on the reorganization alternatives and whether to retain or sell a claim.

To capitalize on potential service opportunities associated with business reorganizations, accountants must understand the Chapter 11 process.

Overview of the Chapter 11 Process

Commencement of the Case. A business may voluntarily elect to file for Chapter 11 protection at any time, as there is no financial test for Chapter 11 eligibility. Three or more creditors holding undisputed claims may also put a company into Chapter 11 involuntarily. The commencement of both voluntary and involuntary cases is fairly inexpensive and quick; it's the remainder of the process that is time-consuming and expensive.

By filing a petition under Chapter 11, the debtor automatically receives protection from the court as it attempts to get its affairs in order and develop a plan to reorganize the company. Creditors are prevented from pursuing collection of outstanding debt or foreclosing on collateral while the company is in Chapter 11.

Case Administration. Within 15 days (a deadline routinely extended by the court), the Chapter 11 debtor must file a schedule of all assets, debts, and other claims. Creditors either may file proofs of claims by the deadline imposed on a case-by-case basis or accept the claim amount as scheduled by the debtor. As the case progresses, the debtor must file monthly operating reports and other information required by the court's local rules or by the United States trustee. As the governmental agency charged with monitoring certain aspects of bankruptcy cases, the United States Trustee maintains monthly operating reports including the debtor's condensed financial information and proof of payment of all payroll and other withholding taxes.

In many Chapter 11 cases, debtors also agree, or may be ordered, to provide their lenders or other creditors with extensive financial reports, including payable and receivable agings, availability of bank credit, backlog information, cash-flow projections, and liquidation analyses for some or all parts of the business. Often, a debtor's chief financial officer or controller is requested to produce reports not previously available or to re-format reports previously issued, often on extremely short notice. The court may require delivery of cash-flow and profit-and-loss reports with cash projections a few days into the following month. Many activities in a Chapter 11 case, such as a debtor's ability to use its cash or other assets, or a request to close underperforming store locations or branch sales offices, will require further analyses and development of financial projections. These reporting demands frequently tax the capabilities of the debtor's financial staff, which may seek outside professional assistance.

Formation of Committees and Appointment of Professionals. The Bankruptcy Code permits the formation of a creditors' committee to oversee the financial results of operations and progress of the case and to negotiate with the debtor regarding the business plan by which the debtor hopes to emerge from Chapter 11. The largest unsecured creditors are asked to serve on the committee. In larger cases, the court may permit formation of a committee of shareholders or more than one creditors' committee. Chapter 11 committees may hire attorneys, accountants, and other professionals, all at the debtor's expense.

Development of the Reorganization Plan. Within the first 120 days of the case (another timetable routinely extended), the debtor has the exclusive right to file a "plan of reorganization." Essentially, the Chapter 11 plan details the amount and timing of all creditor payments, the means for effectuating such payments (such as the sale of assets, refinancing, or compromise of disputed claims), and the essential legal and business structure of the debtor as it emerges from Chapter 11 protection. The creditors' committee, any creditor, or other party may file a plan after 120 days or with the court's permission.

All plans must be filed with a "disclosure statement," which is similar to a prospectus, for soliciting votes for the acceptance or rejection of the plan. The disclosure statement must present an analysis of the treatment of each class of creditors and equity holders, outline projected financial performance, and provide an estimate of the liquidation value of the debtor. The court must approve the accuracy and adequacy of the information contained in the disclosure statement at the start of the confirmation process. The information included in the disclosure statement is critical to a creditor's evaluation of the reorganization plans offered for acceptance, as compared to possible other plans or even liquidation.

Voting, Feasibility Review, and Confirmation. After the disclosure statement is approved by the court, it is sent with the plan to creditors and shareholders for voting. Following tabulation of the votes, the court conducts a hearing to consider confirmation of the plan, including whether the plan is feasible. Generally, to confirm a plan, the court will assess whether the plan is more likely than not to be achievable given the prevailing economic conditions and other circumstances affecting the debtor and its industry. Often, the central focus of the feasibility issue is the reasonableness of the debtor's projections for its future financial performance and its ability to generate the cash necessary to make the promised payments to creditors. Plan opponents may challenge plan feasibility and request a formal hearing on the issue. Attorneys for the plan proponent and any plan opponents may present evidence on the issue of feasibility and call witnesses to provide expert testimony about the plan.

If the plan is confirmed, the debtor has emerged from bankruptcy. The debtor then effectuates or consummates the plan by making creditor payments and taking the other steps required in the plan.

Client Service Opportunities

The Chapter 11 process provides a number of service opportunities for accountants. Given their expertise in the development of projections, financial reports, and business plans, accountants may assist both the debtor and its creditors throughout the bankruptcy case. Even accountants new to the Chapter 11 process will recognize familiar service opportunities, including development of specialized financial reports and pro forma statements; development and evaluation of business plan alternatives, such as sales of business segments or assets, refinancing, or business combinations; creation of a business strategic plan; and consultation or testimony as an expert on projections, assumptions, estimates, and industry trends underlying the reorganization plan.

Evaluating the Reorganization Plan

In their service to the debtor or its creditors, accountants have an opportunity to provide value by assisting in the evaluation of the quality and feasibility of the plan of reorganization. Many accountants gain experience evaluating the reasonableness of a plan to remedy financial distress when they consider the issue of a company's ability to continue as a going concern. Evaluating the feasibility of a plan is similar to the work performed by auditors in connection with their responsibility under SAS No. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern.

Many of the factors considered by auditors of distressed enterprises are similar to those considered by the court in its evaluation of plan feasibility. As noted earlier, before a plan can be confirmed, the court must determine that the plan is feasible. As noted in Colliers on Bankruptcy, the court typically considers the following factors in its feasibility review:

* Adequacy of the debtor's capital

* Earnings power of the debtor
business (with special emphasis on the cash flow available for creditor payments)

* Ability of debtor management

* Probability of continuity of debtor's

* Availability of credit

* Economic conditions

* Other issues that affect the prospect for the debtor to perform all plan provisions.

Perhaps the most significant factor to be considered in an evaluation of plan feasibility is the cash flow projections that support the payments to be made under the proposed plan. Bankruptcy case law suggests three requirements for the projections. They must be--

* prepared by someone capable of preparing accurate and credible forecasts,

* accurate and consistent with the entity's past performance, and

* based on sound and reasonable assumptions.

Clearly, accountants can provide valuable service if they are experienced in the development of projections and knowledgeable about the debtor's situation.

Feasibility Tested

The issue of plan feasibility is critical to the court, the debtor, and others making important decisions during the bankruptcy case. Just how effective is the court's evaluation of feasibility? In fact, the bankruptcy system does not track the outcome of confirmed plans. An original study by the author investigated the outcome of reorganization plans that were confirmed following a feasibility challenge by the plan opponents. The study is interesting because it examines the outcome of plans that resulted in confirmation despite the fact feasibility was contested. An analysis of the 43 plans confirmed over a 15-year period found that only 50% of confirmed plans calling for reorganization of the business (rather than liquidation) were successfully carried out. Thus, despite the scrutiny of the court and the testimony of expert witnesses, assessing the feasibility of a reorganization plan remains a difficult undertaking.

Bankruptcy practitioners participating in the feasibility study were asked to identify the characteristics associated with plan success and failure. More than half of the successful plans in the sample called for--

* significant restructuring or contraction of the business

* material recapitalization of the debtor.

Slightly less than half of the successful plans called for--

* change in debtor management

* sale of a material part of the debtor business

* conversion of entity's debt to equity.

While these characteristics were observed in many successful cases, they were identified in less than 10% of the failed plans. Experienced practitioners recognize that successful plans typically take advantage of the Chapter 11 process to make fundamental changes in the business itself to address the underlying issues that precipitated the filing. A successful reorganization addresses both the weaknesses in the balance sheet (e.g., overreliance on debt and underproducing assets) and the income statement (e.g., strength of revenue sources and the related strategic focus of the company).

The practitioners surveyed also noted that successful plans usually were the result of extensive negotiations by key interested parties and committed principals of the business. Requesting the participation of major creditors and vendors in plan negotiations was viewed as critical to winning their support of the eventual plan of reorganization. Not surprisingly, bankruptcy practitioners noted that the existence of favorable economic
conditions typically leads to a successful outcome, whereas failed plans were
most frequently attributed to unrealistic projections.

Other Service Opportunities

For the seasoned accountant, the action plan for evaluating the reorganization plan is familiar: Carefully scrutinize the debtor's projections (especially focusing on pro forma cash flows), realistically assess the economic conditions prevailing in the debtor's industry, assess management's competence and commitment to the plan, and trust your instincts.

Creditor Service. Creditors must consider whether to sell a claim or whether to accept or reject a proposed reorganization. In large Chapter 11 cases, securities traders have begun to establish markets for the sale or purchase of general claims of all sizes. For example, if a creditor were owed $35,000 by a national retailer for carpet installation and the retailer filed under Chapter 11, it could receive one or more unsolicited offers to sell the "claim" for a few cents (or more) on the dollar in cash. Often, the paperwork is minimal, and the creditor has virtually nothing except rumors and press clippings on which to base its sell/hold decision. Many creditors sell their claims for quick cash, only to find a few weeks later that a Chapter 11 plan was soon to be circulated offering much higher payments. Others hold their claims and turn down the cash, only later to find that Chapter 11 is a failure and no significant payments will be issued.

Creditors have similar decisions to make when offered the choice between plans. One plan may offer a small cash dividend now; another may promise less now but more over time, often dependent on the debtor's future success. The aforementioned studies show that a substantial number of plans, even if found feasible by the judge, are not fully effectuated, leaving creditors without promised payments. Armed with an enhanced appreciation of the Chapter 11 process, and especially the factors that contribute to plan success, the creditor's accountant is able to provide valuable guidance as the creditor chooses among a quick sale of its claim for short cash, waiting for possible confirmation of a Chapter 11 plan promising somewhat more cash, and perhaps an alternative plan promising less or no cash but significant value over an extended period.

Debtor Service. In addition to providing assistance with development and presentation of the reorganization plan, the other key area of opportunity at the debtor company involves preparation and review of a variety of financial reports. The accountant might assist with development of the monthly operating reports, cash flow statements, the receivable and payables agings, and the payroll tax analyses. Accountants may prepare many of the special reports and analyses requested by the court in support of debtor's proposed actions in the case. Additionally, the accountant may assist with the presentation of the GAAP financial reports in accordance with the provisions of Statement of Position 90­7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code. Accountants should be familiar with reporting issues during the bankruptcy process (including presentation of liabilities subject to compromise and those not subject to compromise, accounting for professional fees and interest, and the treatment of reorganization-related activities in the statement of income) and with the fresh-start reporting that may be used by the entity once it has emerged from bankruptcy. Given the demands on its finance personnel, debtor's management often appreciates having a responsive and experienced accountant available to help.

Engagement Administration

Fees. Before starting work for a company in Chapter 11, it is important to know the rules governing approval and payment of professional fees. Obviously, service performed for particular creditors is a matter of agreement between the accountant and client. But work performed for the debtor, or as a court-approved advisor for a committee, is governed by the Bankruptcy Code and often by specific local rules.

The Proposal. The most significant issue to keep in mind is that all professional services for the debtor in Chapter 11 must be approved by the bankruptcy court before they are performed, even if the debtor is an ongoing client. Prior to commencing the engagement, the accountant must provide the court with a description of the work to be performed and an estimate of the related fees. The proposal may be fee for service (e.g., flat fee for specific work such as a tax return) or based on an hourly rate. The court will consider the value of the services to be performed and the prevailing rate for similar services in determining whether to approve the proposal.

In connection with the proposal, the accountant must also disclose all significant relationships with the debtor or other major parties in the Chapter 11 case. The court may reject an accountant's engagement where there is a clear conflict between the professional advisor and the interested parties.

The Fee Application. After the services are performed, the court must approve payment for the work. The court's approval is obtained by the accountant's submission of a very detailed bill and request for payment, referred to as a fee application. Many of these fee applications are prepared with assistance of debtor's counsel. All fee applications submitted to the court must include a copy of the order approving the engagement. If the work was performed at an hourly rate, the accountant must include detailed contemporaneous time records, often in increments of aQ; to eQ of an hour. Providing the court finds the fee application to be in order, payment is on a timely basis. Fee applications may be submitted as often as every 120 days.


There are only a limited number of accountants working in the bankruptcy area. Those accountants with extensive reorganization experience may consider applying for recognition as a Certified Insolvency and Reorganization Accountant (CIRA). The Association of Insolvency Accountants permits CPAs, chartered accountants, individuals with accounting degrees and at least four years of public accounting experience, and certified management accountants to enroll in a course of study for the CIRA designation. Applicants with at least 4,000 hours of reorganization experience may complete coursework and a written examination in the areas of turnaround management, plan development and accounting, financial reporting and taxation and earn certification as an insolvency and reorganization specialist. *

Nancy R. Baldiga, CPA, is an assistant professor of accounting at the College of the Holy Cross in Worcester, Mass. She is a member of the Association of Insolvency Accountants.

By Nancy R. BaldigaIn Brief

A Company's Problems Are an Accountant's Opportunity

Accountants looking to capitalize on the potential service opportunities provided by Chapter 11 need to understand the bankruptcy process, including the procedures governing professional fees. As can be seen in this overview of the Chapter 11 process, there are numerous practice opportunities for practicing accountants. Drawing on insights provided by bankruptcy practitioners who participated in an original study, the author presents factors to consider when evaluating a proposed plan of reorganization and provides valuable information on the critical issue of plan feasibility.

The fees have to be preapproved by the bankruptcy court.


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