By Scott Cousins and William E. Chipman, Jr.
Evaluating the Alternatives
A businesss accounting advisers are often among the first to know when an organization is facing financial difficulty. They are in a unique position to work with legal counsel in evaluating the companys financial problems and developing effective restructuring efforts. The sooner a restructuring plan is created, the more options will be available to the bankrupt company and the greater the likelihood of an eventual turnaround. The authors review several alternatives under the bankruptcy code and how to utilize them.
Chapter 11 of the United States Code (11 USC 101-1330), the bankruptcy code, provides a mechanism for a financially troubled business to restructure its operations and its balance sheet in an attempt to remain a viable business enterprise. Subject to certain exceptions, any business can file for Chapter 11 protection as long it has assets, a domicile, a place of business, or property in the United States.
There is no requirement that a company be insolvent or have an inability to pay debts in order to seek relief under Chapter 11, although creditors may challenge a debtors right to seek Chapter 11 protection if the filing was not made in good faith. It should be noted that the board of a troubled company operating within vicinity of insolvency must be advised of its additional fiduciary duties to creditors, not just shareholders. The point of insolvency occurs when the value of a corporations assets has sunk below the amount of its debts, without regard to whether statutory proceedings (e.g., bankruptcy proceedings) have commenced.
Benefits of Chapter 11
The filing of a Chapter 11 petition invokes the automatic stay under the bankruptcy code. Subject to certain limited exceptions, the automatic stay prevents all creditors from taking steps to collect those amounts owed to them (including a prohibition on the continuation of litigation) unless the bankruptcy court orders otherwise. The automatic stay is one of the fundamental protections afforded to debtors. It ensures that disputes concerning the debtor will be centralized in the bankruptcy court in order to prevent conflicting judgments and ensure equal treatment of similar creditors. The automatic stay prevents a race to the bankruptcy courthouse and gives the debtor room to concentrate on stabilizing its business, developing a new business plan, and formulating a plan of reorganization.
In addition, upon filing for Chapter 11, prebankruptcy management is automatically authorized to continue to operate the business without interruption. The company in Chapter 11 is referred to as a debtor-in-possession, and may use, sell, or lease its property in the ordinary course of its business without prior approval from the bankruptcy court. A trustee is not automatically appointed, although a creditor may seek court authorization to displace debtor-in-possession management with a trustee for cause, including fraud, dishonesty, incompetence, or gross mismanagement.
With certain limited exceptions, the debtor-in-possession acts as the trustee. Although debtor-in-possession management may continue to operate the business in the ordinary course, the company cannot generally pay preChapter 11 debts. Such claims are usually paid according to a plan of reorganization at the conclusion of the case, although the company may seek authority from the court to pay prebankruptcy amounts owed to employees and other creditors, such as critical suppliers, to the extent necessary to avoid a failure of the business. Moreover, the debtor-in-possession can continue to obtain unsecured financing for operations, such as trade credit or unsecured loans, without court approval. Secured financing from new or existing lenders can only be obtained with prior court approval.
Subject to certain limited exceptions, the debtor-in-possession can also seek authority to assume favorable executory contracts or reject unfavorable executory contracts under Chapter 11. An executory contract is generally a contract under which the obligations of both parties to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other. Assumption results in the contract becoming an obligation that the company must perform both during and after the bankruptcy. Rejection releases the company from its obligation to perform the contract pursuant to the terms of the bankruptcy court order rejecting and terminating the contract. Rejection of a contract can occur at any time during the Chapter 11 case (e.g., to effect immediate costs savings) or upon confirmation of the plan of reorganization. Rejection gives the other contract party a damage claim against the debtor, albeit one that is treated as if it had occurred before the bankruptcy along with other unsecured claims.
A successful Chapter 11 restructuring culminates with a plan of reorganization. Under this plan, the company is valued and distributions based upon such values are made in accordance with the priority scheme under the bankruptcy code. A plan is typically the product of negotiations among the debtor-in-possession, its creditors (including any statutorily appointed committee of creditors), and other parties of interest. The plan may provide for the orderly liquidation of all or any part of its businesses, a restructuring of existing operations, or even a continuation of operations without change. The plan might contain the debtors offer to pay in full claims held by creditors upon emergence from Chapter 11; to give creditors stock in the reorganized debtor as payment; to satisfy part of their claims with future cash payments; or some combination thereof. Existing shareholders might retain their equity interests in the reorganized debtor, or the plan might provide for redemption, dilution, or cancellation of stock.
The bankruptcy code sets forth the economic and legal requirements a Chapter 11 plan must satisfy. These requirements establish the minimum distributions to which each creditor and shareholder is entitled under the plan. In addition to providing the basis for the negotiation of a plan, these requirements also have a substantial impact on the formation of an out-of-court restructuring because all involved parties should realize that if they refuse to recognize the rights held by the other side, the matter may ultimately be decided in the context of a Chapter 11 case.
The bankruptcy code provides that each class of senior claims must accept its treatment under the plan by the requisite majority (two-thirds of creditors who vote) and amount (one half of amount voted) in order for classes of junior claims to be entitled to any distribution. The cramdown procedures of the bankruptcy code permit the bankruptcy court to confirm a plan over the objection of senior claims, even where junior claims receive a distribution, provided that certain rules are met.
Application of these general principles to a particular situation will be undertaken by a companys managerial, financial, accounting, and legal team in conjunction with the financial and claims analysis.
Some Chapter 11 Strategic Alternatives
There are three general categories of Chapter 11 proceedings: 1) a prepackaged case, including staggered solicitations of partial prepackaged cases whereby there is a prepetition solicitation and a postpetition solicitation of a class or classes neither impaired nor solicited prepetition, 2) a prearranged or prenegotiated case, where the proposed plan of reorganization is negotiated with certain of the debtors creditors prepetition and filed with the bankruptcy petition, but the votes are not solicited until after the commencement of the case, or 3) a freefall case, which does not involve the filing of a proposed plan of reorganization with the petition.
Prepackaged Plans of Reorganization
In a prepackaged reorganization, a prospective debtor negotiates and solicits acceptances or rejections of its proposed plan from creditors and interest holders before initiating a Chapter 11 case. Such acceptances or rejections are used after the commencement of a Chapter 11 case to seek court confirmation of a plan of reorganization. If the solicitations were done properly, a creditor or interest holder of the debtor that has accepted or rejected a plan before commencement of a Chapter 11 case is deemed to have accepted or rejected a plan after commencement.
A prepackaged reorganization gives the debtor an opportunity to quickly and effectively reorganize its financial obligations under Chapter 11 while avoiding many of the risks and costs associated with a freefall Chapter 11 proceeding. For the most part, a prepackaged reorganization proceeds much like a traditional bankruptcy. The terms of a reorganization are hammered out with the major creditors (usually debt holders), offering literature is prepared, and the plan is negotiated. In a prepackaged reorganization, the debtor and affected creditors negotiate the plan, and the debtor disseminates the disclosure statement and solicits acceptances of the plan.
Negotiating the plan prior to the initiation of bankruptcy proceedings allows a company to restructure the right side of its balance sheet and avail itself of many of the benefits under the bankruptcy code while steering clear of many of the shortcomings that inevitably accompany a traditional, and often lengthy, bankruptcy case. Once a sufficient number of creditors and interest holders have voted in favor of the proposed prepackaged plan, the debtor files its petition under Chapter 11.
By minimizing court supervision, a prepackaged plan reduces many of the costs of a Chapter 11 bankruptcy proceeding. An advantage for companies with federally registered securities is that a prepackaged reorganization allows a company to restructure its debts without the holdout problem posed by dissident debt holders in exchange offers, while significantly reducing the traditional delay, expense, and risks. Outside of bankruptcy, holdouts to exchange offers can prevent a company from restructuring its debts. This often becomes an attempt to elicit additional consideration from the debtor, or to reap appreciation in the value of existing securities if the exchange offer is ultimately successful. If a significant number of bondholders hold out, other creditors will often reject an out-of-court exchange offer in order to prevent the holdouts from profiting at the expense of tendering creditors.
Liquidating Plans of Reorganization
While many debtors seek Chapter 11 protection to reorganize their business, some troubled companies cannot successfully emerge from bankruptcy protection without selling all or a portion of their assets. The bankruptcy code specifically contemplates liquidations within Chapter 11. In a liquidation, the sale of assets typically occurs prior to confirmation of the reorganization plan. Once the assets are transferred, these debtors generally have no significant operations and focus on winding down the remainder of the company, confirming a Chapter 11 plan of liquidation, emerging from bankruptcy court protection, and eventually dissolving.
There are several benefits for both debtors and creditors to a liquidation under Chapter 11 rather than Chapter 7. Unlike a Chapter 7 debtor, a Chapter 11 liquidating debtor is afforded greater protections, including valuable exemptions from transfer taxes and securities registration requirements, the absence of which could adversely impact the recoveries of creditors and equity holders. Second, rather than the independent trustee appointed to administer a Chapter 7 case, the management of a Chapter 11 debtor often retains control of the debtor-in-possession through a significant portion of the entire Chapter 11 process. The continuation of management is presumably more cost-effective than the appointment of a trustee unfamiliar with the debtors operations. A liquidating Chapter 11 debtor that ceases operations post-confirmation is not, however, entitled to a discharge upon confirmation of a plan of reorganization.
In addition, because of the requirements facing the proponent of a plan of reorganization (often the debtor-in-possession) to confirm a liquidating Chapter 11 plan in the event of a cramdown contest, a plan proponent has little motivation to propose a plan of reorganization that does not strictly adhere to the absolute priority rule of the bankruptcy code. Accordingly, unlike some reorganization plans, all liquidating plans should distribute the remaining assets to creditors and interest holders in the order of their legal priority without a junior class of creditors or interest holders that is favored over a more senior class because of the inability to satisfy the new value exception to the absolute priority rule. Since the shareholders of a liquidating company have no emerging business in which to reinvest, it is unlikely that the new value exception would affect a liquidating Chapter 11 cramdown contest.
Although generally a debtor may continue to operate its business without court oversight, any transactions outside of the ordinary course of business must be approved by the bankruptcy court after notice and a hearing. Even occasional or uncommon transactions may be ordinary-course transactions. A sale of substantially all of the debtors assets, however, would fall outside the ordinary course of a companys business.
Courts have almost uniformly held that approval of a proposed sale of property prior to the confirmation of a plan of reorganization is appropriate if the transaction represents a reasonable business judgment on the part of the debtor. To satisfy this test, debtors should follow the well-established principle of bankruptcy law that the debtors duty is to obtain the highest price or greatest overall benefit possible for the estate. Typically, bidding procedures are proposed by the debtor and approved by the bankruptcy court to establish procedures for the submission of competing, higher, and better offers from other interested parties at an auction. The auction is conducted prior to the sale hearing to ensure that the highest price is obtained.
A debtor-in-possession may also sell property free and clear of any lien, claim, interest, or encumbrance in or against such property if 1) such a sale is permitted under applicable non-bankruptcy law, 2) the party asserting such a lien, claim, interest, or encumbrance consents to such sale, 3) the interest is a lien and the purchase price for the property is greater than the aggregate amount of all liens on the property, 4) the interest is the subject of a bona fide dispute, or 5) the party asserting the interest could be compelled, in a legal or equitable proceeding, to accept a money satisfaction for such interest. The court may approve a sale free and clear provided at least one of the subsections is met. Therefore, if a company has assets that can be sold, but there is a lien holder that will not agree to a sale, or is threatening to foreclose on the assets, bankruptcy protection can be used to sell the assets free and clear of the lien. The lien would then attach to the proceeds of the sale.
When going concerns are liquidated through a Chapter 11 proceeding, there are often assets that are not evident in reviewing the financial statements that can be sold to generate cash. For example, below-market leases have value that can be marketed and sold through a bankruptcy sale process. Under section 365 of the bankruptcy code, the debtor can assume and assign unexpired leases of real and personal property to a third party for value if the debtor is not in default under the lease and the assignee provides adequate assurance of future performance. Any anti-assignment provisions contained in the lease are deemed to be invalid and the assignee will step into the shoes of the debtor.
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