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An Overview of the Chapter 11 Reorganization Process

An Overview of the Chapter 11 Reorganization Process. THE SECOND FORUM FOR ASIAN INSOLVENCY REFORM (FAIR) Bangkok, Thailand December 16 & 17, 2002. Presented by George Kelakos, Co-Chair of the International Committee of the American Bankruptcy Institute. Introduction.

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An Overview of the Chapter 11 Reorganization Process

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  1. An Overview of the Chapter 11 Reorganization Process THE SECOND FORUM FOR ASIAN INSOLVENCY REFORM (FAIR)Bangkok, ThailandDecember 16 & 17, 2002 Presented by George Kelakos, Co-Chair of the International Committee of the American Bankruptcy Institute

  2. Introduction • Economic Premises of Chapter 11 (Reorganization) • Players • Strategic Objectives of Players • Valuation Issues

  3. Phases Of A Chapter 11 Case • Prepetition • Initial Phase • Middle Phase • Final Phase

  4. Economic Premises of Chapter 11 (Reorganization) • A business, even though not currently able to meet its obligations, can sometimes be restructured so that creditors receive more from future profits (or a sale of company) than the “auction value” of the assets; excess of “going-concern value” of assets over “auction value” (“going-concern premium”) is usually divided between creditors and stockholders so that in a successful reorganization, both groups do better than they would under Chapter 7.

  5. Economic Premises of Chapter 11 (Reorganization) • Chapter 11 case commenced when bankruptcy petition is filed with bankruptcy court • Voluntary petition can be filed by Debtor • Creditors (with certain requirements) and a foreign representative of a debtor’s estate in a foreign proceeding can file an involuntary petition

  6. Who May Be A Debtor? • Bankruptcy remedies are available to all business entities in the U.S. (corporations, limited liability companies, sole proprietorships, and partnerships are all eligible for liquidation under chapter 7 or reorganization under chapter 11) • Chapters 7 and 11 are also available to individuals

  7. Who May Be A Debtor? • Other chapters include chapter 9 (reorganization of municipalities and other subdivisions of state government), chapter 12 (reorganization of family farms), and chapter 13 (a simplified reorganization available to individuals with regular income and limited debts) • Railroad reorganizations have specific requirements under chapter 11 • Stock and commodity brokers cannot file chapter 11, only chapter 7

  8. Cast of Principal Characters • Debtor-in-possession (“DIP”) - debtor remains in control (fiduciary, no trustee appointed), and has possession of assets • DIP has rights, powers, and duties of a trustee • Bankruptcy judge (independent court /“unit” of U.S. District court given decision-making power over bankruptcy cases)-- primary role is to adjudicate disputes • U.S. Trustee - officer of department of justice administers cases and performs a number of statutory duties

  9. Cast of Principal Characters • Committees “watch dog” for their constituents (may be multiple committees) (fiduciary role), and can file plan • Bank(s) • Trade creditors (“single shot”/“long-term”) • Machinery and equipment lender(s) • Landlord(s) • Equity security holders

  10. Cast of Principal Characters: Professionals • Legal advisors (Debtor/committee/bank/other creditors) • Financial advisors (Debtor/committee) • Accountants • Turnaround management/business advisors • Investment banker • Valuation/liquidation experts • Brokers

  11. Strategic Objectives of Players What are their goals? • The debtor keeps business alive (for benefit of equity holders) • Banks and M&E lenders maximize return on disposition of collateral • Landlord: • Rising real estate market: oppose reorganization efforts • Falling real estate market: may support reorganization efforts

  12. Strategic Objectives of Players What are their goals? • Unsecured creditors: • “Single shot” no interest in long-term, oppose debtor • “Long run” retain debtor as a customer, support debtor • Equity holders: keep business alive

  13. Valuation Issues • “Retail”-value (fair market value?) at which collateral can be sold to ultimate user • “Wholesale”- value at which collateral can be sold to dealer • “Forced Sale”- “quick and dirty” value(necessary with perishables) • “Going Concern” or “Enterprise” value”--essential operating assets are sold as an entity (calculate value by applying a multiple to projected profit)

  14. Valuation Issues • “Reorganization value” - “going concern” value plus the “upside” (future expectation) • Combination of two or more of the foregoing Source: Queenan, James F., “Standards for Valuation of Security Interests in Chapter 11,” 92 Commercial Law Journal at 19, et. seq.

  15. Phases Of A U.S. Reorganization Case • Prepetition • Strategic considerations • Debtor • Lenders • Trade creditors

  16. Phases Of A U.S. Reorganization Case • Initial phase • Petition/automatic stay • Cash collateral • Postpetition borrowing • Relief from the automatic stay

  17. Phases Of A U.S. Reorganization Case • Middle phase • Executory contracts and unexpired leases • Assets sales (public/private) • Avoidance actions • Development of business plan (exclusivity extensions/bar date motion)

  18. Phases Of A U.S. Reorganization Case • Final phase • Plan confirmation process • Elements of a plan of reorganization • Disclosure statement • Confirmation standards

  19. PrepetitionStrategic Considerations • Open lines of communication with parties may result in debtor filing case with support of bank and major creditors • Parties gain time to prepare voluminous paperwork required for a reorganization case (prenegotiated or prepackaged)

  20. PrepetitionStrategic Considerations • When events cause an emergency filing of a petition or where the major players (bank/key trade creditors) are not consulted, a number of issues may arise: • Immediate cash crunch • Increased tensions/lost debtor credibility/diminished creditor confidence

  21. PrepetitionStrategic Considerations • When events cause an emergency filing of a petition or where the major players (bank/key trade creditors) are not consulted, a number of issues may arise: • Creditors may take precipitous action (file an involuntary petition) • Emergency may be harmful to debtor’s business/operations

  22. Prepetition Debtor • Does debtor have cash reserves? If so, what is the “burn rate” • How will case be funded? (cash collateral stipulation/motion/borrowing motion) • Are there sufficient funds to cover initial payroll? Can petition be timed to minimize unpaid prepetition wages?

  23. Prepetition Debtor • Is an open line of communication maintained with key lender(s) and trade creditors? • Have the debtor and its reorganization team begun to prepare the documents and motions necessary for a bankruptcy filing? • Does the debtor have an exit strategy?

  24. Prepetition Lender • Is lender receiving sufficient information from the debtor (is there an open line of communication)? • Does lender “want out” of the credit? • If so, lender may take aggressive action forcing debtor to file • Does lender want to continue financing a DIP? • If so, lender will seek to negotiate key terms of cash collateral/postpetition borrowing stipulation

  25. Prepetition Trade Creditors • Strategy may depend on “which side of the fence” the creditor falls • “Single shot” creditors may not have an interest in pursuing a long term relationship with the debtor will aggressively pursue collection efforts • “Long-term” creditors may wish to maintain debtor as a future customer (make up losses through future sales) will cooperate with debtor and actively support reorganization (extend postpetition credit)?

  26. Initial Phase • Petition/automatic stay • Cash collateral • Postpetition borrowing • Relief from automatic stay • Summary of strategic consideration • Valuation issues

  27. Initial PhasePetition / Automatic Stay • Debtors (or creditors) run to court (castle) to seek relief (sanctuary/time/control of asset disposition) • Once debtor enters castle gate (bankruptcy petition filed/order of relief is entered), the gate is closed (automatic stay (moratorium) is imposed) • Automatic stay stops actions against debtor or property of the estate

  28. Initial PhasePetition / Automatic Stay • Automatic stay (moratorium) freezes position of creditors and makes bankruptcy court the sole forum for dispute resolution • Relief from automatic stay is granted only upon leave of court

  29. Initial PhaseCash Collateral • The problem: • Debtors usually face a “cash deficit” at outset of case • Cash or cash equivalents are often a secured creditor’s “cash collateral.” They are collections of accounts subject to security interests or proceeds from the sale of pledged inventory or equipment.

  30. Initial PhaseCash Collateral • The problem: • Unless there is an agreement with creditor to use “cash collateral,” debtor must seek emergency relief to use “cash collateral” • Without court relief, there is no hope of a successful reorganization

  31. Initial PhaseCash Collateral • The solution: • Under U.S. Law, a prepetition security interest does not apply to postpetition property (exception: proceeds) • Debtor is allowed to use non-cash collateral (real estate, M&E, inventory) in the “ordinary course of business” • Secured creditor is entitled to ask court for “adequate protection” of its interest in the property

  32. Initial PhasePostpetition Borrowing • Debtors often cannot operate (or reorganize) without new funding (even use of cash collateral may not be enough to keep business afloat) • In U.S., solution is for debtor to obtain a new loan (with court approval) from either the existing lender or a new lender (super priority loan)

  33. Initial PhasePostpetition Borrowing • Postpetition Lenders in U.S. Often attempt to attach “onerous” terms to the new loan: • Higher interest rates • Cross-collateralize prepetition debt with postpetition collateral • “Sign off” by all parties on validity/perfection issues/release of claims • Assignment of proceeds of avoidance actions • Bind future and successor trustees

  34. Initial PhasePostpetition Borrowing • Courts in U.S. will often allow economic terms but will strike onerous terms from loan agreement (“level the playing field”)

  35. Initial PhaseRelief From Automatic Stay • For “cause,” including lack of “adequate protection” • Where debtor has no equity in property and property is not “necessary to an effective reorganization”

  36. Initial PhaseRelief From Automatic Stay • What is “adequate protection”? • Protection vs. decline in “value” • Common forms of adequate protection: periodic cash payments; replacement lien on postpetition assets

  37. Initial PhaseSummary of Strategic Considerations • For all - avoid “crying wolf” (your credibility is at stake). Seek and expect only the minimum relief necessary • For all - pick your fights carefully (attempt to resolve disputes out of court) • Bank - is lender satisfied with debtor’s projection? Does lender intend to continue funding debtor postpetition? Get budget from debtor

  38. Initial PhaseSummary of Strategic Considerations • Debtor - has the debtor team provided the necessary projections and budget information to lender and to parties in interest (cash collateral)? Has the debtor’s team prepared the necessary backup information for motion to pay prepetition wages and other first day motions (procedural motions / professional retention)? • Creditors - preserve creditors’ rights (Court may grant minimum relief -- to preserve balance in negotiating positions) / may want to file proof of claim

  39. Initial PhaseValuation Issues • Automatic stay • Does debtor have “equity” in collateral above the lien? • Has collateral experienced a “loss or diminution of value”? • Is proposed “adequate protection” sufficient?

  40. Initial PhaseValuation Issues • Use of cash collateral: • Has collateral experienced a “loss or diminution of value”? • Is proposed “adequate protection” sufficient?

  41. Initial PhaseValuation Issues • Postpetition borrowing • Valuation of “new” collateral for new loan (risk assessment)

  42. Middle Phase • Executory contracts and Unexpired leases • Asset sales • Examination/pursuit of avoidance actions • Development of business plan • Valuation issues

  43. Middle PhaseExecutory Contracts and Unexpired Leases • “Executory” contracts or leases - are contracts or leases where performance, to some extent, remains due on both sides • If executory, debtor may assume or reject • Examples of executory contracts: • Franchise or distributor agreements

  44. Middle PhaseExecutory Contracts and Unexpired Leases • Examples of non-executory contracts: • Personal service contracts/contracts to make a loan or extend financing • Debtor may assume an executory contract or an unexpired lease under the following conditions: • Debtor must cure defaults or provide adequate assurances that it will promptly cure defaults, and provide adequate assurances of future performance under the contract/lease

  45. Middle PhaseExecutory Contracts and Unexpired Leases • Once debtor assumes executory contract or unexpired lease, debtor may assign such contract/lease to a third party if such third party provides adequate assurances of future performance • Special rules for non-residential leases and other types of contracts

  46. Middle PhaseAsset Sales • Purpose: • Dispose of non-essential assets in a manner generating highest possible return for debtor’s estate

  47. Middle PhaseAsset Sales • Sales of assets (public or private) outside of a plan of reorganization must be authorized by the court and may be permitted under following circumstances: • Assets are rapidly deteriorating (boatload of fish) • Notice and opportunity for hearing must be provided • Courts require that sale motions provide sufficient background / disclosure to justify sale outside of a plan • Courts will test “commercial reasonableness” of proposed sale (method of sale, marketing and advertising)

  48. Middle PhaseAsset Sales • How will assets be sold (public vs. Private sale)? • Professionals (broker/liquidation/valuation expert/auctioneer) will often be employed to maximize return to debtor’s estate • How will parties (and court) know that method ofsale/proposed sale will generate highest possible return? • Parties will seek advice of professional valuation expert to obtain fair market value, liquidation value appraisals to demonstrate that price/method of sale is commercially reasonable and is in best interest of debtor’s estate

  49. Middle PhaseAsset Sales • Benefits of Asset Sales: • Finality (protection for good faith purchases, no unwinding of sale on appeal) • Speed • Costs/expenses are usually less than alternatives • Generally, “clean” title (sale free and clear of liens, encumbrances and attachments) (particularly in real estate transactions) is transferred

  50. Middle PhaseAvoidance Actions • U.S. law favors fair and equal treatment of similarly-situated creditors in proportion to their claims (as opposed to first come, first served) • Prepetition transactions may be “avoided” (set aside) for actual fraud, inadequate consideration (“fraudulent transfers”), or preference of one creditor over others

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