Overview of US Bankruptcy Law

Overview of US Bankruptcy Law • J. Robert Stoll • Mayer Brown LLP • Visiting Professor • University of Belgrade Faculty of Law • U.S. Workout/Insolvency Law Course • University of Belgrade Faculty of Law • FALL 2015 • Aaron Gavant • Mayer Brown LLP

Introduction I. Statutory Framework / Key Players and Concepts II. Overview of Asset Sales Under Section 363 of the Bankruptcy Code III. DIP Lending and Cash Collateral Financings IV. Recovery of Vendor Claims: From Reclamation to Critical Vendor Programs V. Avoidance Powers: Fraudulent Transfer and Preference VI. Plan of Reorganization: Some Rules of the Road

Statutory/Judicial Framework: Bankruptcy System for Business Entities • US Has a National System of Bankruptcy Laws • Provides a uniform set of laws (the Bankruptcy Code) and procedures (the Bankruptcy Rules) • Even so, regional differences exist – e.g., critical vendor • Who May be a Debtor under the Bankruptcy Code? • Almost all business entities qualify (e.g., corporations; partnerships; individuals and sole proprietorships) • Excludes entities subject to specialized regulatory schemes: • Banks and insurance companies have separate regimes

Statutory/Judicial Framework: Bankruptcy System for Businesses • Other Eligibility Requirements are Modest: • No requirement of insolvency: to encourage early resort to bankruptcy when reorganization is possible • Good faith is required: Must suffer from financial problems justifying resort to bankruptcy laws • Must have nexus to US – be a US entity; have assets or principal offices in US • Commencement of the Case • Voluntary: order for relief is automatic upon filing • Involuntary by creditors: order for relief is only after court determines debtor is generally unable to pay its debts

Statutory/Judicial Framework: Bankruptcy System for Businesses • Types of Bankruptcy Code Cases: • Chapter 7: Governs Liquidation Proceedings • Trustee is always appointed to liquidate assets and distribute proceeds to creditors in accordance with statutory priorities • Chapter 11: Governs Reorganization Proceedings • Goal is negotiation of a plan of reorganization • Flexible process designed to preserve “going concern” value • No automatic trustee appointment • Chapter 9: Governs Reorganization Proceedings for Municipalities and other Governmental Entities • Chapter 12: Governs Reorganization Proceedings for Farmers • Chapter 15: Governs Foreign and Cross-Border Insolvency Cases

Statutory/Judicial Framework: Bankruptcy System for Businesses • Federal Bankruptcy Court System • Bankruptcy judges: Appointed to handle only bankruptcy matters; have special expertise • Expansive jurisdiction to consolidate all matters involving the debtor and its property before the court • Appeals go through the federal court system • Venue • Bankruptcy courts are in every state • Favored venues for large cases: NY and Delaware

Initiation of Cases • Voluntary: Commenced by filing of petition with the bankruptcy court by the debtor • There is no insolvency or other financial conditions requirement • Involuntary: Commenced by filing of petition by creditors against the debtor • If the debtor has <12 creditors overall, only one creditor is required to sign the petition, who must hold noncontingent, undisputed, and unsecured claims that aggregate at least $15,325 • If the debtor has >12 creditors, the petition must be signed by three creditors who hold noncontingent, undisputed, and unsecured claims that aggregate at least $15,325 • An involuntary case may only be commenced under chapter 7 or chapter 11; a municipality cannot be the object of an involuntary petition in a chapter 9 case

Key Players • Debtor in Possession: Curse or Blessing? • Pre-bankruptcy management remains in control in Chapter 11 cases – philosophy is that they can best maximize values • Trustees can be appointed in cases of fraud, gross mismanagement or other cause • Trustees are rarely appointed in Chapter 11 – even in cases of spectacular failures (Lehman and Enron)

Key Players • Unsecured Creditors Committee – Chapter 11: Curse or Blessing ? • Selected from largest unsecured creditors, unless adverse interest • Active player on all major issues – DIP financing; assets sales; reorganization plans; litigation against other creditors • Acts to protect interests of unsecured creditors as a whole • Professionals of the UCC are paid by the estate

Key Players • Secured Creditors • Often the key constituency – control access to financing • Rarely have official committees for secureds • Bankruptcy Judges • No direct managerial involvement in debtor; rule on matters requiring court approval or adversary proceedings • Rules prohibit “ex parte” communications; still, often perceived as having “pro-debtor” tendency

Key Players • US Trustee: Intended as a Watchdog • Governmental Appointees • Acts to protect the integrity of the bankruptcy system, but sometimes seen as inflexible • Handles administration: Select trustees; Appoints committees

Key Concepts: Automatic Stay • Upon filing, creditors are stayed from collecting claims, from taking possession or control of property, or from taking setoffs • Purpose is to protect the estate from dismemberment and to give DIP/Trustee a breathing spell • Stay can be lifted for cause – e.g., to allow setoff or if collateral is not “adequately protected” • A number of actions are exempt from the stay • Swaps; repos; securities contracts can be closed out • Exercise of police power – e.g., environmental laws are enforced

Key Concepts: Who Trumps Whom – Priority Scheme in Bankruptcy – Claims and Interests • Secured Creditors (DIP lenders and pre-bankruptcy lenders) – get highest priority but only to extent of the proceeds/value of collateral • Administrative Expense Claims • First to DIP lender with superpriority • Second to post-bankruptcy claimants (vendors; professionals; obligations under assumed contracts) and to some pre-bankruptcy vendor claims • But, then give priority to subsequent Chapter 7 creditors

Key Concepts: Who Trumps Whom – Priority Scheme in Bankruptcy • Pre-bankruptcy claims • First, to priority claims (taxes; employees priority; deposits) • Second, to general unsecured claims (trade; deficiency claims of secureds; rejection claims) • Third, to subordinated creditors • Fourth, to equity holders (together with any litigation claims based on equity)

II. Claims and Interests (cont’d) • Trading/Sale of Claims: Substantial market for trading of claims; particularly in large cases • Validity/Enforceability • Original Issue Discount • Setoffs/Preferences • Subordination Risks • Warranties/Reps in Assignment/Sale Documents • Disclosure Issues: Bankruptcy Rule 2019 may require certain disclosure of information

Key Concepts: Executory Contracts and Leases – a Brief Overview • DIP/Trustee has right to assume or reject contracts • Decision is left to DIP/Trustee’s business judgment • Some exceptions: e.g., agreements to make loans • Pending decision, non-debtor must generally perform if paid currently for its performance • Assumption, requires DIP/Trustee to cure all defaults, and give adequate assurance; and then must perform going forward • Can also assume and assign • Rejection relieves debtor from all obligation to perform, but gives non-debtor a claim for damages; special rules cap damage claims for leases

Key Concepts: Asset Sales Under Section 363 of the Bankruptcy Code • Section 363(b) of the Bankruptcy Code authorizes a debtor to sell property of the estate outside of the ordinary course of the debtor’s business with the prior approval of the bankruptcy court • Sales or dispositions of property that are in the ordinary course do not require court approval • 363 sales are increasingly common for various reasons, including the speed and finality with which they enable a debtor to monetize its business assets on a going concern basis and the fact that there are increasingly fewer successful reorganizations in Chapter 11

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • 363 sales provide important protections and related benefits to buyers that acquire assets • Assets sold under Section 363 of the Bankruptcy Code are transferred “free and clear” of interests claimed by third parties • Typically, claims or interests of third parties will attach to the proceeds of the sale, and the amount and relative priority of such claims and interests can be determined at a later date after the sale has closed

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • Ability to sell assets subject to third party claims and interests is not unlimited; sale must satisfy one or more of the following five requirements: • Applicable non-bankruptcy law permits sale of such property free and clear of interests • Entity claiming an interest consents to the sale free and clear of its interest or claim • The claimed interest is a lien and the price to be obtained exceeds the aggregate of all liens against the property • The claimed interest is subject to a bona fide dispute • Entity claiming an interest can be compelled in a legal or equitable proceeding to accept money satisfaction of its interest

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • Case law is mixed whether Section 363(f) of the Bankruptcy Code authorizes bankruptcy court to order that a sale is free and clear of successor liability • Better view is that the order cannot provide such protection, especially when the asserted claim bears no relationship to the subject assets • However, where it can be established that the party asserting successor liability received notice of the sale and did not timely object or preserve its rights, party may be barred from seeking to impose successor liability under principles of res judicata

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • One of the benefits of acquiring assets under a 363 sale is that it eliminates any fraudulent transfer risk since • Terms of the sale, including purchase price and other considerations, will be “blessed” by the sale order entered by the court • No issue whether value paid is reasonably equivalent since assets were sold pursuant to court-approved process

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • Party objecting to proposed 363 sale must obtain stay pending an appeal in order to prevent consummation of a sale to a “good faith” purchaser • Section 363(m) provides that reversal of sale order on appeal does not affect transfer of assets to a good faith purchaser; sale order should contain specific finding that buyer is entitled to protection of 363(m) • In such circumstances, objecting party will need to post a bond, typically an amount equal to purchase price, to prevent consummation of sale pending its appeal • Sale agreement should provide buyer with discretion to decide whether to close in the face of such an appeal

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • Summary overview of 363 sale process • Absent extraordinary circumstances, proposed sale will be subject to competitive bidding process • DIP/Trustee must demonstrate proposed sale is result of sound business judgment and in best interests of estate • DIP/Trustee must demonstrate assets were effectively marketed and that the sale process will yield the “highest and best” value obtainable for the assets under the circumstances

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • In connection with a competitive bidding process, there often is a “stalking horse” bidder • DIP/Trustee and its professionals typically will seek to negotiate an initial purchase agreement with a stalking horse bidder and then seek approval of the sale to that party or to a higher bidder pursuant to proposed bidding procedures • Process can take many different forms • Much of the actual due diligence, marketing and negotiations to determine the stalking horse may take place before a 363 sale motion is even filed, particularly in larger cases with sophisticated debtors

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • Advantages to Being a Stalking Horse Bidder: • Provides timing advantage where extensive due diligence or regulatory approval is necessary since stalking horse bidder likely to have advantage over other potential competing bidders; ability to demonstrate certainty and ability to close provides advantage over competing bids • Can shape the sale contract and potentially require other competing bidders to use its form of agreement • Ability to negotiate bid protections, including, at least, expense reimbursement and typically some amount of a break-up fee; bid protections require bankruptcy court approval • Influence bidding procedures, including minimum overbids, closing contingencies, right to credit-bid break-up fee, mechanism for valuing non-cash consideration, criteria for qualifying competing bids, and process of identifying higher and better bids at auction

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • Potential Disadvantages to Being a Stalking Horse Bidder • Due diligence/negotiation expenses at risk until bid procedures, including, inter alia, expense reimbursement, are approved • May over-price assets • Potentially allows other bidders to utilize your due diligence efforts at less expense

Overview of Asset Sales Under Section 363 of the Bankruptcy Code • 363 Sales Usually Involve a Two-step Process • Motion to approve bid procedures, including bid protections, • Typically, this will be heard on fairly expedited basis, some period of due diligence may follow and, if qualified bids submitted, a sale auction will be held to determine highest and best bid • Motion also will seek to schedule a hearing to approve the sale • Includes proposed form of sale order; minimum 20 days’ notice required before sale hearing, which usually is scheduled as close to completion of auction as court’s calendar allows • Also includes process of identifying executory contracts and unexpired leases to be assumed and assigned to winning bidder, including notice and cure procedures

Changing Nature of Section 363 Asset Sales • Nature of 363 sales has changed in recent years • Previously, generally used to sell some assets of the debtor (attempts to sell all assets disfavored as “sub-rosa” plan). • Now, often used to sell all assets of the debtor • Has led courts to develop increasingly standardized process for “all-asset” 363 sales • Auction process • At least 30 days to bid • “Stalking horse” bid • Qualified bid requirements • No plan or creditor vote required to Section 363 sale • Potential for abuse by debtor/purchase (especially when purchaser is also a creditor)

Changing Nature of Section 363 Asset Sales • Gifting provisions • Assets sold as part of Section 363 sales are usually fully encumbered  only secured parties benefit from sales • To avoid objections, secured creditors often “gift” some portion of proceeds to unsecured and/or lower-priority creditors • Potentially problematic to the extent lower-priority creditors receive distributions prior to and/or greater than higher-priority creditors

Changing Nature of Section 363 Asset Sales –GM & Chrysler • Each of GM, Chrysler and Detroit bankruptcy cases characterized by carefully-structured Section 363 sales meant to cushion retirees from blow of bankruptcy • All good assets sold to newly-created entities (“New GM” and “New Chrysler”) with U.S. government serving as secured lender during bankruptcy and to new entities • Primary consideration paid by new entities was assumption of some, but not all legacy liabilities, in particular those liabilities relating to retirees (e.g., healthcare benefits). • New Chrysler paid only $2 billion; New GM paid nothing. • Protected lower-priority creditors (i.e., retirees) at expense of higher-priority creditors (e.g., noteholders)

DIP Financing / Cash Collateral Financings Introduction • “Offensive” DIP Lending • “Defensive” DIP Lending • Adequate protection • “Bootstrapping” • Cash Collateral Financings • “Exit” Financing

Timeline for DIP Financing • Short Timeline to Finalize DIP Financing • Limited Due Diligence • Expense Agreement • Documentation: Term Sheet; Credit Agreement and Order Approving DIP Financing • Two-Step Court Approval Process

Timeline for DIP Financing • The Interim Hearing and Order • “First Day” Motion; limited opportunity to object • Capped Commitment – limit as necessary to prevent irreparable harm until the final hearing • Finding of Good Faith: protects lender from reversal on appeal • The Final Hearing and Order • Schedule for the final hearing • Re-trading the deal with creditor committee, US trustee/negotiating leverage • Good faith lender still protected against appeals

Reasons to Engage in DIP Financing: Offensive • Profitable: Interest rates and fees are often higher than traditional lending • Business Opportunity: DIP Loans may lead to exit loans and other post-confirmation business • Bankruptcy Protections

Reasons to Engage in DIP Financing: Offensive • Court Order Provides • Lien package • Lien on free assets / junior lien on liened assets • Priming lien / if “adequate protection” to existing lienholder • Automatic perfection of collateral • Given superpriority claim • Clearer path to exercise remedies upon default • Protection from appeals

Reasons to Engage in DIP Financing: Defensive • Leverage to Get “Adequate Protection” for Secured Loans • Cardinal Rule: Adequate Protection Required for Secureds • No use of cash collateral permitted without adequate protection • Debtor’s use of collateral conditioned upon provision of adequate protection • Stay must be lifted if adequate protection is not provided • What is Required: Protect from Diminution in Collateral Values • Numerous considerations taken into account (e.g., valuation; debtor’s financial performance)

Reasons to Engage in DIP Financing: Defensive • Typical Forms of Adequate Protection • Periodic cash payments • Junior replacement lien on DIP lenders’ collateral package • Junior superpriority claim – to extent protection is inadequate • Additional “Defensive” Benefits • Approval of budget process; financial reporting requirements • Other performance covenants, e.g., requiring assets sales • Secure waiver from debtor to challenge liens; limit time for creditors committee to bring challenges

Reasons to Engage in DIP Financing: Defensive • “Bootstrapping” Strategies • Bootstrapping – Cross-Collateralization • Granting liens to “shore-up” existing loans is controversial • Almost never approved if lender is not fully collateralized • Purpose of adequate protection is protecting not improving position • Sometimes approved if lender is fully secured and financing not otherwise available • Bootstrapping – “Roll-up” • Using DIP loan to pay out existing loans • Also controversial: protects from “cramdown” and restructuring • Some courts will approve if loans are fully secured and if successful reorganization is likely • “Roll-over” – using collections to first pay down existing debt raises similar issues

“Cash Collateral” Financings • Form of Defensive Financing: • Similar to DIP lending, except: • No “new” $$ lending • Recycles cash and collections • Finances operations and preserves going concern values • Way to obtain adequate protection – similar to DIP lending • Similar Short Timeline to Negotiate Cash Collateral Financing • Similar Two-Step Approval Process • Avoids Litigation Risks in “Contested” Cash Collateral Hearing

Other DIP Lending / Cash Collateral Issues • Carve-Out • Most courts require “carve-out” to pay professional fees • Typical arrangement – “carve out” $$ amount from collateral • Carve-out allows for wind-down • Restrictions on use of carve-out: not to litigate with lenders • Termination of DIP Loan / Cash Collateral Order • Relief from stay; notice; bankruptcy court involvement • Collateral Surcharge • Recover from collateral cost of its preservation and sale • Waiver provisions remain controversial

Potential Risks Associated with DIP Lending / Cash Collateral Financing • Limited Due Diligence • Potential Creditor Challenges to Prepetition Claims and Liens • Second Lien Disputes over Waivers of Adequate Protection and Related Rights • Failure to Confirm Plan / Conversion to Chapter 7

Exit Financing • Purpose of Exit Financing: Funds Emergence fromChapter 11 • Benefits to Lenders • Debtor has “deleveraged” balance sheet • Defensive: releases and protections for existing lenders • Special findings and decrees • Potentially higher fees and interest rates

Recovery of Vendor Claims: From Reclamation to Critical Vendor Programs • Bankruptcy Code provides sellers of goods with certain additional protections that are not afforded to other creditors • Whether creditor is a “seller of goods” (e.g., as opposed to, provider of services) may be subject to dispute • Courts look to various definitions (e.g., Bankruptcy Code, Uniform Commercial Code, etc.) • Seller may “reclaim” goods it has sold to the debtor, if goods were received by debtor within 45 days of petition date assuming debtor as already insolvent (subject to any priority rights of a secured creditor in same goods)

Recovery of Vendor Claims: From Reclamation to Critical Vendor Programs • Seller may also seek to recover unpaid prepetition amounts through “critical vendor” payment programs • Not expressly authorized by statute and may be contrary to other payment/priority provisions of the Bankruptcy Code • Debtor’s ability to obtain approval of such program may therefore depend on particular jurisdiction and particular judge

Avoidance Powers: Preferences • Elements of Preference, Bankruptcy Code § 547 • Transfer made on account of preexisting debt • Made while debtor is insolvent • Made within 90 days of bankruptcy (1 year if insider) • Allows creditor to recover more than in liquidation • Limitation period for suit – 2 years • Typical Examples: • Grant of collateral to unsecured lenders; • Payments made to creditors – lenders and suppliers

Avoidance Powers: Preferences • Key Defenses to Preferences • Payment was made in the ordinary course of business • New value: value given by creditor to debtor after an otherwise preferential payment • Payments to a “fully secured” creditor – so that not receiving more than in a liquidation • Contemporaneous exchange for new value – no antecedent debt

Avoidance Powers: Fraudulent Transfer • Fraudulent Transfers, Bankruptcy Code §§ 544, 548 • DIP/Trustee Can Avoid Transfers and Obligations incurred within 2 years of filing: • If (1) debtor didn’t receive “reasonably equivalent” value, (2) debtor was insolvent or had unreasonably small capital, or (3) transfer was to an insider under an employment contract, not in the ordinary course of business • Certain charitable contributions exempt • Can also challenge based on debtor having had actual intent to defraud, delay or hinder creditors (no need to show insolvency)

Avoidance Powers: Fraudulent Transfer • Highly Fact-Intensive Determinations • Determinations are made as of the date of the transaction • Battle of experts • Limitations period for voiding transfers is 2 years under bankruptcy law, and extends to 4 to 6 years using state laws

Avoidance Powers: Fraudulent Transfer • Remedy for Fraudulent Transfer • Recovery of the property transferred or its value • Elimination of the obligation incurred • If party was in “good faith,” then protected from avoidance to the extent of the value given • Examples of Fraudulent Transfer Attacks • Pre-petition sales of assets • LBO transactions have also been subject to attack • Dividends

Set Offs: An Overview • Set off is Protected in Bankruptcy, except • It is subject to the Automatic Stay • Cannot set off if no “mutuality” (same parties; same capacity) • Cannot set off if claim owed to Debtor was incurred or acquired during the preference period for purpose of creating a setoff • The pre-bankruptcy exercise of a setoff can be avoided to the extent the creditor got an improvement in its position during the 90-day preference period.

Overview of US Bankruptcy Law