The Life Cycle of a Chapter 11 Debtor T H Rough the D E B T O R's Eyes

AMERICAN BANKRUPTCY INSTITUTE

JOU Issues andRN Information for the Insolvency ProfessionalA L one well-known example. Second, chapter plan is the “fix” that dictates the parties’ Chapter 11 - 11 enables a debtor to restructure its balance rights—who will sell the assets, how they sheet to better reflect the actual—and will be sold, over what time period and who “1 0 1 ” usually diminished—ability of the business will receive the proceeds. It is worthwhile to to service debt. This is accomplished note that, with increasing frequency, the through the formulation and approval (the “fix” that is seized upon by debtors is a sale The Life Cycle of a “confirmation”) of a chapter 11 reorgani- of all or substantially all estate assets under zation plan. Bankruptcy Code §363 rather than a Insofar as chapter 11 often is just a reorganization plan—a phenomenon that Chapter 11 Debtor matter of making a deal with various may make some bankruptcy judges feel like stakeholders, one may well ask, “why can’t auctioneers—but the prototype is still a Th r ough the you just do it all informally, without the cost, chapter 11 plan, and so we discuss that here inconvenience and stigma of a bankruptcy and leave §363 sales for a future discussion. case?” The answer is you can, and often you It is impossible to generalize what De b t o r ’s Eyes do when you don’t need to use unique activities and events will occur in any Part II “bankruptcy powers” to make an operational particular chapter 11 case because each case fix. Plenty of times a debtor and its creditors is so different. However, the typical chapter Contributing Editors: can simply make and carry out deals without 11 case does involve certain interrelated Prof. John D. Ayer court intervention, so much so that some groups of activities or processes. These University of California at Davis people even refer to an out-of-court workout include claims administration, avoidance and Chico, Calif. as a “private chapter 11.” confirmation. We offer some thoughts on jd a y e r @ u c d a v i s . e d u But chapter 11 does permit you to each below. Michael Bernstein accomplish some purposes that you may not There is no rule that prescribes the order Arnold & Porter; Washington, D.C. be able to achieve on your own. Here are in which such tasks must be completed. mi c h a e l _ b e r n s t e i n @ a p o r t e r . c o m a few: Rather, when, or even if, these activities will • Perhaps most important, if you get the take place in any given case will depend on a Jonathan Friedland right number of votes, you can impose multitude of factors, including whether the Kirkland & Ellis LLP; Chicago the plan on dissenters (while outside of case involves a “free fall,” “pre-arranged” or jo n a t h a n _ f r i e d l a n d @ c h i c a g o . k i r k l a n d . c o m chapter 11 you may not even be able to “pre-packaged bankruptcy;” whether the Editor’s Note: This is the third in this find all of the creditors, much less get case involves a reorganization, liquidation or column series for the newly minted chapter their attention or their consent). a sale of all assets to a third party; and the 11 professional. In our last installment, we • Because of the automatic stay, you get level of creditor cooperation. It will also began to paint a portrait of a chapter 11 to hold creditors at bay while you try to depend on what issues are of most pressing debtor’s life, from preparing for a make your deal. concern in the particular case. bankruptcy filing to first-day hearings, the • You get a “cleaner deal” than you may It should also be noted that the manner in effect of the automatic stay, financing issues be able to get outside bankruptcy— which one of these tasks is performed may and the treatment of executory contracts. more clarity and finality about the rights impact the others. For instance, the claims- Last month’s cliffhanger left the debtor of the parties. administration process is sometimes a critical having successfully filed its case and • You get to use some of those part of the plan-confirmation process. As we learning to operate in chapter 11. This bankruptcy powers that simply aren’t touch upon later, a plan cannot be confirmed month, we take the reader on a quick tour of available anywhere else. unless the bankruptcy court makes a number the “rest” of the case. The confirmation of a plan may be of specific findings. One such finding is that the debtor will be able to pay most §503 and ny entity that subjects itself to viewed as the last step in the fix, or 507 “administrative” and “priority” claims— chapter 11 obviously has some alternatively as a description of what the fix those claims that Congress has determined serious problems that need to be is and how it will be implemented. A A confirmed plan becomes the “law of the should enjoy priority over other unsecured fixed. Here, we examine the nature of the claims—on the “effective date” of the plan. fix. Broadly stated, there are two ways case”—a substitute contract that replaces the Thus, thinking ahead to confirmation, chapter 11 helps a debtor deal with its old creditor claims and equity interests. debtors sometimes spend great resources on problems. First, it provides the debtor with a Some debtors, as we discussed in a claims administration, addressing not only host of powers that can help it to remedy prior column, do not use chapter 11 to the validity and amount of claims, but also operational problems. The ability to reject reorganize, but as a forum for an orderly their priority levels. executory contracts and unexpired leases is liquidation. But even in those cases, the The American Bankruptcy Institute 44 Canal Center Plaza, Suite 404, Alexandria, VA 22314-1592 • 703 739 0800 Claims Administration purposes of voting whether the creditor has BigBank wants to beat out competing third- If you are going to pay claims, you have an “allowed” claim, how big it is, and what party contenders, he will have to “perfect” to make sure you know whom to pay. If you class the claim is in. this security interest—probably by filing a are going to solicit votes on a plan, you have As to classification: Section 1123 “financing statement” in the public records. to know who gets to vote. If you are going to provides that the plan may “designate.. If he fails to perfect, he will lose out to a put claims into different classes, you have to .classes of claims.” Section 1122 says you competing creditor who gets a lien, or share know who goes in which class. So the may put a claim in a particular class only if ratably with unsecured creditors. problem of claims administration requires the claim is ‘substantially similar’ to other Recall that the trustee is a kind of agent attention in even the simplest chapter 11 case. claims in the same class. But you may be of creditors. So it is not surprising to learn The debtor gets the ball rolling by filing able to take claims that appear similar for that the trustee enjoys the rights of a lien schedules of all its debts. If you are a non-bankruptcy law purposes and put them creditor. In our case, this means that if the creditor and the debtor has scheduled your in different classes for purposes of the security interest is unperfected at the time of claim correctly, that is enough to put you on bankruptcy plan. This happens often enough the bankruptcy filing, the trustee gets to set it the list. If not, you can file a claim (but for that some of the worst fights in chapter 11 aside. Se e 11 U.S.C. §544(a). what it is worth, your authors would involve plan classification, with the P r e f e r e n c e s : Now, still another case. ordinarily file a claim in any event, just to be dissenters arguing that the plan proponent is The debtor owes $10 each to the butcher, the sure) prior to the applicable deadline (or “gerrymandering” the classes, while the baker and the candlestick maker. The debtor “bar date”). proponent argues that there is a principled has assets worth only $10. He transfers all After there is a complete list of basis for its classification scheme. his assets to the butcher in satisfaction of the butcher debt, leaving the baker and the “possible” claims, as a result of the Avoidance schedules and the proofs of claim, the debtor candlestick maker unpaid. What is the By avoiding a particular transfer of result? Observe that under the two rules we and other parties have the chance to assert property, the trustee or debtor-in-possession objections. Sometimes these are asserted on described above, it is probably bulletproof. (DIP) can cancel a pre-petition (or, There’s nothing to indicate it could be set a claim-by-claim basis; other times the occasionally, an unauthorized post-petition) objections will fall into broad categories and aside by a lien creditor. It (probably) wasn’t transaction and force the return or done to defraud other creditors, and the you will see “omnibus objections”—a single “disgorgement” of the payments or property, pleading objecting, for a similar reason, to debtor did get fair value for the payment which then are available to pay all creditors (satisfaction of the $10 debt). Quite the dozens or even hundreds of claims. Here are pursuant to the priority rules set forth in the some common objections: contrary: Whatever the debtor did here, at Bankruptcy Code. These powers are used to least he paid a debt. • The claim is invalid under non- prevent unfair pre-petition payments to one bankruptcy law. For the most part, you Preferring one creditor over another creditor at the expense of all other creditors. usually is not wrong outside bankruptcy. But don’t have a claim in bankruptcy unless Below are the common avoidance powers in you would have a claim against the bankruptcy is all about distributing assets chapter 11. among creditors “as their interests may debtor outside bankruptcy, so this Fraudulent Transfers: A pre-petition objection can be a knockout punch. appear.” If you let the debtor pick and transfer may be avoidable as either choose whom he pays, you may upset the • The claim is valid but overstated (the “intentional fraud” or “constructive fraud.” debtor’s books and records reflect a purpose of bankruptcy. Thus, bankruptcy The former is a transfer made with actual law allows a trustee (or DIP) to avoid certain lower amount due). intent to hinder, delay or defraud creditors. • The creditor is holding money or pre-petitition debt repayments even though Think of the debtor-to-be who is being they would not be avoidable outside of property of the debtor that he must hounded by creditors, and so conveys his return before his claim is allowed. (Se e bankruptcy. Se e 11 U.S.C. §547. Typical house and his bank account to his mother so examples of preferential transfers include the §5 0 2 ( d ) ) . that the creditors won’t seize them. The • The claim was filed too late. Claims late payment of a trade debt (outside the latter is a transfer made for less than “ordinary course of business”), the granting filed after the bar date may be reasonably equivalent value, while the disallowed or subordinated. of a security interest to a previously debtor is insolvent (or which renders the unsecured or undersecured lender, and • The creditor asserts the wrong priority. debtor insolvent or leaves it with High-priority claims get paid before delayed perfection of a security interest unreasonably small capital). Also within this granted by the debtor at the time it incurred low-priority claims. As a general matter, category could be the sale of a $10 million knocking the creditor down the priority an earlier debt. The reach-back period for factory for $3 million, or the payment of a preferences is 90 days before bankruptcy, ladder reduces his chance of get- dividend to shareholders by an insolvent ting paid. although it extends to one year if the corporation, even if there were no intent to recipient is an “insider” of the debtor (for Aside from allowing claims for harm creditors. payment, there is the matter of establishing definition of “insider,” se e §1 0 1 ( 3 1 ) ) . The Bankruptcy Code includes its own Vats of ink have been spilled over the claims for purposes of voting on the plan. To fraudulent transfer power, set forth in §548. understand this point, you have to know a bit trustee avoiding powers, and we don’t do But a trustee (or DIP) may also utilize state any more than hint at the difficulties here. about the voting rules. When read together, fraudulent conveyance laws, which tend to §§1126 and 1129 provide that any creditor We intend to devote a separate column, be generally similar to the federal statute, but maybe two, to the topic later on. We raise who is “impaired” by a plan gets a chance to with significantly longer reach-back periods. vote on the plan. Creditors vote by classes. the topic here mostly for one reason: The Strong-arm Powers: Now, here is a way you manage the avoiding powers may To confirm a plan, you have to get the different case. Before bankruptcy, the debtor approval of a majority in number and two drive the chapter 11 case. In some cases, the borrowed $1 million from BigBank and, to avoiding powers provide the motive for thirds in amount of claims in each voting secure the loan, granted BigBank a security class. So, just as for payment, it matters for filing—either to recover the transfer or to interest in its equipment. Typically, if use the threat of doing so to reach a deal. On The American Bankruptcy Institute 44 Canal Center Plaza, Suite 404, Alexandria, VA 22314-1592 • 703 739 0800 the other hand, there may be cases where we bankruptcy. Articles of incorporation can be (i. e . , that the debtor has a credible business will finesse the avoidance problems in order changed in a plan to change the voting rights plan and can reasonably be expected to to make a deal that wouldn’t happen of different issues of shares or modify anti- perform its obligations and accomplish the ot h e r w i s e . takeover measures. objectives set forth in the plan). The Disclosure Statement. No one may If any individual creditor votes against Confirmation solicit acceptance of a plan until the court the plan, then the plan must also pass the Here is the basic chronology in approves a “disclosure statement” sufficient “best interests of creditors” test. This test confirming a plan: so a voter can “make an informed judgment requires the court to determine that the • Negotiate a plan with creditors (or their about the plan.” 11 U.S.C. §1125(a)(1). The dissenting creditors or shareholders are ag e n t s ) . disclosure statement thus serves a function receiving under the plan at least as much (in • Draft a plan and “disclosure similar to a prospectus for an offering under present value terms) as they would receive if st a t e m e n t . ” securities law. (In addition, compliance with the debtor were instead liquidated under • Get court approval for your “disclosure the disclosure statement requirements creates chapter 7. It requires the court to compare st a t e m e n t . ” a limited safe harbor from certain securities (1) the probable distribution to the dissenting • Only after getting that approval, solicit laws requirements that would otherwise be creditors or equity-holders if the debtor were votes from holders of impaired claims. applicable. Se e 11 U.S.C. §1145). liquidated with (2) the present value of the • Count the votes. Since no one can solicit consents payments or property to be received or • Ask the court to confirm your plan. without a court-approved disclosure retained by the same creditors or equity- Plan Formulation. Key to the timely statement, the hearing on disclosure holders under the plan. Stated more simply, confirmation of a plan is a well-defined exit typically becomes the first point of contact if a class votes in favor of the plan, the plan strategy. The plan proponent must determine between the plan and the court. There are will be binding on dissenters in that class as what exactly it wants from the reorgani- sometimes fights about the adequacy of the long as dissenting class members are getting zation, and how, from a business per- debtor’s disclosure statement. Most of the at least as much as they would get in spective, it plans to achieve it. Most often, time, these really have more to do with li q u i d a t i o n . the chapter 11 plan is proposed by the confirmation than disclosure issues. If a class of creditors votes to reject the debtor. And during the “exclusive period” Objectors often see the disclosure statement plan, it may nevertheless be imposed on the (the first 120 days of the case, or longer if hearing as a first chance to raise concerns class (“crammed down”) if (1) at least one the court grants an extension—which it about the plan. In response, judges often tell impaired class has voted to accept the plan often does), the debtor has the sole right to such objectors to “save it for the confir- and (2) the court finds that the treatment propose a plan. But after the exclusive mation hearing.” provided for objecting classes under the plan period expires, other parties may propose a So l i c i t a t i o n . After the approval of the does not “discriminate unfairly” and is “fair plan—and if you play this game long disclosure statement, the proponent solicits and equitable” (the “fair and equitable” test). enough you will see some plans proposed by votes. Voting is done on a class-by-class The prohibition against “unfair creditors’ committees, secured lenders and basis. In order for a class to be deemed to discrimination” means that, ordinarily, other parties. That is why we refer later on to have accepted a plan, the plan must be similar claims or equity interests must be the “plan proponent” rather than the accepted by a majority in number of treated in like manner. There are examples “d e b t o r . ” creditors who vote and at least two-thirds in of “fair” discrimination, however. For Plans may, and frequently do, provide debt amount of voting creditor claims in that example, the enforcement of a contractual for comprehensive changes in the financial class. For these purposes, the claims of subordination provision to subordinate the and business structure of the debtor. Such insider creditors don’t count. If every claims of one class to the claims of another changes may include sales of assets, impaired class of creditors votes to accept class does not discriminate “unfairly” cancellation or refinancing of debt (or the plan, the proponent then asks the court to against the subordinated class. conversion of debt to equity), curing or confirm the plan. If no impaired class votes The precise determinations required for waiving of defaults, satisfaction or to accept the plan, then the plan is dead on meeting the fair-and-equitable test turn on modification of liens, amendment of the arrival and the debtor must come up with whether the class is secured or unsecured. debtor’s corporate charter, or changes in the something else, or head back to the Cramdown of a secured class will be amount, interest rate or maturity of bargaining table. If some impaired classes permitted if the plan provides (1) that the outstanding debt. vote to accept and others vote to reject, then objecting secured creditor class will retain a A plan can provide that a creditor’s the proponent may seek to “cram down” the lien to the extent of its secured claim and claim will be reduced, or paid back over a dissenting classes (see more about that will receive deferred cash payments that greater period of time or at a different be l o w ) . have a present value equal to at least the interest rate than was contained in the Basic tests for confirmation. U p o n value of the creditor’s interest in the original instrument. Bankruptcy courts have receipt of the necessary acceptances, the collateral, (2) for the sale of the secured confirmed plans with repayment periods of plan proponent will request the bankruptcy creditor’s collateral with the creditor’s lien up to 20 years or longer. A plan can also court to confirm the plan at the confirmation attaching to the proceeds or (3) for the cancel existing issues of stock, replace he a r i n g . realization by the secured class of the existing issues with new issues or swap The Bankruptcy Code requires the “indubitable equivalent” of its secured equity for debt and vice versa. bankruptcy court to make a number of claim. (Nobody seems to know exactly what Investors and would-be acquirers can specific findings to “confirm” (approve) a “indubitable equivalent” means, but one use chapter 11 as a means for accumulating plan and make it binding on all parties. These thing it may mean is returning the secured control of a debtor-corporation and for include determinations that the plan complies creditor’s collateral to it in satisfaction of the influencing the corporate governance of a with all applicable law and has been secured claim.) The permutations of debtor, taking actions that often would be proposed in good faith. The bankruptcy court possibilities under the different cramdown more difficult outside the realm of must also determine that the plan is feasible options can become quite complex, but as a The American Bankruptcy Institute 44 Canal Center Plaza, Suite 404, Alexandria, VA 22314-1592 • 703 739 0800 general rule they boil down to the secured creditor receiving at least the lien value of its co l l a t e r a l . The fair-and-equitable test for unsecured claimants and shareholders is much simpler. Generally speaking, a class of unsecured claims can be crammed down if the plan provides either that the creditors in the class receive (over time) cash payments equal to the present value of their unsecured claims (i. e . , payment in full) or that junior classes (such as subordinated creditors or stockholders) receive nothing under the plan. Equity security-holders may be crammed down along similar lines. Cramdown cases are far more often threatened than confirmed, but the cramdown power provides important bargaining leverage. Post-confirmation Confirmation represents a significant achievement in a chapter 11 case, and it is generally viewed as the end goal of a filing; it represents consummation of the business “deal” between the relevant parties. Confirmation, like chapter 11 itself, should not be the goal in and of itself. Rather, chapter 11 is a venue for getting to a deal and confirmation is akin to the signing of the contract that memorializes the deal. Moreover, in practical terms, confir- mation does not end a case. A number of important aspects often remain to be completed after confirmation. This may include consummating transactions provided for in the plan, resolving claims and litigating adversary proceedings. ■ Reprinted with permission from the AB I Journal, Vol. XXII, No. 8, October 2003. 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The American Bankruptcy Institute 44 Canal Center Plaza, Suite 404, Alexandria, VA 22314-1592 • 703 739 0800