Bankruptcy Process

Chapter 11 of the United States Bankruptcy Code (commonly referred to as, the “Bankruptcy Code”) is the chapter under which businesses are able to reorganize and refinance in order to prevent liquidation. A Chapter 11 case is commenced by the filing of a petition for relief with a United States Bankruptcy Court, after which, the company is referred to as the “debtor.” In most cases, a “voluntary” petition is filed by the debtor. Occasionally, however, three or more creditors may commence the case by filing an “involuntary petition.” In a chapter 11 case, the debtor automatically assumes an additional identity as the “debtor in possession.” The term refers to a debtor that keeps possession and control of its assets while undergoing a reorganization under Chapter 11, without the appointment of a trustee. Chapter 11 was created by Congress to give companies the “breathing room” to stabilize their operations while keeping creditors at bay.

The end result of a “successful” Chapter 11 could be an internal reorganization (in which claimants receive cash and/or new debt or equity securities of the reorganized entity) or a sale of all or part of the business. Not all companies are able to reorganize, however, and some are forced to liquidate their assets. Liquidations are accomplished either through the filing of a Liquidation Plan under Chapter 11 or the case may be converted into a case under Chapter 7, in which case a Chapter 7 Trustee will be appointed to liquidate the company.

Companies seek bankruptcy protection for a variety of reasons, including general economic weakness, competition, operational problems, flawed business strategies, regulatory changes, litigation, environmental claims, and fraud. In most cases, companies are forced to file petitions due to severe liquidity constraints that leave the business in risk of, or in actual, default under debt instruments.

Upon the commencement of a Chapter 11 case, the Bankruptcy Code creates an “automatic stay” which prevents creditors from taking any action against the debtor during the pendency of the case. The automatic stay provides a period of time in which all judgments, collection activities, foreclosures, and repossessions of property are suspended and may not be pursued by the creditors on any debt or claim that arose before the filing of the bankruptcy petition. All creditors are essentially frozen in their prepetition position. The automatic stay is designed to provide the debtor with time to investigate and formulate a plan of reorganization, negotiate the plan with creditors and solicit votes, and complete the restructuring.

Shortly after the filing of a Chapter 11 petition, the U.S. Trustee will appoint a creditors’ committee to represent the interests of all unsecured creditors. Typically, the unsecured creditors’ committee is comprised of creditors who hold the largest unsecured claims against the debtor. Also known as the Official Unsecured Creditors Committee, these groups will typically consist of an amalgam of trade claimants, landlords, and bondholders. Creditors’ committees play an important role in Chapter 11 cases. The committee consults with the debtor in possession on the administration of the case, investigates the debtor’s conduct and operation of the business, and participates in formulating a plan, among other things. A creditors’ committee may, with the court’s approval, hire an attorney or other professionals to assist in the performance of the committee’s duties.

Early in the Chapter 11 proceedings petition, the debtor files certain “first day” motions with the bankruptcy court to allow for the continued operation of the debtor’s business. Key among these motions would be requests relating to retention of legal and financial professionals, use of cash collateral and/or approval of debtor-in-possession financing.

Frequently, the debtor in possession will institute a lawsuit, known as an adversary proceeding, to recover money or property for the estate. Adversary proceedings may take the form of lien avoidance actions, actions to avoid preferences, actions to avoid fraudulent transfers, or actions to avoid post-petition transfers. At times, a creditors’ committee may be authorized by the bankruptcy court to pursue these actions against insiders of the debtor if the plan provides for the committee to do so or if the debtor has refused a demand to do so. Creditors may also initiate adversary proceedings by filing complaints to determine the validity or priority of a lien, revoke an order confirming a plan, determine the dischargeability of a debt, obtain an injunction, or subordinate a claim of another creditor.

The debtor in possession has what are called “avoiding” powers. These powers may be used to undo a transfer of money or property made during a certain period of time before the filing of the bankruptcy petition. By avoiding a particular transfer of property, the debtor in possession can cancel the transaction and force the return or “disgorgement” of the payments or property, which then are available to pay all creditors. Generally, and subject to various defenses, the power to avoid transfers is effective against transfers made by the debtor within 90 days before filing the petition. But transfers to “insiders” (i.e., relatives, general partners, and directors or officers of the debtor) made up to a year before filing may be avoided.

Bankruptcy provides the debtor with time to stabilize their operations while analyzing alternatives to restructure their balance sheet. Two beneficial elements of in-court operational restructurings are the ability to sell assets and assume or reject executory contracts.

For many financially distressed companies, asset sales can be an effective way to increase liquidity and reduce leverage. A debtor will often divest an asset that is not performing well, not vital to the company’s core business, worth more to a potential buyer or as a separate entity than as part of the debtor, or in order to raise funds for continuing operations. Section 363 of the bankruptcy code is an important provision for buyers and sellers that want sell assets in a financially distressed context. Among the important advantages to the buyer is the ability to purchase the asset “free and clear” of virtually all liens and claims, with little or no risk of the transaction being subsequently unwound. Section 363 can also provide a buyer with a visible time line and certainty (via an auction process approved by the court). For the seller, section 363 can provide certain tools to allow the debtor to maximize value for the bankruptcy estate (e.g., heavily negotiated auction terms and procedures, use of a “stalking horse” bid, minimum bid increments, etc.).

The bankruptcy code also allows the debtor to examine its executory contracts (including leases, employment agreements, service contracts, and supply contracts) to determine whether any are disadvantageous. If so, the debtor has the ability to terminate the contract (for which the counter-party would derive an unsecured pre-petition claim against the company) or to renegotiate the contract on a basis that would produce a similar economic result. This ability to assume or reject executory contracts is an important tool to a debtor initiating operational restructuring.

After the debtor’s day-to-day operations are stabilized, the next goal of the reorganization process is to develop a new business plan or strategy for the firm.

A plan of reorganization outlines how the debtor intends to restructure its business, pay or discharge its debts, and emerge from bankruptcy. Chapter 11 affords the debtor with the exclusive right to file a plan of reorganization for a period of 120 days. In practice, courts regularly grant debtors additional extensions (but in no event may the exclusivity period, including all extensions, be longer than 18 months). If the “exclusive period” expires before the debtor has filed and obtained acceptance of a plan, other parties in interest in a case, such as the creditors’ committee or an individual creditor, may file a plan. Such a plan may compete with a plan filed by the debtor or by another party in interest. A proponent of a plan is subject to the same requirements as the debtor with respect to disclosure and solicitation.

The theory behind plan exclusivity is that the debtor needs time to stabilize its operations, explore its alternatives, negotiate with its constituencies, and develop a restructuring proposal that maximizes value and accommodates the conflicting goals of multiple groups in the case. From a negotiating perspective, exclusivity gives the debtor considerable leverage. Constituencies desiring an exit may be willing to make more concessions to the debtor than they would in the absence of the debtor’s exclusivity. The creditors’ right to file a competing plan provides incentive for the debtor to file a plan within the exclusivity period and acts as a check on excessive delay in the case.

In connection with the solicitation of votes for a Plan of Reorganization, the debtor is required to prepare a prospectus-like document called a “disclosure statement,” which is intended to contain all material information about the debtor, its business, and the proposed plan to allow creditors to make an informed decision when they vote on whether or not to accept the plan.

After the disclosure statement is filed, the court holds a hearing to determine whether the disclosure statement has “adequate information” to be approved. While the information required is governed by judicial discretion and the circumstances of the case, the plan must include a classification of claims and must specify how each class of claims will be treated under the plan.

In bankruptcy, claims are grouped according to similarity (called classification). These groupings are based upon various factors, such as identity of the obligor (claims against the parent entity vs. their subsidiaries may be separately classified), collateral interests (secured vs. unsecured), senior vs. subordinated, post-petition vs. pre-petition, claims entitled to certain priorities (such as government tax claims), and so forth. Interests are also grouped in the same manner, with preferred stock and common stock having their own classes. Generally, a plan will classify claim holders as secured creditors, unsecured creditors entitled to priority, general unsecured creditors, and equity security holders. A plan of reorganization does not have to provide for the full payment of all prepetition bankruptcy debts (and usually does not). Certain classes of creditors may be deemed “impaired” (i.e., whose contractual rights are to be modified or who will be paid less than the full value of their claims under the plan), while other classes may be deemed “unimpaired” (i.e., whose claims will be paid in full in cash or otherwise reinstated on its original terms).

A plan of reorganization does not have to provide for the full payment of all prepetition bankruptcy debts (and usually does not). Certain classes of creditors may be deemed “impaired” (i.e., whose contractual rights are to be modified or who will be paid less than the full value of their claims under the plan), while other classes may be deemed “unimpaired” (i.e., whose claims will be paid in full in cash or otherwise reinstated on its original terms).

In theory, there is a strict hierarchy of payment among claims of differing priorities (called the “absolute priority rule”). This well-established bankruptcy principle states that claim holders with higher priority should receive 100% of their claim in full before the next (lower priority) class receives any portion of the reorganization proceeds. In practice, it is common for chapter 11 bankruptcies to violate the absolute priority rule. For example, “give ups” or “carve-outs” by senior classes of creditors to achieve confirmation of a plan have become an increasingly common feature of the chapter 11 process, as stakeholders strive to avoid disputes that can prolong the bankruptcy case and drain estate assets by driving up administrative costs.

In terms of recovery rates, bank debt recovered on average of 72% of the amount owed in the 2002-2003 downturn (according to Standard & Poor’s LossStats Database). Senior unsecured bonds recovered 29% on average of the amount owed (a materially lower yield due to lack of collateral/security). Subordinated unsecured bonds recovered 21% on average of the amount owed (a lower recovery compared to senior unsecured bonds due to their lower priority). In the current environment, recovery rates across the capital structure are expected to be materially lower compared to prior distressed periods due to (1) higher average secured debt levels in today’s corporate capital structures (a significant amount of second lien senior secured debt was issued in the 2004-2007 period), (2) materially weaker (i.e., more borrower friendly) credit agreement terms (including the proliferation of no-covenant and covenant-lite structures), and (3) expectations for a deeper and longer recession compared to the last few economic downturns.

After the plan of reorganization and disclosure statement have been prepared, the next step in the bankruptcy proceeding is for the debtor to initiate the plan solicitation and voting process.

Creditors whose claims are impaired are entitled to vote on the plan by ballot. For a class of creditors to accept a plan of reorganization, in excess of two-thirds of the dollar amount and half of the number of claimants must approve. The measurement is of those actually voting, so a plurality of actual claims may be able to accept on behalf of the class. In an accepting class, non-voting and rejecting holders are bound by the vote of the accepting holders. If there are impaired classes of claims, the court cannot confirm a plan unless it has been accepted by at least one class of non-insiders who hold impaired claims. Holders of unimpaired claims are deemed to have accepted the plan and, therefore, cannot vote on the plan.

After the ballots are collected and tallied, the court will set a date and time for a hearing to determine whether to confirm the plan. Any party in interest may file an objection to confirmation of a plan. Before confirmation can be granted, the court must be satisfied that there has been compliance with all the requirements of confirmation set forth in the bankruptcy code, even in the absence of any objections. For example, the court must determine that the classification of claims and interests has been done appropriately, that the voting process met certain technical requirements, and that the requisite number of claims (both by dollar amount and number of creditors voting) and interests (by number of shares voting) approved the plan. In addition, the court must find (1) that the plan has been proposed in good faith, (2) that the plan is feasible (i.e., not likely to be followed by liquidation or the need for further financial reorganization), (3) that creditors receive more than they would under a hypothetical Chapter 7 liquidation (the so-called “best interests test”), and (4) that no creditor receives value for more than 100% of its claim. After the plan has been confirmed by the court, the court then sets a date to implement the restructuring (referred to as the “plan effective date”).

Sometimes a company has discussed a plan of reorganization with its creditors and has reached agreement in principal with its key constituents prior to a Chapter 11 bankruptcy filing, although the constituencies are not legally bound to act in any way (referred to as a “pre-negotiated plan”). In contrast, a “pre-packaged plan” is a bankruptcy plan of reorganization for which the requisite votes of creditors have been obtained prior to the Chapter 11 filing (generally conducted in parallel with an out-of-court exchange offer) and key constituents are legally bound to vote in favor of the plan. Use of pre-negotiated and pre-packaged plan of reorganizations can help to speed up the bankruptcy process.

Notwithstanding the entry of the confirmation order, the court has the authority to issue any other order necessary to administer the estate. This authority would include the post-confirmation determination of objections to claims or adversary proceedings, which must be resolved before a plan can be fully consummated. The Bankruptcy Code requires a debtor in possession or a trustee to report on the progress made in implementing a plan after confirmation. A Chapter 11 trustee or debtor in possession has a number of responsibilities to perform after confirmation, including consummating the plan, reporting on the status of consummation, and applying for a final decree.

On average, bankruptcy cases last between one and two years; however, pre-negotiated or pre-packaged bankruptcies can sometimes be resolved within a year, while other bankruptcies can last 4 years or more. The duration of an individual bankruptcy case will be affected by a number of factors, including the complexity of a debtor’s legal and capital structure, the number of creditor classes and level of hostility, pre- and post-petition litigation, environmental and other contingent liabilities, asset sales, labor and regulatory issues, and fraud. Creditors typically will not receive any recovery until 30-90 days after a plan of reorganization is declared effective and the debtor (or plan administrator) has completed the claims reconciliation process. In the current environment, bankruptcy case duration is expected to increase due to the significant number of recent bankruptcy filings and the backlog of cases in the federal bankruptcy courts.

Lastly, in terms of other considerations, creditors should be aware of the possible types of consideration (payment received for a debt or claim) provided to creditors in a reorganization. Consideration may come in the form of cash, debt, common stock, warrants or a combination thereof. Claim holders who receive common stock or warrants often find this type of “soft consideration” hard to value and difficult to liquidate (particularly if there is no current or liquid market for the reorganized entity’s stock).