I. THE COMMITTEE OF UNSECURED CREDITORS
A. Rationale for Formation of Committee
Congress, in enacting the Bankruptcy Code, envisioned a process which would be primarily driven by negotiation between the debtor, its creditors, and other interest holders. Chapter 11 is intended to be a temporary “safe harbor” while the debtor “works out” its financial (and operational) problems.
Unsecured creditors are generally a homogeneous group, at least with respect to the priority of their claims. There is some economy achieved by the formation of a smaller body to act as the representative of the entire unsecured creditor class in negotiations and other matters which arise during the case. Furthermore, an unsecured creditor generally cannot justify the expense of individual professional representation unless the size of its claim is extremely large and/or a large percentage recovery is likely. Absent statutory intervention it is unlikely that there would be anybody looking out for the interests of unsecured creditors in most cases. Congress, appropriately, provided for the formation of committees to negotiate on behalf of unsecured creditors and to otherwise “police” the case on behalf of the class.
The Code provides that the Office of the United States Trustee (“U.S. Trustee”) “shall” appoint a committee of unsecured creditors and “may” appoint additional committees of creditors or of interest holders as it deems appropriate. This language makes clear that Congress envisioned that committees, particularly unsecured creditors’ committees, would not only be formed, but would also play an important role in the Chapter 11 process
Section 1102 of the Bankruptcy Code is the specific statutory provision mandating the appointment of an unsecured creditors’ committee in Chapter 11 cases. The committee is formed by the U.S. Trustee. The committee is usually comprised of unsecured creditors who are among the debtor’s 20 largest and who have indicated a willingness to serve.
The committee must have at least three members and generally will have no more than seven members. However, the goal of the appointment process is to create a body which is “representative” of the class of unsecured creditors, and the U.S. Trustee may appoint a committee larger than seven members as necessary to make the committee a fair representative of the class.
The fact that members of the committee have different interests or views does not justify the formation of separate committees. However, if there are distinct groups within the class who cannot be adequately represented by a single committee, the U.S. Trustee and/or the bankruptcy court can be petitioned for the formation of a separate committee.
The committee formed pursuant to Section 1102 of the Bankruptcy Code is known as the “official” committee. It has the powers and duties set forth in Section 1103, as will be discussed below. There is nothing to prevent a group of creditors with similar interests from banding together to form an “unofficial” committee. While an unofficial committee would have the right to be heard, it does not have official standing within the Bankruptcy Code.
C. Adding and Deleting Members
As indicated above, it is the U.S. Trustee which is responsible for appointing committees. Any requests for changes in the membership or size of a committee should be addressed, in the first instance, to the U.S. Trustee. Any disagreement with the U.S. Trustee’s response to a request may be brought before the bankruptcy court. While at least one court has held that there is no requirement under the Code that an interested party first submit its request to the U.S. Trustee, the better practice is to first address concerns to that office.
The request to add a creditor to the committee can probably be accomplished by a simple letter addressed to the U.S. Trustee, together with copies to the debtor, debtor’s counsel and committee counsel. The addition would become formal by the U.S. Trustee amending its official membership list. Some degree of formality is required. It is necessary to seek the approval of the U.S. Trustee (or court) of the addition of a member in order for that member to be authorized to vote on committee decisions. There is, however, nothing to prevent committee members from allowing other creditors or parties to serve as “ex-officio” members of the committee. The committee can set guidelines regarding the rights of “ex-officio” members.
In addition to having the power to add additional committee members, the U.S. Trustee can also remove members and, if it is deemed appropriate, appoint substitutes. It would appear that the U.S. Trustee’s power to remove a committee member is governed by the requirement that the removal be for “cause,” although there is no controlling statutory provision. “Cause” can be for something as significant as a belief that the member represents an interest adverse to the class of unsecured creditors, or something as “insignificant” as a belief that the committee member is not active enough. It does not appear that there is any need for judicial approval of the removal. Removal would probably be effective upon the publication by the U.S. Trustee of a new membership list. Any disagreement with the decision of the U.S. Trustee can probably be “appealed” to the bankruptcy court.
Upon request of a party in interest, the Court may order the US Trustee to change the membership of a committee if the court determines that the changes is necessary to ensure adequate representation of creditors. The 2005 amendments to the code specifically provide that the court may order the US Trustee increase the number of members of a committee to include a creditor that is a small business concern, if the court determines that the small business creditor holds claims the aggregate amount of which, in comparison to the annual gross revenue of that small business creditor, is disproportionately large.
The committee would seem to have standing to address any decision by the U.S. Trustee to add or remove members. In addition, it would seem that the committee has the right to initiate a request to the U.S. Trustee to add or remove a member where it deems appropriate.
There is no bankruptcy statute or rule setting forth the procedure for resigning from the committee. It is, nevertheless, good practice to make the resignation formal. This can be accomplished by sending a letter to both the chairperson and counsel to the committee advising them that the member is officially resigning from the committee. The resigning member should request that counsel for the committee notify the U.S. Trustee of the resignation. For internal committee business, the resignation should be considered effective as of the date that the letter to the chairperson and committee counsel is received.
E. Fiduciary Responsibility of Committee Members
Committee members are said to have a “fiduciary” obligation to the class which the committee represents. A fiduciary obligation is the highest obligation which a person can owe to any other persons. It requires that one’s actions be guided solely by the interest of the person which the fiduciary represents.
Notwithstanding the recognition of the fiduciary nature of the obligations of the committee members, the concept of an operational Chapter 11 committee would become unworkable if the obligations of the committee members were truly “fiduciary.” Committees are comprised of individual creditors with their own claims against the debtor. The claims may be disputed. In addition, individual members may have “agendas” that are inconsistent with those of other members of the committee. For example, some members of the committee may be suppliers to the debtor and may have an interest in seeing the debtor reorganize even though a liquidation might generate a higher yield on account of prepetition debt. It is clear that, along with representing the class of unsecured creditors, each individual committee member also has the right to represent his company’s own interest in the bankruptcy case.
In order to make the concept of an operational committee workable, the “fiduciary” obligation of committee members pertains to any votes or other actions the members take as part of the committee. When there is a matter before the committee which affects an individual member differently from unsecured creditors generally, that individual member should make that fact known and, depending on the circumstances, consider not participating in the discussion or the vote concerning that matter. Outside of the committee vote, however, there is nothing to preclude the committee members from protecting their own interests.
Committee members should not, however, under any circumstance, seek to use their membership on the committee to obtain (or attempt to obtain) some advantage over other unsecured creditors. Examples would include such things as utilizing information gained as a committee member to take over the debtor’s business, utilizing the position as a committee member to crowd out other suppliers, etc. If any member believes that his individual interests require him to attempt to obtain some advantage, it would be appropriate to resign from the committee.
F. Powers and Duties of Committee
Section 1103 of the Bankruptcy Code lists the specific powers and duties of the committee.
The section authorizes the committee, at a scheduled meeting in which a majority of the members are present, to select one or more attorneys, accountants, or other agents to represent it or to perform services for it.
Section 1103 further provides that the committee may:
- consult with the Chapter 11 trustee (if one has been appointed), or debtor-in-possession, concerning the administration of the case;
- investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor’s business, the desirability of the continuance of such business, and any other matters relevant to the case or to the formulation of a plan;
- participate in the formulation of a plan and advise the members of the class which it represents of the committee’s position as to any plan formulated;
- request the appointment of a Chapter 11 trustee or examiner (pursuant to Section 1104 of the Bankruptcy Code), or if the committee determines that it is in the creditors’ best interest to have a trustee liquidate the business, seek the conversion of the case to a Chapter 7;
- and perform such other services as are in the interest of the creditors.
The committee has the absolute right to appear and be heard in any matter brought before the bankruptcy court and to intervene in any lawsuit involving the debtor filed in the bankruptcy court.
Committee business generally involves reviewing issues which have arisen in the bankruptcy case and deciding upon a course of action (or inaction) in response, meeting with the management of the debtor-in-possession to discuss the administration of the case and the rehabilitation of the operations, and engaging in discussions regarding the reorganization plan. During the course of the administration of the case, the committee can investigate the debtor’s pre- and postpetition acts, conduct, assets, liabilities, and financial condition in order to determine the desirability of continuing the business and the fairness and feasibility of any plan proposed by the debtor.
The committee can conduct business as a complete unit or, where it deems appropriate, form subcommittees. Subcommittees can be useful for specific purposes such as reviewing the debtor’s operations, reviewing potential causes of action, negotiating a plan, etc. The formation of a subcommittee can enable the committee to operate more efficiently by allowing those with a special interest or expertise in a particular activity to play a primary role. In any event, major decisions which impact the administration of the bankruptcy case should be brought to the full committee for a vote. Notwithstanding the extensive powers and duties of a committee in a bankruptcy case, there is no requirement that the committee engage in every activity available to it. Judgments about the extent of committee involvement must be based on the availability of information, the cost of obtaining information, and whether the size of the case and the significance of the issues justify an investigation and response. Decisions concerning the degree of the activity of the committee and the actual conduct of committee business must be made on a case-by-case basis and, further, within any given bankruptcy case, on a matter-by-matter basis.
The Committee also has a duty to solicit and receive comments from the other creditors in that class whom are not on the committee and may be compelled by the court to disclose relevant information about the case to those non-committee members.
The committee has flexibility as to how formally or informally it wishes to conduct its business. As with the degree of involvement, the degree of formality is normally a function of the size of the case and the significance of the matter being voted upon. For example, in larger cases where there is a great deal at stake, formality should probably be observed with respect to all committee business. On the other hand, in smaller cases, the amount at stake probably does not justify the time and expense of maintaining a high degree of formality. Even in small cases, however, significant decisions such as voting to oppose a proposed plan of reorganization or seeking the appointment of a Chapter 11 trustee or the conversion of a case to Chapter 7 should be by formal vote.
By-laws are a useful mechanism for formalizing the rules governing the conduct of committee business. The adoption may be a useful exercise if for no other reason than to clearly define the mechanism for calling committee meetings, conducting committee business, and recording minutes. A sample set of by-laws is attached to this guidebook as Appendix “A.”
As discussed above, one of the powers of the committee is to retain counsel, accountants, or other professionals to aid it in conducting its business. Not surprisingly, the size of the case and the issues at hand will determine what kinds of professionals the committee needs. At a minimum, the committee should retain counsel. An attorney can engage in discussions with counsel for the debtor concerning administration of the bankruptcy case, advise the committee on legal issues arising in the bankruptcy case, and will have the licensing necessary to appear for the committee in court proceedings.
Counsel may not, however, be qualified to perform accounting functions, appraisal functions, or other functions which may be necessitated by the particular circumstances of the case. Authorization to retain these other types of professionals can be sought when the members of the committee believe it necessary to help the committee conduct one or more of its duties.
Each professional must be approved by the bankruptcy court before he can begin to perform services on behalf of the committee and be entitled to compensation. The court must make a finding that the professional is a “disinterested person” and that he does not represent an interest adverse to the bankruptcy estate.
The Bankruptcy Code provides for the bankruptcy estate to pay the fees of all committee professionals. The fees of these professionals are treated as a first priority administrative expense claim against the bankruptcy estate. While this priority is higher than that of general unsecured creditors, it is obviously subordinate to the liens of secured creditors. Accordingly, there is no guarantee that professionals will get paid in a bankruptcy case if there are secured creditors with liens on all, or substantially all, of the debtor’s assets.
Compensation is ordinarily sought by a fee application. Notice of fee applications is generally distributed to all creditors. All creditors have an opportunity to review and challenge the fees sought from the bankruptcy estate by any professional in a bankruptcy case, whether it be a professional retained by the committee, debtor, or any other party.
It should be noted that while committee professionals are paid before unsecured creditors, no individual unsecured creditor is forced to bear the total expense alone. The effect of the priority is to have the expense of committee professionals shared, pro rata, by all of the members of the unsecured creditors’ class. This certainly makes sense as the work of the committee, and therefore its professionals, benefits the entire class of unsecured creditors. It is certainly cheaper for unsecured creditors to indirectly bear the expense of professionals pro rata than to have each to bear the entire expense of individual professional representation.
While professionals generally look to the bankruptcy estate in the first instance for payment, there is nothing to prohibit the committee from making arrangements to guarantee the professional’s fees. For example, substantially all of the debtor’s assets may be subject to security interests in which case the committee may have difficulty convincing professionals to represent it. In that instance, the committee could decide itself, or together with other non-committee unsecured creditors, to guarantee payment to counsel or other professionals, in order to get the benefit of representation. However, unless the committee members have expressly agreed to guarantee the professionals’ fees, they are not obligated for those fees, and committee counsel or other professionals will be entitled to look only to the debtor’s assets for compensation.
I. Reimbursement of Committee Expenses
The Bankruptcy Reform Act of 1994 amended the Code to make express provision for the reimbursement of the out-of-pocket expenses of the individual committee members incurred as a result of committee participation. Expenses could include such things as travel, mailing and copying costs, telephone expenses, etc. The expenses must be reasonable and necessary. Reimbursement for these expenses can be sought by application to the court. Requests for reimbursement must be supported by detailed records.
The Bankruptcy Code contains no express provision for the termination of the committee. It is generally presumed that the committee terminates at the conclusion of the Chapter 11, whether that conclusion be the result of a conversion to Chapter 7, the dismissal of the bankruptcy case, or the confirmation of a Chapter 11 plan. However, there are differing opinions. One recent opinion held that a committee continues beyond confirmation of the plan through to plan “consummation.” Another recent opinion held that the committee may continue to exist (and perform services) following a conversion to Chapter 7 under certain circumstances.
In the event of a dismissal of the bankruptcy case and in most conversions, it is clear that there are no further functions for the committee to perform and the committee should be considered to be dissolved. In the event of confirmation of a Chapter 11 plan, the matter is not quite as clear. Plans often involve some amount of post- confirmation “wrap up” that may require some amount of committee monitoring (if not active committee participation). It is this type of situation where the issue normally arises.
The prudent practice is for the committee to insist upon some provision to be written into a plan providing for a description of its post-confirmation powers and duties and its right to continue to be represented by counsel where the plan proposes any treatment for unsecured creditors that will not be fully consummated on the effective date of the plan. To the extent that the committee negotiates a plan which leaves it to the unsecured creditors to pursue their state law rights in the event of a default under the plan, this should be made clear in the plan and in a post- confirmation mailing. The committee will want to make sure that its constituency understands at what point the committee’s obligations end and the obligations of the individual unsecured creditors’ to enforce their own rights are resumed.
K. Qualified Immunity of Committee Members
Committee members have been held by several courts to enjoy a “qualified immunity” for acts taken within the scope of their authority as conferred by statute or by the court. This means that the committee members are immune from suit for acts within the scope of the committee authority unless the challenged conduct amounted to “willful misconduct.” Committee business should always be conducted in a manner to preserve that qualified immunity.
II. BUSINESS ISSUES IN A TURNAROUND
A. Distinguishing Between Legal and Business Issues in a Chapter 11
Chapter 11 is a legal process. The administration of a Chapter 11 case is governed by legal statutes and rules, and many issues are resolved by the court during the course of legal hearings. The legal aspects of a Chapter 11 will significantly impact its course. However, a Chapter 11 reorganization remains, at its core, a business situation. No amount of legal maneuvering will save a business which cannot be operated profitably.
The term “turnaround” generally refers to steps taken to change the operations of a business to improve its profitability. A situation demanding a turnaround is one where the business has been performing persistently below some minimally acceptable level. Actions taken to turnaround a business can include, but not be limited to: the reduction of expenses; the elimination of unprofitable products, product lines, divisions, etc.; reduction of capital required to operate the business; etc. The term “workout” generally refers to the negotiations that result in a change in a company’s obligations or financial structure, for example, extending or reducing payments to lenders and creditors, converting debt into equity, etc. Most turnarounds are accompanied by a workout.
Turnarounds and their related workout activities can occur outside of a Chapter 11 proceeding. In fact, most experienced turnaround managers and consultants prefer “out-of-court” workouts. Reasons for avoiding Chapter 11 include, but are not limited to, the risk of loss of control which exists in a Chapter 11, the expense of a Chapter 11 proceeding, the additional time imposed upon managerial resources by the legal requirements of a Chapter 11 proceeding, and the stigma of a bankruptcy filing. Management in a Chapter 11 proceeding operates in what has often been referred to as a “fishbowl.” Every management decision is subject to micro analysis.
On the other hand, Chapter 11 provides significant tools to aid a business in both the turnaround and workout. Chapter 11 provides for an automatic stay which provides the debtor time to implement a turnaround strategy and to seek the approval of its creditors, allows a debtor to obtain new financing in ways that are generally not available outside of bankruptcy, allows sales free and clear of liens, allows a debtor to reject burdensome contracts and leases, and allows a debtor to avoid and recover certain prepetition transfers. Whether the turnaround occurs in or out of court, many of the principles are the same.
B. The Turnaround as a Distinct Business Strategy
It has been observed by Donald Hambrick, an author of a number of articles on turnaround strategy, that, in order to warrant a classification as a distinct business strategy, there must be something which distinguishes the turnaround from other types of business strategic settings. Hambrick suggests that there are four factors which serve to set turnaround situations apart from other strategic settings, those being:
- limited resources;
- poor internal morale;
- skeptical stakeholders;
- and urgency.
Outside of Chapter 11 there may be some benefit to going through the exercise of clearly defining a situation as being one requiring a “turnaround” and, further, specifically identifying those factors which set the situation apart from other business situations. In Chapter 11, the fact that a business has operated persistently below some minimally accepted level and has limited resources, poor internal morale, skeptical (if not hostile) stakeholders, and urgency, can be taken for granted. However, the debtor occasionally forgets these factors because the automatic stay insulates it from its stakeholders, gives it the ability to use available resources, alleviates the urgency, etc. One function which the committee can perform during the course of the case is to remind the debtor that the four factors defining the situation as a turnaround have not gone away simply because of the Chapter 11 filing.
Much of the literature on the turnaround process refers to distinct stages. For example, one author identified three stages, those being crisis, stabilization and rebuilding. The Association of Certified Turnaround Professionals, in its body of knowledge outline, identifies five stages, those being the management change stage, the situation analysis stage, the emergency action stage, the business restructuring stage, and the return to normal stage. Some practitioners do not separately identify a situation analysis stage, instead suggesting that evaluation must continue throughout the turnaround process.
Although identifying distinct stages, the literature acknowledges that the stages overlap and that it is often impossible to identify, in any turnaround, the exact point where one stage ends and the next begins. The benefit of recognizing the existence of different stages is to highlight the ground which needs to be covered during the course of the process.
In the context of a Chapter 11 case, we would suggest that the committee think in terms of a four-stage process, that being as follows:
- Stage I – the Chapter 11 filing and operational stabilization;
- Stage II – situation analysis;
- Stage III – strategy formulation; and
- Stage IV – strategy implementation.
Again, it is important to remember that these are not distinct stages with readily ascertainable beginnings and ends. Instead, there will be extensive overlap.
D. Stage I – the Chapter 11 Filing and Stabilization
There is a flurry of activity associated with a Chapter 11 filing.
There are a number of legal documents which must be prepared immediately following the bankruptcy filing. These documents include the voluntary petition, the schedules showing the debtor’s assets and liabilities as of the date of the bankruptcy filing, and a statement of financial affairs. The debtor will also be filing applications seeking court approval of its counsel and other professionals it wishes to retain, and may ask for authorization to take certain actions, such as to pay accrued salaries and employee benefits. The debtor will, immediately following the filing, be gearing itself up to deal with the administrative burdens of a Chapter 11.
Other parties with an interest in the case, such as secured creditors, landlords, major suppliers, shareholder groups, and, of course, the unsecured creditors’ committee, will also be getting organized and retaining professionals. To a certain extent, all of the parties will be evaluating the implications of the filing and determining preliminary strategies.
One significant matter which frequently arises extremely early in the case is postpetition financing. To the extent that creditors have liens on a debtor’s inventory, accounts receivable, cash, and other assets readily converted to cash, the debtor will need court approval (or the consent of the secured creditor) before using the cash or cash proceeds. In addition, the debtor’s current working capital might have been inadequate and postpetition financing must be obtained (called “Debtor-in- Possession” or “DIP” financing). Many banks and commercial finance companies have units capable of providing DIP financing.
At the same time that the debtor is negotiating (or litigating) the use of cash and cash proceeds or seeking authority to enter into some sort of DIP financing, it should also be taking steps to improve operating cash flow.
In turnaround literature, establishing positive operating cash flow (i.e., stopping the bleeding) is normally considered the first stage of the turnaround process. While the committee must take steps to protect the interests of unsecured creditors with respect to all legal proceedings occurring at the outset of the case, it must also satisfy itself that the debtor is taking steps to immediately maximize positive operating cash flow. If the debtor is not, then helping the debtor to focus on the need to do that should be among the first priorities.
The actual steps taken to maximize positive operating cash flow depends upon the situation. There are, however, some general principals.
First, the debtor needs to “get a handle” on cash flow. In order to “get a handle” on cash flow, it is necessary for it to:
- determine the actual cash availability;
- prepare projections for cash availability and usage (at least for the first 60 to 90 days of the bankruptcy case); and
- prepare a mechanism for monitoring and controlling cash flow.
The committee can review the debtor’s determination of actual cash availability, its projections, and the mechanism which it has implemented in order to monitor and control cash flow.
Monitoring can include weekly reports of key financial information such as; sales, accounts receivable; inventory (raw material, work in progress, and finished goods); contract backlog; availability under credit line(s); cash disbursements; accrued payables (including taxes); gross profit margin; etc.
Secondly, the debtor must identify and implement a plan for improving cash flow. The debtor can pursue both balance sheet and income statement strategies.
The most basic income statement strategy is to reduce expenses to the absolute minimum necessary to maintain operations.
Balance sheet strategies include consolidating all cash accounts, taking steps to reduce days outstanding for accounts receivable (and collect overdue accounts), being more careful about extensions of credit (based on the philosophy that the debtor is better off with lost sales than bad debt), seeking to discount notes and other receivables, avoiding expense prepayment, and liquidating surplus inventory and plant, property and equipment. With respect to the liquidation of inventory, plant, property and equipment, and discounting notes and other receivables, the goal should be to realize the fair market value for the assets. The fact that the sale would result in the debtor’s reporting a loss because book value exceeds fair market value is irrelevant. As long as fair market value is being obtained, cash flow becomes more important than reportable profits.
In a typical turnaround situation, accounts payable may be perceived as a potential source of cash. That is an unacceptable source of cash in a Chapter 11. The committee should monitor and oppose any buildup of postpetition administrative expense claims (which would include unpaid postpetition trade credit). Any buildup of post-Chapter 11 expenses needs to be subtracted from the month-to-month cash flow in order to determine if cash flow is really improving.
E. Stage II – Situation Analysis
There are essentially two aspects to situation analysis. The first is to determine whether the debtor’s business is viable. The second is to determine the return to unsecured creditors if the business were liquidated.
(1) Determination of Operational Viability
To a certain extent, the determination of operational viability and strategy formulation go hand in hand. Whether the business is viable may depend upon assumed changes to the debtor’s operations. For example, operational viability may change depending upon how may products or product lines are retained, how many operating assets are retained, how many employees are retained, etc.
Within the context of the debtor’s strategic assumptions, some degree of operational analysis can and should be done. The types of things which would aid the committee (and the debtor) in doing an operational analysis include the following:
- cash projections (through at least one business cycle) together with the assumptions relied upon by the debtor in creating the projections (with sensitivity analysis);
- a break-even analysis (together with a detailed allocation of the debtor’s costs between those perceived to be fixed and those perceived to be variable);
- a thorough analysis of assets in order to identify which ones are necessary and which ones are surplus;
- a review of the debtor’s information systems (i.e., identifying exactly what kinds of information the debtor’s management is receiving on a daily, weekly and monthly basis and whether that information is sufficient to effectively manage the business );
- the capability of the debtor’s management;
- the debtor’s competitive position in light of its intra-industry competitors, its suppliers, its customers, substitute products, and potential entrants to its industry;
- whether the debtor has any competitive advantages; and(viii) projected income statements, balance sheets, and statements of cash flow (with sensitivity analysis).
What the debtor actually prepares and what is available is a function of the level of sophistication of the debtor and its management and the size of the case. In a large case, one would expect fairly sophisticated strategic analyses, well-defined assumptions, and extensive projections of financial statements. In smaller cases, the available documentation will be significantly less. Regardless of the size of the case, the committee should satisfy itself that some level of operational analysis has been done and that there is some reason to believe that the debtor can operate profitably and generate positive cash flow if its plan is confirmed. If the debtor is not showing evidence of positive operating cash flow during the course of the Chapter 11 case and has offered no viable strategy for achieving positive operating cash flow and profitability, the turnaround will probably be unsuccessful and should be aborted.
(2) Evaluate Liquidation Value
One of the most important functions of a creditors’ committee is to determine the liquidation value of the debtor. Liquidation can, of course, be accomplished in bulk or piecemeal. Liquidation values can range from that for the ongoing business (if the business can be sold as an ongoing operating entity), through an orderly piecemeal liquidation (the debtor liquidates while it continues to operate), to the forced liquidation of the various assets in a single auction. The actual methodology used for determining value depends upon the circumstances of the case.
The causes of action need not be considered as part of the liquidation analysis. Causes of action can generally be pursued whether the company liquidates or not. While the pursuit of causes of action should be dealt with at (or before) the time of plan negotiations, they are not necessarily relevant to a determination of whether the business can be turned around.
In addition to carefully analyzing the liquidation value of the debtor’s assets, the committee also needs to carefully analyze the various classes of creditors, the respective priorities of their claims, and the validity of those claims. This will allow the committee to determine how far the proceeds in a liquidation will reach.
The more likely that a liquidation will yield some return to unsecured creditors, the more aggressive the committee would need to be in demanding evidence that the debtor has a viable turnaround in prospect. Absent such evidence, the committee would need to seriously consider the liquidation alternative.
F. Stage III – Strategy Formulation
There are several generic turnaround strategies which a debtor can pursue. These would include increasing revenues, cutting costs, downsizing the scope of operations, liquidation of surplus assets, and/or some combination.
The committee should demand a clear statement as to the debtor’s reorganization strategy, request a list of factors which leads the debtor to believe that the strategy is viable, ask for a list of steps which the debtor proposes to take in order to implement the strategy, a timetable for implementation, and, finally, a set of projected financial statements showing the anticipated effect of the implementation of the strategy.
The committee may also want to consider (if available) a sensitivity analysis involving a range of assumptions (from best to worst case), along with “fall back” strategies and contingency plans. The existence of this information would show, if nothing else, the extent of the debtor’s analysis. Of course, how much of this information can reasonably be expected to be available is a function of the size of the case and the sophistication of the debtor.
The committee should identify the specific implementation steps which need to be taken within the Chapter 11 and those which can be taken after the confirmation of a reorganization plan. If plan feasibility requires the steps to have been taken before a plan is confirmed, a timetable for the implementation of those steps should be obtained. If the steps are proposed to be done in a plan, a timetable should be provided in the plan or disclosure statement.
Benchmarks should be chosen and the implementation process monitored. The committee will want to see evidence that the turnaround is proceeding (on schedule) and that the process is resulting in operational improvements.
The Bankruptcy Code is said to have essentially three purposes. Those purposes are not mutually exclusive and may overlap.
The first of those three purposes is to allow the debtor a “fresh start.” This purpose is ordinarily associated with individuals in Chapter 7. It is accomplished by the liquidation of all of the debtor’s nonexempt assets and the distribution of the proceeds to the creditors. The debtor gets a discharge of his debts in return for giving up his nonexempt assets.
A second purpose is to effect an “equitable distribution” of the debtor’s assets among his/its creditors. An equitable distribution requires that creditors of a higher priority ranking be paid before creditors of a lower priority ranking, and that creditors of equal rank share pro rata. This equitable distribution purpose is more closely associated with a liquidation, be it a liquidation of an individual or business debtor, but is also achieved in a reorganization. The realization of an equitable distribution is aided by the automatic stay which prevents continued collection activity by individual creditors.
The final of the three purposes of the Bankruptcy Code is to allow for the reorganization of debts so as to allow the debtor to remain in possession of his/its assets, and to the extent the debtor is in business, to remain operating and therefore provide jobs, contribute to the country’s productivity, etc. This final purpose is mainly achieved by a Chapter 11 reorganization. It is aided by the automatic stay preventing all collection activities while the debtor rehabilitates its business and negotiates a payback with its creditors. To the extent a plan of reorganization is confirmed, all pre-confirmation debt, except as retained in the plan, is discharged.
Some knowledge of the liquidation procedure in a Chapter 7 is useful in understanding Chapter 11.
Upon the filing of a bankruptcy case, whether in Chapter 11 or 7, a “bankruptcy estate” is formed. Section 541 of the Bankruptcy Code defines what constitutes property of the bankruptcy estate. “Property of the estate” generally includes all of the tangible and intangible assets of the debtor as of the date of the bankruptcy filing.
In a Chapter 7, an “interim trustee” is immediately appointed by the “U.S. Trustee” to take control of the “bankruptcy estate.” The U.S. Trustee is an arm of the United States Justice Department which has the obligation to monitor bankruptcy cases and to aid in the administration of those cases. Among the duties of the U.S. Trustee is the maintenance of a panel of individuals who are available to be appointed as trustees in bankruptcy cases.
The “interim Chapter 7 trustee” (or his successor as voted by the creditors at the Chapter 7 Section 341 meeting), will, in accordance with the provisions of Chapter 7, liquidate all of the assets of the bankruptcy estate and distribute the proceeds of the liquidation to the various classes of creditors in accordance with statutory priorities.
While there is a provision in Chapter 7 for the formation of a creditors’ committee at the Section 341 meeting, the function of that committee is limited. The members of the Chapter 7 creditors’ committee may consult with the Chapter 7 trustee or the U. S. Trustee in connection with the administration of the estate, make recommendations to the Chapter 7 trustee and the U.S. Trustee respecting the performance of the Chapter 7 trustee’s duties, and submit to the court or the U.S. Trustee any questions affe cting the administration of the estate. That committee does not, however, have authorization to take any affirmative actions on its own or to be represented by professionals. The philosophy behind limiting the function of a Chapter 7 creditors’ committee is that the duties of the committee are generally performed by the Chapter 7 trustee.
The Bankruptcy Code provides for different levels of priority for the claims against the bankruptcy estate. An appreciation of the different priorities is useful for an understanding of Chapter 11.
Secured creditors are paid first with respect to funds generated by the liquidation of assets in which they have perfected liens. To the extent the value of the collateral is insufficient to pay secured creditors’ claims in full, the deficiency will generally be treated as a general unsecured claim. There are some limited circumstances under which a deficiency claim will be granted a priority over all other claims.
Normally, the highest level of priority after secured creditors is that of debts incurred in the “ordinary course” of the debtor’s postpetition operation or liquidation, or as otherwise authorized by the bankruptcy court. These are referred to as “administrative expense” claims. Administrative expense claims arise in both Chapters 7 and 11. When a case is converted from Chapter 11 to 7, Chapter 7 administrative expenses will generally have priority over Chapter 11 administrative expenses.
Subordinate to administrative expense claims are prepetition priority claims which include “gap” claims (debts incurred between the date of an involuntary petition and the date an order for relief is entered), certain prepetition wage and benefit claims, and certain tax claims.
General unsecured creditors come last, followed only by shareholders or other “interest holders.” Occasionally, there may be classes of creditors subordinated to the class of unsecured creditors either by agreement or by court order.
A. Creation of Estate and Duties of Debtor-in-Possession
In Chapter 11, like Chapter 7, upon the filing of the case essentially all of the assets of the debtor become property of the bankruptcy estate. However, unlike Chapter 7, a trustee is not appointed. Instead, the debtor filing the case is “transformed” into a new entity which is referred to as the “debtor-in-possession.” The debtor-in-possession (“DIP”) has many of the rights and the duties of a bankruptcy trustee. Those duties include, but are not limited to: operating the business; being accountable to the creditors for all property received; examining proofs of claims and objecting to the allowance of any claim that is improper; furnishing such information concerning the estate and the estate’s administration as is requested by any party-in-interest; filing the tax returns and operating statements required under applicable tax laws and under Bankruptcy Rules; and filing as soon as practicable a plan of reorganization and, after confirmation of the plan, filing such reports as are necessary to close the bankruptcy estate.
B. Right to Continue to Operate Business
A DIP has authorization to operate the business unless otherwise ordered by the bankruptcy court. The DIP’s right to conduct ordinary course of business transactions continues after the bankruptcy filing (“postpetition”) unaffected by the bankruptcy filing. The right to engage in day-to-day transactions without bankruptcy court (and creditor) interference is well recognized by the courts. In one reported decision, a court denied a request by trade creditors to be given veto power over certain ordinary course of business decisions by the debtor. The court decided that neither it, nor the creditors, had authority to interfere with the day-to-day business decisions of a DIP. The court indicated that the trade creditors could, if they felt that the management was incompetent, seek the appointment of a Chapter 11 trustee or an examiner.
On the other hand, matters that are not simple day-to-day ordinary course of business decisions are subject to court and creditor review. One way of determining whether a matter is “ordinary course” is to examine whether it involves the commitment of a “significant” amount of the debtor’s resources. Matters involving a significant portion of the debtor’s assets are typically not “ordinary course.” A less subjective method for determining whether a transaction is “ordinary course” is to look at whether the transaction was regular and reoccurring during the course of the debtor’s prepetition business operations and/or whether the transaction is regular and reoccurring among other businesses in the debtor’s industry. For example, opening and closing stores might be considered “ordinary course” for a debtor which operates a total of 75 retail outlets, whereas the opening or closing of a single location would not be ordinary course for an entity which operates one or two locations.
Under normal circumstances, a DIP must file a motion seeking court authorization to engage in any transaction which is not “ordinary course.” One of the functions of a Chapter 11 creditors’ committee is to evaluate such motions and make a decision whether it should be supported or opposed based on legal and business ramifications.
During the first 120 days following the filing of the Chapter 11 petition, the DIP has the exclusive right to file a plan of reorganization. The DIP can seek an extension of that exclusive period as long as the request has been filed before the period expires. If the plan is filed within the original (or extended) exclusive period, the DIP has 60 additional days to obtain acceptances from the creditors. Previously, Debtors would often request extension after extension to the exclusivity period, sometimes holding the exclusive right to file the plan for several years. However, the 2005 amendments to the Code prevent this behavior, mandating that the exclusivity period may not be extended beyond a 18 months after the date the petition was filed. After the expiration or termination of the exclusive period, any party-in-interest, including the committee, can propose a plan.
In some case, the right to be the exclusive proponent of a plan is an important source of negotiating power. As a practical matter, however, whether the extension of the right of exclusivity is important depends upon the ability of a party other than the debtor to formulate and implement a plan of its own.
In addition to the “plan” document, a proponent of a plan must prepare a “disclosure statement.” The disclosure statement is a document which provides supplemental information, as far as is practicable in light of the condition of the debtor’s books and records, that would enable a hypothetical reasonable “investor,” typical of the holders of claims against the debtor, to make an informed judgment about the reorganization plan. The Code uses the term “investor” is used since voting on the plan by those who are having their legal rights modified is an “investment” type decision.
Expanding upon the “investor” analogy, the disclosure statement can be thought of as being similar to a “prospectus.” It generally contains financial and qualitative information that should help creditors to make an intelligent and informed decision a bout the plan.
Typically, a disclosure statement contains financial projections, a liquidation analysis (for comparison to the plan payout), a discussion of the debtor’s history and factors causing the bankruptcy filing, a review of what the debtor has accomplished since the filing, a description of the debtor’s strategy for the rehabilitation of the business, and a summary of the plan.
Disclosure statements may also include some or all of the following:
- A description of the available assets and their value.
- The anticipated future of the company.
- The sources of information relied upon in preparing the disclosure statement.
- A discussion of scheduled claims.
- The accounting methods utilized to produce financial information and the name of the accountants responsible for that information.
- The future management of the debtor.
- The estimated administrative expenses of the Chapter 11 including attorneys and accountants fees.
- The collectability of accounts receivable and other matters relevant to cashflow.
- Information relevant to the risks of the plan.
- The actual or projected values of various pending litigation including the recovery of preferential transfers.
- Tax attributes of the debtor.
- Relationship of the debtor with affiliates.
The funding for a plan of reorganization can come from a number of different sources although it will usually involve one or more of the following:
- the continued operation of the business;
- the liquidation of assets in part or in total; and
- a third-party investor or lender.
When a debtor proposes to rely totally on future operations to fund plan payments, the plan is often referred to as a “stand alone” or “bootstrap” plan. The feasibility of such a plan is, of course, dependent upon the prospects of the debtor and its industry and the degree to which the debtor rehabilitated its business during the administration of the bankruptcy case.
As indicated, the debtor can also fund plan payments through the liquidation of some or all of its assets or through the solicitation of outside investors or lenders. It should be noted that there is nothing in Chapter 11 which precludes a liquidation plan which proposes to sell all of the assets of the debtor, either piecemeal or in bulk. However, liquidations in Chapter 11 are generally disfavored by the courts. In the situation where the debtor intends to liquidate all of its assets, the committee should seek the conversion of the case to Chapter 7 absent some compelling reason for keeping the case in Chapter 11. A compelling reason might be the inability to find a Chapter 7 trustee (because of potential environmental liability), special expertise on the part of the debtor necessary to maximize the value of the assets in liquidation, and/or the potential for a dispute over the distribution of the proceeds because of competing claims that might be more easily resolved in Chapter 11 negotiations than in a Chapter 7 liquidation.
Section 1123 of the Bankruptcy Code lists the items which must be included in a plan of reorganization. A plan must:
- designate classes of claims, each class to contain only those claims which are substantially similar to each other;
- specify all classes of claims or interests that are not impaired, i.e., do not contain members whose rights to payment are being modified in the plan either in amount, manner of payment, or contractual terms;
- provide the same treatment for each claim or interest of a particular class unless the holder of the particular claim or interest agrees to a less favorable treatment;
- provide adequate means for the plan’s implementation, such as:
- retention of all or any part of the property of the estate in the continued operation of the business;
- transfer of all or any part of the property of the debtor to one or more entities, whether organized before or after the confirmation of the plan;
- merger or consolidation of the debtor with one or more entities;
- sale of all or any part of the property of the estate, either subject to or free of any liens, or the distribution of all or any part of the property of estate among those having an interest in such property of the estate;
- satisfaction or modification of any liens;
- cancellation or modification of any indenture or similar instrument;
- curing or waiving of any default under any contracts;
- extension of a maturity date or a change in interest rates or other term of outstanding debt obligations;
- amendment of the debtor’s charter; and/or
- issuance of securities (stock, notes, debentures, etc.) for cash, for property, for existing securities, or an exchange for claims or interest, or for any other appropriate purposes.
In addition, a plan may:
- impair or leave unimpaired any class of claims, secured or unsecured, or any interest;
- provide for the assumption, rejection, or assignment of any executory contract or unexpired lease not previously rejected prior to confirmation; and
- provide for the settlement or adjustment of any claim or interest belonging to the debtor or to the estate or for the retention and enforcement by the debtor or by a representative of the estate appointed for such purpose.
The process for plan confirmation commences with the preparation of the plan and disclosure statement and the filing of those documents with the court. The court then conducts a hearing on the disclosure statement in order to ascertain whether it contains “adequate information.” If it is determined that it does not, the debtor is ordinarily given an opportunity to amend. Once the disclosure statement is found to contain adequate information, it and the plan are distributed to the creditors for a vote.
The court will enter an order which will set the deadline for voting on the plan and for filing objections to the plan. The order will also schedule the date, time and place for the hearing on plan confirmation. The order setting the deadlines for voting and the confirmation hearing will be included with the plan and disclosure statement when they are sent to the creditors for voting.
Only members of impaired classes who are to receive some distribution under the plan are entitled to vote on the plan. Unimpaired classes, i.e., classes whose rights are not modified in any fashion, and impaired classes who receive absolutely nothing under the plan, are not entitled to vote. Unimpaired classes are deemed to have accepted the plan and impaired classes who receive nothing under the plan are deemed to have rejected the plan. A voting class of creditors is deemed to have accepted a plan if of those claims in the class voting on the plan, at least two-thirds in dollar amount and over one-half in number vote in favor of the plan. Accordingly, a minority of the claims in a class can control the class if only a minority of the members of the class vote. If the committee feels strongly about the plan, one way or the other, it is important for it to advise members of its class to vote.
H. Requirements for Plan Confirmation
Section 1129 of the Bankruptcy Code identifies the requirements for plan approval (“confirmation”). The court must find that the requirements have been satisfied before “confirming” the plan. The most significant of the confirmation requirements are as follows:
- the plan and the plan proponent must have complied with applicable provisions of the bankruptcy Code;
- the plan must have been proposed in good faith and not by any means forbidden by law;
- payments to be made under the plan must have been identified in the plan;
- post-confirmation officers and directors and the compensation to be paid to those officers and directors must have been identified in the plan or disclosure statement;
- payments to Chapter 11 administrative expense claimants must be scheduled to be paid on the effective date of the plan, and payments to other priority creditors must be scheduled to be made within the periods of time allowed within the Code (unless th e claimants have agreed to some other treatment);
- all impaired classes of claims and interests must have voted in favor of the plan;
- the plan must be feasible, i.e., not likely to be followed by a liquidation, or the need for further financial reorganization (unless such liquidation or reorganization is expressly proposed in the plan); and
- the plan must be in the “best interest of the creditors.”
I. Requirement That Plan Satisfies “Best Interests of Creditors” Test
The “best interests of creditors” test requires that creditors not voting, or voting against the plan, receive, on account of the plan, at least as much as they would have received in a Chapter 7 liquidation. This is an important requirement since a class may be deemed to have accepted a plan, notwithstanding the fact that some members of the class voted against the plan. Even though the dissenting and non-voting members of a class will be bound by the plan, the “best interest of creditors” test is suppose to guarantee that they will not be worse off under the plan than they would have been in a Chapter 7.
J. Requirement That all Impaired Classes Have Voted in Favor of the Plan (“Cramdown”)
Another important element of plan confirmation is the requirement that all impaired classes have voted in favor of the plan. However, this requirement can be overcome provided certain conditions are met. This is the only requirement for plan confirmation that can be overcome. In the event that there are impaired class(es) who have voted against the plan, or have been deemed, because of no distribution, to have rejected the plan, the plan may still be confirmed providing that the court finds that: (1 ) at least one impaired class has accepted the plan; (2) the plan is fair and equitable; and (3) the plan does not violate the “absolute priority rule.”
Confirmation of a plan notwithstanding the rejection of it by one or more impaired classes is termed “cramdown.”
The requirement that at least one impaired class has accepted the plan is fairly self-explanatory. It prevents a “cramdown” of a plan which had no impaired classes accepting the plan. The “fair and equitable” requirement is not defined within the Code but appears to be interpreted by the courts as imposing a sort of “commercial reasonableness” on the treatment of an impaired class. This condition for cramdown is often made an issue when the treatment to be crammed down is against a secured creditor. For example, courts often refuse to “cram down” a plan against a secured creditor when the plan provides for a period of negative amortization. If there is no equity cushion and/or the collateral is decreasing in value, a period of negative amortization is simply not “commercially reasonable.”
Notwithstanding its more common use by secured creditors, the “fair and equitable” standard also protects unsecured creditors and may be cited in opposition to a plan which proposes treatment that may technically satisfy the “absolute priority rule,” but is not otherwise commercially reasonable.
“Fair and equitable” treatment includes satisfying the “absolute priority rule.” However, satisfaction of the absolute priority rule does not definitively make the plan “fair and equitable.” Therefore, the satisfaction of the absolute priority rule can be thought of as a separate condition. The absolute priority rule requires that a higher priority class be paid in full before a subordinate class receives any distribution on account of its claim (or interest).
Under the absolute priority rule, the class of unsecured creditors are entitled to be paid in full before a subordinate class, such as equity interest holders, receive any distribution under the plan, including the retention of an equity interest.
The absolute priority rule can be an extremely important negotiating point if the debtor’s reorganization stock will have any value. Where, however, the value of the debtor as an ongoing business is entirely dependent upon the equity interest holder(s)’ willingness to continue to run the business, particularly in the case of small Chapter 11’s where the owner(s) of the business also manage it, the protection of the absolute priority rule becomes less significant. Unsecured creditors may often find it prudent to agree to allow equity to retain its stock if that is necessary to preserve current management, notwithstanding the fact that unsecured creditors receive less than 100 cents on the dollar.
One last point needs to be made about the “absolute priority rule.” There is an ongoing controversy about whether there is a “new value exception” to the absolute priority rule. The “new value exception” existed under the old Bankruptcy Act. It provided that equity interest holders could retain their equity interest even if unsecured creditors were not being paid 100 cents on the dollar if equity provided new economic value to the debtor which was: (1) necessary for the reorganization; and (2) was in a substantial amount. Some courts have found that the “new value exception” did not survive the enactment of the present Bankruptcy Code. Whether the “exception” becomes an issue in any case depends upon the facts of the particular bankruptcy case (including whether equity has the funds to make a “new value” investment).
All of the above factors, along with the feasible alternatives (if any), must be considered when negotiating a plan. The most common alternative is liquidation. The committee should determine what the likely distribution to unsecured creditors would be under other scenarios (including liquidation) and negotiate a distribution to unsecured creditors consistent with what it believes is the best that can be achieved under the circumstances (i.e., the committee must identify its best alternative to a negotiated agreement with the debtor and negotiate in light of the return to unsecured creditors under that alternative). While more is always desired, it is sometimes necessary to accept less in order to assure the feasibility of the plan and, therefore, some distribution to unsecured creditors.
In addition to the actual dollar amounts, the committee should also pay particular attention to the terms of the plan to the extent that the plan proposes to pay unsecured creditors over time out of future operations (“bootstrap” plan). Terms to be considered should include, but not be limited to:
- some provision for monitoring the debtor’s compliance with the plan including periodic reports to unsecured creditors;
- some means of monitoring the debtor’s post-confirmation operations including the distribution of periodic financial statements;
- some means of securing distributions such as obtaining a security interest on behalf of the class of unsecured creditors; and/or
- provisions for the acceleration of debt in the event of a default, the identification of incidents of default, and the identification of remedies in the event of default including the right to sue for default under the plan in state court.
The actual terms negotiated are controlled by feasibility and basic business judgment.
L. Alternatives to Debtor’s Plan
In addition to a consideration of the particular elements of a plan and the requirements for confirmation, the committee must also consider alternatives to the debtor’s plan. Mentioned above was the option of seeking the liquidation of the debtor. Other alternatives include seeking the dismissal of the bankruptcy case and the preparation of a committee plan of reorganization (or liquidation).
Dismissal of the bankruptcy case constitutes a termination of the process. All parties are put back into the positions (insofar as is practicable) they had on the day of the filing.
While dismissal is certainly an option which the committee could elect to pursue, it does not satisfy any of the purposes of bankruptcy including equitable distribution. On the other hand, where there is absolutely no cooperation from the debtor and/or there is no prospect for a successful reorganization, and the nature of the case suggests that a liquidation will be difficult if not impossible, dismissal will at least get the case out of bankruptcy and allow those unsecured creditors who are so inclined to pursue their state law rights. Of course, in the situation where the debtor is solvent or substantially solvent and a dismissal may result in severe consequences to debtor’s management or owners, the threat may lead to improved cooperation.
Another alternative is a committee plan. Committee plans will generally take one of two forms. One is to provide for the cancellation of all existing stock and the issuance of new stock to the creditors. Under this form, the plan could provide for t he members of the committee to serve as the initial board of directors of the reorganized debtor. Whether this is a viable alternative depends upon the nature of the business, the make-up of the committee and the committee members’ willingness to serve as the board of directors, the ability to locate operating managers, and finally, the financial condition of the debtor (including working capital). While such a plan is often complex and extremely difficult to implement, it is an option which is available to the committee and should be considered. The other alternative would be a liquidation plan . However, a liquidation plan, in order to be justifiable, should be based upon some identifiable reason why a Chapter 11 plan is preferable to a Chapter 7.
M. Seeking Appointment of Chapter 11 Trustee or Examiner
One of the options to be considered by creditors dissatisfied with the progress of a Chapter 11 case is to seek the appointment of a Chapter 11 trustee or an examiner.
A Chapter 11 trustee is a “disinterested” outsider who is appointed to take over control of the debtor, exercising such day-to-day control as he or she deems appropriate. The Chapter 11 trustee is paid a commission based on the amount of funds disbursed by him during his tenure. In addition, the Chapter 11 trustee typically retains counsel. Seeking the appointment of a Chapter 11 trustee will increase the cost of the administration of the bankruptcy case.
Simply because the creditors want a Chapter 11 trustee does not mean one will be appointed. The court will generally only appoint a trustee if “cause” exists such as fraud, dishonesty, incompetence, or gross mismanagement by the debtor’s current management, or if the court is satisfied that the benefits of such appointment outweigh the costs. While the debtor’s financial condition at the time of the filing may be evidence of incompetence, that is not the type of gross incompetence that would justify an appointment of a Chapter 11 trustee. To establish that the benefits outweigh the costs is difficult to prove without evidence of fraud or other malfeasance. Accordingly, creditors should recognize that a Chapter 11 trustee, although perhaps desirable, is not easily obtained.
An examiner, like a trustee, is a disinterested outsider. However, the examiner’s duties are less broad than that of a trustee. Unlike the trustee who takes over the day-to-day control of the debtor, the examiner is generally appointed for some specific activity. The most common purpose for the appointment of the examiner is to investigate suspected fraud and other irregularities. However, an examiner can be appointed for practically any purpose that would aid in the administration of the bankruptcy case including such things as mediating deadlocks in plan negotiations.
V. PLAN DEFAULT AND POST-CONFIRMATION REMEDIES
A. Effect of Plan Confirmation
Confirmation of a Chapter 11 reorganization plan binds all creditors whether they voted for the plan or not. Creditors’ claims will be paid as provided for in the plan. Any claims arising before the date of plan confirmation are discharged except to the extent otherwise expressly provided for in the plan. For example, if the plan provides for a distribution to unsecured creditors of 20 percent, then the other 80 percent of their claims are discharged by plan confirmation.
The plan could, and should, define not only how the claims will be treated under the plan but also the rights and remedies of the creditors in the event of a default. The committee should insist on provisions in the plan setting forth incidents of default and remedies of creditors in the event of a default. Such provisions could include, but not necessarily be limited to, the acceleration of debt in the event of default, interest in the event of default, right to collect attorneys’ fees in the event that some sort of state court action must be brought in order to enforce a debtor’s obligations under the plan, etc.
B. State or Federal Court Lawsuit for Default
A confirmed plan, like a contract, creates rights and liabilities. In the event of a breach, the plan can be sued upon like a contract. A lawsuit can be initiated in any court of competent jurisdiction including, but not limited to, state or federal court. Whether an action can be brought in bankruptcy court depends upon the nature of the action and whether the bankruptcy court has retained jurisdiction in the plan to hear matters related to collection actions by creditors under the plan. Plans typically do not include provisions for the retention of jurisdiction by the bankruptcy court for that purpose.
The obvious problems with a lawsuit to enforce a plan is that such a lawsuit may be expensive and time consuming and may not achieve the result desired by the creditor (particularly if the plan does not provide for the acceleration of all debt due to b e paid under the plan). Furthermore, suit does not, in and of itself, guarantee payment. A judgment obtained in a state or federal court lawsuit must still be collected, and the value of any such judgment depends upon the extent and value of the debtor’s unencumbered post-confirmation assets.
The bankruptcy court’s jurisdiction to deal with post-confirmation issues is generally limited to those types of matters for which jurisdiction has been expressly retained in the plan. There are, however, certain post-confirmation remedies which can be sought in the bankruptcy court whether jurisdiction has been retained or not. These remedies are those expressly provided for within the Bankruptcy Code.
- Revocation of Confirmation. Any time before 180 days after the date of the entry of an order of confirmation, the court may revoke the order of confirmation if and only if such order was procured by fraud. Any order revoking confirmation must contain such provisions as are necessary to protect any entity acquiring rights in good faith and in reliance on the order of confirmation.Seeking revocation of confirmation in the event of a post-confirmation default has obvious limitations. First, it must be sought within 180 days of the date of plan confirmation. Secondly, it can only be granted in the event that the creditor can show t hat the confirmation order was procured by fraud. Simply inability to comply with the terms of a plan does not, in and of itself, establish that confirmation was procured by fraud. Finally, all the remedy does is put the debtor back into the bankruptcy case. Once the order of confirmation has been revoked, there will either have to be the prospect of a new plan or the case will likely be converted to Chapter 7.
- Modification of the Plan. The Bankruptcy Code allows the proponent of the plan, or the debtor (if different from the proponent), to modify the plan at any time after confirmation but before substantial consummation. Substantial consummation is typically defined as the commencement of payments under the plan. Payments typically commence on the effective date of the plan. Substantial consummation must be distinguished from complete consummation. It is not necessary for all payments under the plan to have been made in order for the plan to be substantially consummated.There are two obvious limitations to the remedy of modification. The first is that only the proponent of the plan, or the debtor, can seek modification. Thus, a creditor who was not the proponent of the plan cannot utilize the remedy. Secondly, it is only available up through the date of substantial consummation. Since payments ordinarily commence on the effective date of the plan, and the effective date usually occurs within a short time after plan confirmation, there is a limited window of opportunity to utilize this remedy.
- Section 1142 Order to Aid in Implementation of Plan. Section 1142 directs the debtor to carry out the plan and to comply with any orders of court. Section 1142 further provides that the court may direct the debtor, and any other necessary party, to execute or deliver, or to join in the execution of delivery of, any instrument required to effect the transfer of property dealt with by the confirmed plan and to perform any other act, including the satisfaction of any lien, that is necessary for consummation of the plan. To the extent that the debtor has failed to transfer property or to otherwise comply with the plan, Section 1142 may provide a remedy. Section 1142 would not, however, appear to be the appropriate remedy where the default is a failure to make payments provided for under the plan.
- Conversion of Case. The Bankruptcy Code authorizes the court to convert a case to Chapter 7 where there is an inability to effectuate substantial consummation of a confirmed plan, where there has been a material default by the debtor with respect to a confirmed plan, or where a plan is terminated by reason of an occurrence or condition specified in the plan.Notwithstanding the existence of the statutory authority for a conversion of a bankruptcy case post-confirmation, there are courts which have questioned the effect of a post-confirmation conversion. Those courts observe that while the bankruptcy estate continues to exist post-confirmation, all of its assets may have revested in the debtor as a result of plan confirmation and, therefore, a conversion would be meaningless since there would be no assets for the Chapter 7 trustee to administer. Despite this minority view, most courts will grant a conversion where there has been a material default under a confirmed plan, and treat it as affecting all of the debtor’s assets.In those courts where the effect of a post-confirmation conversion is questioned, an alternative remedy would be to file an involuntary petition against the reorganized debtor (provided that the conditions for an involuntary bankruptcy can be satisfied).
- Other Remedies. There may be other remedies available to a creditor which are suggested by plan language and/or the retention of jurisdiction by the bankruptcy court in a plan or in any post- confirmation order. Reference to both must be made in the event of any post-confirmation problem.
VI. RECURRING ISSUES IN CHAPTER 11
There are a number of issues which commonly arise in Chapter 11 bankruptcy cases. The purpose of this chapter is to provide some very brief background information on a number of those issues.
B. Relief from the Automatic Stay (Section 362)
During the course of a bankruptcy case, the debtor may be subjected to a motion for relief from the automatic stay.
The automatic stay enjoins all actions by prepetition creditors to collect on their claims. This includes secured creditors.
It is common for secured creditors to file motions for relief from stay which, if granted, permits them to resume collection activities with respect to their collateral. A secured creditor will ordinarily argue one of two grounds for relief from stay. The first ground is lack of adequate protection. The second ground is that there is no equity for the bankruptcy estate in its collateral, and that the collateral is not necessary for an effective reorganization. If a secured creditor can satisfy either ground, it is entitled to relief from stay.
“Adequate protection” is a term of art within the Bankruptcy Code. Adequate protection is protection granted to the secured creditor to prevent any diminution in the value of its “secured claim” during the pendency of the bankruptcy case. The creditor’s secured claim is the lesser of the secured creditor’s claim, or the value of its collateral. Thus, its secured claim might be less than its total claim if the value of its collateral is less than its total claim. In such a case, the secured creditor is considered to be “undersecured.”
Under the Bankruptcy Code, undersecured creditors are not entitled to postpetition interest on their claims. Oversecured creditors, however, are entitled to interest, attorneys’ fees and other damages provided for within in the contract between it and the debtor.
Adequate protection can take the form of replacement liens, periodic payments, or other relief that preserves the value of a secured creditor’s secured claim. If the secured creditor’s collateral is diminishing and, therefore, its secured claim is being reduced, it is entitled to relief from stay unless the debtor provides it with periodic cash payments, replacement liens, or some other means of preserving the value of its secured claim.
The alternative ground is lack of equity for the bankruptcy estate and the lack of need for the collateral to an effective reorganization. Accordingly, where the collateral is overencumbered by liens, and where that collateral is not necessary to an effective reorganization, the secured creditor is entitled to relief with respect to that collateral, even if the debtor is willing to provide it with adequate protection. If there is equity or the collateral is necessary for an effective reorganization, relief from stay will be denied as long as the debtor is able to provide the secured creditor with adequate protection.
C. Use of Cash Collateral/Cash Collateral Stipulation (Section 363)
A debtor is prohibited from using “cash collateral” without obtaining prior court approval or the consent of the creditor secured by the cash collateral. “Cash collateral” means cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents which are subject to a security interest. As “cash collateral” constitutes the working capital of the business, and therefore the “life blood” of continued operations, it is common for there to be some activity very early in the case involving the debtor’s desire to use cash collateral. Often, the debtor and the secured creditor will enter into a cash collateral stipulation which authorizes the debtor to continue to use the cash collateral subject to certain conditions.
From the committee’s perspective, any cash collateral stipulation must be reviewed to make sure that a secured creditor is not given an opportunity to improve its position as a condition for allowing the debtor to use cash collateral. The acceptable condition for allowing the debtor to use cash collateral is reasonable adequate protection.
D. Sale of Assets Other Than in the Ordinary Course of Business (Section 363)
As indicated elsewhere in this guidebook, the sale of assets may be an important part of the reorganization effort. When a sale involves assets of the debtor which it is not in the business of selling, such sales are outside of the ordinary course and must comply with the requirements contained within this particular Bankruptcy Code section, and the related Bankruptcy Rules.
Motions to approve sales need to be reviewed by the committee to make sure that the sale is being conducted in good faith, is not to an insider or affiliate of the debtor for inadequate consideration, and that the sale will enhance the debtor’s prospects for a reorganization.
Committees frequently object to a sale of what amounts to a substantial portion of a debtor’s assets on the basis that such a sale constitutes a “de facto” plan. Such a sale would constitute a “de facto” plan because once it is approved, the debtor’s reorganization alternatives are limited to dealing with the remaining assets. Except where absolutely necessary, courts ordinarily require, if requested by the committee, that the debtor incorporate the proposed sale into a disclosure statement and plan of reorganization and thereby give creditors an opportunity to vote on that disposition.
E. Postpetition Credit (Section 364)
As indicated elsewhere in this guidebook, the debtor can, subsequent to the bankruptcy filing, continue to operate its business and engage in ordinary course day-to-day activities without prior bankruptcy court approval or supervision. Under Section 3 64 of the Bankruptcy Code, the debtor may also incur debt in the ordinary course of its business. Such debt would be entitled to a Chapter 11 administrative expense priority. Ordinary course means, essentially, those types of reoccurring expenses which are ordinary and necessary in conducting the debtor’s business. Again, prior court approval is not required.
It is not unusual for suppliers to go on a COD basis with a customer which files for bankruptcy. The Bankruptcy Code, in Section 364, authorizes the debtor to incur debt outside of the ordinary course of business (for example a working capital loan) t o be granted a Chapter 11 administrative expense claim priority and, to the extent that the debtor is still unable to obtain credit, to grant the lender a super-priority administrative expense claim and/or a postpetition lien on assets. A super-priority administrative expense claim is an administrative expense claim which is granted priority over other Chapter 11 administrative expense claims.
Any request to incur debt other than in the ordinary course must be closely scrutinized to make sure that the terms are fair and reasonable, that the debtor could not obtain credit without granting the lender a super-priority claim or a lien on assets, and, finally, that the loan is necessary to the reorganization and that it will enhance the value of the bankruptcy estate.
F. Executory Contracts and Leases (Section 365)
Under the Bankruptcy Code, a debtor may assume, and in certain cases assign, executory contracts and leases, even though it is in default under the terms of the contract or lease. In order to assign a lease or executory contract, the debtor must first assume it. In order to assume a lease or contract in default, the debtor must show a present ability to cure the default within a relatively short period, must show the ability to promptly compensate the other party for any pecuniary loss resulting from the debtor’s default, and finally, must provide adequate assurance of the ability to perform in the future.
Special rules pertain to the assumption of non-residential real estate leases. Among those rules is the requirement that the debtor file a motion to assume or reject the non-residential lease within 60 days of the date of the bankruptcy filing, or with in any extension of that period granted by the court. If not assumed, the lease is deemed automatically rejected. Ordinarily, the debtor has until the date of plan confirmation to assume or reject other types of leases and executory contracts.
If a debtor elects to reject a contract or lease, the prepetition default along with any rejection damages which may be available to the other party would be treated as a prepetition unsecured claim. If the debtor assumes the contract and then default s, damages may be treated as a postpetition Chapter 11 administrative expense claim. Contract damages can be quite extensive and, therefore, the committee must carefully analyze any request to assume a contract to make sure that the debtor will, in fact, be able to perform in the future and that the benefit to the bankruptcy estate by the assumption outweighs the risk of future default.
Where the debtor seeks to reject the contract, the risk to the reorganization is much less, but the committee would still need to review the action in order to determine whether the debtor is giving up any value by releasing the contract.
G. Equitable Subordination (Section 510)
While it is not common for an action to be initiated seeking to equitably subordinate a creditor’s claim, it is something that is frequently discussed within the context of a bankruptcy case. Equitable subordination is the reduction in priority of a particular creditor’s claim. For example, a claim of a secured creditor may be reduced to that of general unsecured creditors, or a claim of a general unsecured creditor may be reduced below that particular class. To subordinate a claim the court must find that the creditor engaged in some inequitable conduct. Where an insider of the debtor has a large secured or unsecured claim, an investigation into the viability of an equitable subordination action is often appropriate.
H. Substantive Consolidation (Section 105)
Like equitable subordination, an action seeking substantive consolidation is not common, although it is often discussed.
Substantive consolidation is essentially the pooling of the assets and liabilities of a particular debtor with another debtor or some non-debtor person or entity. Substantive consolidation is the bankruptcy version of “piercing the corporate veil.” It is appropriate when some other entity utilized the debtor as an alter-ego, undercapitalized the debtor, or otherwise engaged in inequitable conduct prepetition. In addition, substantive consolidation is appropriate where it is difficult, if not impossible, to determine which of several debtors own particular assets.
Where there are few, if any, assets in a particular bankruptcy estate to satisfy the claims of unsecured creditors, an analysis of other insiders and affiliates of the debtor is appropriate to determine whether an action for substantive consolidation (or other derivative suit) exists.
I. Fraudulent Conveyances (Sections 544 and 548)
Of all of the terms associated with bankruptcy, probably the most commonly discussed is “fraudulent conveyance.” “Fraudulent conveyances” consist of those transfers of assets undertaken with the intent to defraud creditors or for which the debtor receives inadequate consideration in return.
Ordinarily, intentional fraud is evident when the transfer is to an insider or an affiliate for what clearly amounts to insufficient consideration. The definition includes, however, any transfer for inadequate consideration, whether or not there was any actual intent to defraud.
For the committee, all transfers occurring within two years of the date of the bankruptcy filing must be reviewed in order to determine whether the debtor received adequate consideration in exchange.
As indicated elsewhere in this guidebook, one of the goals of the Bankruptcy Code is to effect an equitable distribution of the debtor’s assets. In order to achieve this goal, it is necessary to prevent executing creditors (or those creditors with a greater degree of influence) from “dismembering” the debtor on the eve of bankruptcy filing or, for that matter, as the debtor slides toward a bankruptcy filing. As a means of achieving this goal, Congress provided in Section 547 for the avoidance of “preferential” transfers. Under Section 547, a preferential transfer is essentially a payment on an old debt. Thus, the debtor cannot, within 90 days of the date of the bankruptcy filing, prefer certain of its creditors to the detriment of others.
In addition to the 90-day preference period, there is an extended preference period of one year prior to the date of the bankruptcy filing for transfers made to insiders and affiliates of the debtor.
Transfers made on account of antecedent debts during the 90-day period of the bankruptcy filing (and within one year with respect to insiders and affiliates) must be considered. These are funds which can be brought into the bankruptcy estate which could serve as a basis for a distribution to unsecured creditors.
It is important to note that the source of these funds are usually other unsecured creditors. To the extent that these other unsecured creditors are forced to disgorge the transfers, they are brought back into the bankruptcy estate as creditors. They are therefore forced to share their “preference” with less fortunate creditors. By this mechanism, the bankruptcy purpose of equitable distribution is realized.
It is unusual for the preferential transfers to constitute a significant asset of the bankruptcy estate, but such causes of action do constitute an asset which must be analyzed and considered by the committee in deciding how it wishes to proceed.
K. Avoidable Postpetition Transfers (Section 549)
After the filing of a bankruptcy, a debtor may not pay any prepetition claims or make any payments outside of the ordinary course of business except as expressly permitted by the Bankruptcy Code or authorized by the court. To the extent that the debtor-in-possession makes unauthorized payments, those payments are recoverable.
The debtor has an obligation to provide the U.S. Trustee and the committee with monthly financial operating reports. In addition, where appropriate, the committee can request breakdowns of the specific disbursements being made every month. Where the payment is not one authorized under the Bankruptcy Code or by the bankruptcy court, an action may lie under Section 549 to recover the payment.
It is not unusual for a creditor to both be owed money by a debtor and to owe money to the debtor. Thus, the creditor and the debtor may have mutual obligations. The Bankruptcy Code incorporates the state law right of a creditor to offset what it owes to a debtor by what the debtor owes to it, dollar for dollar, under certain circumstances. Any claimed setoff by a creditor must be analyzed in order to determine whether it is permitted under the Bankruptcy Code.
The debtor-in-possession has the right to “abandon” any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate. This is an useful tool in avoiding liability for certain costs associated with assets which come into the bankruptcy estate. However, where the burden is the result of environmental hazard, and that environmental hazard constitutes a substantial risk to human health, the ability to abandon the property has been limited by judicial decision.
Although not related to a particular section in the Bankruptcy Code, a common term utilized in a bankruptcy case is “claims litigation.” That essentially describes the process by which claims against the bankruptcy estate are objected to and resolved.
Creditors, for one reason or another, may file inflated claims against the bankruptcy estate. To the extent that the funds available for distribution to creditors are insufficient to make a 100 percent distribution, those creditors with inflated claims will receive a higher distribution on account of their actual claims than those who filed claims in the proper amount. In addition, creditors with contingent, disputed, or unliquidated claims must also participate in the bankruptcy case since their claims will be discharged upon confirmation. Ordinarily, the debtor will dispute the amount claimed by such creditors.
The claims litigation process is a means for conducting, within the bankruptcy court, on an expedited basis, lawsuits to determine the amount of disputed claims. The process allows for all of the claims in the bankruptcy case to become fixed and, therefore, assures that each creditor receives a true percentage in any distribution.