The corporate reorganization bankruptcy (a “Chapter 11 case”) is actually not well understood by either businesses and non-bankruptcy attorneys, or most media reporting on bankruptcy proceedings. The reorganization process is complex, and must account for many variables, some which are known before a filing occurs, and some which develop later in the process. Furthermore, a Chapter 11 case involves negotiation, and even cooperation, between the filing business (the “Debtor in Possession” or “DIP”) and its creditors, or alternatively, the application of the tools, some of which are harsh, that the Bankruptcy Code and related Bankruptcy Rules give to both the DIP and creditors. The following discussion is a broad level survey of Chapter 11 process and does not cover all of the issues that may arise in the context of any particular case.
What can be accomplished through a successful reorganization.
Breathing Room. Concurrent with filing a bankruptcy an injunction (the “automatic stay” of Bankruptcy Code §362) arises prohibiting creditors from taking almost all of the actions which a creditor would like to take against the DIP and the DIP's property. Thus, the bankruptcy process gives the DIP a respite from collection efforts allowing it to attempt a restructuring of its debt and business processes. However, during this breathing spell, other provisions of the Bankruptcy Code impose restrictions on many of the DIP's basic operations. Both the DIP and creditors must look to the bankruptcy court to move forward with most activities.
Forced borrowing. By delaying payment of debt accumulated by the DIP before the case, a significant aspect of a reorganization is the opportunity allowed to a DIP to effectively force unsecured lenders and trade creditors to make an involuntary loan of indeterminate duration to the DIP.
Reduction of unsecured debt paid. The DIP may also reduce the amount of debt owed. However, the ability to reduce debt is constrained by the restrictions of the Bankruptcy Code, in particular the “absolute priority rule.” Subject to limited exceptions, the debt reduction rules generally prevent existing owners from retaining their ownership of the DIP unless creditors are paid in full, or voluntarily accept payment of less than the full amount owed. An exception to these general debt reduction rules is created by the Small Business Reorganization Act of 2019 (the “SBRA”) which applies to businesses having noncontingent, liquidated, secured and unsecured debt of less than $2,725,625 (increased to $7,500,000 through March 27, 2021 by the Coronavirus Aid, Relief and Economic Security Act). Where applicable, the SBRA:
- eliminates the absolute priority rule for cases to which the SBRA is applicable; and
- includes a provision allowing a plan to be approved over an unsecured creditor's objection by payment of all projected disposable income received during the plan to payments for a period of 3-5 years.
Adjustment of the debt on financed equipment. A DIP can ask the court to revalue equipment purchased on credit, and then restructure the DIP's payments based on the new value. The secured creditor's claim on the equipment continues at the new value, and must be paid according to a new payment schedule based on that value, but the difference between the equipment's original contract value and the redetermined value becomes an unsecured claim, and will generally receive the same treatment as other unsecured claims. However, leases or other partially performed contracts (called “executory contracts”), cannot be similarly adjusted and must be taken as is or rejected.
Limitation of the costs of non-profitable contracts. The DIP can review all contracts which have not been completed, including leases, and determine which still make economic sense, and which do not. Thus, if a DIP has an above market lease, or a lease for a location which is no longer profitable, the lease can be rejected. The process of rejection converts the remaining payment obligations on the lease to an unsecured claim in an amount not in excess of the value of one year of lease payments. Executory contracts can be similarly rejected with the effect that the non-debtor party to the contract is allowed an unsecured claim having a value equivalent to the damages the non-debtor party would incur if the DIP breached the contract outside of the bankruptcy context. Rejection requires court approval if made during the bankruptcy case, or by approval of a plan of reorganization containing such rejection. Creditors may object to the DIP's decision, but the court will review a rejection or assumption decision based on whether the action is within the business judgment of the DIP.
Bankruptcy Procedures and Implementation of a Plan of Reorganization.
Cost of bankruptcy. A Chapter 11 bankruptcy is not cheap. Bankruptcy lawyers will require the deposit of a substantial portion of their expected fees as a retainer before taking on a Chapter 11 case. In addition to lawyers, the DIP may need to engage accountants and other personnel if the DIP does not have in house staff capable of supporting the administrative requirements of the bankruptcy process. The first months of a case are often the busiest, and thus the most expensive.
Additional time for company employees. Compliance with the Bankruptcy Code, related rules, and administrative procedures requires additional attention from company management and employees. The DIP's staff must prepare lists of assets and liabilities, as well as summaries of the prepetition business activity of the DIP. The Bankruptcy Code requires that detailed operating reports be filed monthly, and time must be spent assisting lawyers in preparing for and attending hearings and other court related activities. In some cases creditors will seek to obtain more detailed information by taking examinations of the DIP's representatives, and through other formal written and oral discovery procedures.
The plan must fix the problems leading to bankruptcy. The end result of a successful bankruptcy case is the approval of a plan. Development and refinement of that plan, with creditor input, can take place over the course of the bankruptcy. However, if a business considering a bankruptcy does not have a plan to fix the problems that caused it to need to file bankruptcy, the chance of success diminishes. Indeed the most successful cases (called pre-packaged cases) start with the DIP almost immediately filing a plan, and working quickly to implement it. Filing bankruptcy may not help if a business does not have a plan to address the root causes of the need to file a bankruptcy.
The Court and creditors are involved at every stage. As discussed above, the commencement of a Chapter 11 case brings everything before the Bankruptcy Court. The Bankruptcy Code authorizes many routine activities of the DIP to continue. However, most actions, even some which might generally be thought of as routine, require the approval of the Bankruptcy Court after creditors and interested parties are given an opportunity to object and be heard. The approval procedure applies to the following:
- determining that the bankruptcy cases of related companies should be jointly administered;
- establishing procedures related to providing notice of bankruptcy activity to creditors or administering the case;
- extending or shortening deadlines during the case;
- employment of and establishment of compensation procedures for lawyers and other professional service providers;
- authorizing continued use of existing cash management systems, bank accounts and business forms;
- authorizing payment of pre-petition employee benefits and priority wage claims which otherwise are subject to caps provided under §§ 507(a)(3) and (4) and may not be paid quickly enough to retain the workforce;
- authorizing continuation of customer programs and payment of certain pre-petition claims in the ordinary course of business;
- permitting the debtor to honor workers' compensation programs and pay insurance obligations, although federal and state laws, and the U.S. Trustee's guidelines, require that the DIP maintain certain insurance programs;
- establishing deposits or other payments needed to keep utilities in place;
- authorizing payment of sales and use taxes (To the extent the debtor has collected sales and use taxes, such funds may constitute “trust funds” held for payment to the taxing authorities and are not property of the estate (“the Texas sales-use tax is a trust-fund tax”);
- authorizing the use of cash generated by business operations as of the date the case is filed (known as “Cash Collateral”) if such Cash Collateral is subject to the interest of a secured creditor in receivables or the proceeds of sold goods;
- approving assumption or rejection of executory contracts;
- authorizing the sale of property outside the routine operations of the DIP;
- borrowing new funds during a bankruptcy case, or in connection with a plan of reorganization, which requires consideration of the interests of the existing lenders and must be in compliance with the Bankruptcy Code;
- approving information about a plan of reorganization (a “Disclosure Statement”); and
- approving the plan of reorganization (which must be accepted by creditors or imposed against their wishes under rules prescribed by the Bankruptcy Code, and approved by the Court in accordance with the Bankruptcy Code).
The forgoing list covers many issues that arise and require court approval, but it is illustrative rather than exclusive.
Disputes. Creditors rarely welcome a bankruptcy. As soon as a case is filed, many secured creditors will attempt to recover their collateral by either seeking to shorten the time to assume or reject a lease or executory contract, or terminate the automatic stay imposed under Bankruptcy Code § 362 to repossess equipment or real property.
Resolution of claims. The DIP does not always agree that a creditor has a claim. The Bankruptcy Code establishes a set of procedures for resolving disagreements as to the existence and amount of claims, as well as procedures for valuing claims for purposes of voting on a plan of reorganization that will take longer to resolve. Generally, resolution of claims takes place in the bankruptcy court, and moves quickly. However, dispute resolution may take place outside bankruptcy courts due to limitations on the jurisdiction of the bankruptcy court or for improved judicial efficiency.
Payment of fees to the US Trustee's office. A quarterly fee must be paid to the United States Trustee System Fund in each Chapter 11 case (except small business cases) for each calendar quarter, or a portion thereof, between the date a bankruptcy petition is filed and the date the court enters a final decree closing the case, dismissing the case, or converting the case to another chapter in bankruptcy. The quarterly fee is calculated based on the total disbursements for each quarter according to the fee schedule found at United States Department of Justice Chapter 11 Quarterly Fees. In a busy case, with substantial payments, this fee can be quite large, and must be paid.
Creditor Vote and Feasibility. The final goal of a Chapter 11 bankruptcy is confirmation of a plan. Bankruptcy Code §1129 sets out a list of criteria that the plan must meet, as determined by the court. From a practical perspective, the two most important criteria are:
- achieving the approval of the required creditors, by number and amount of claim, which is a combination of negotiating around objections, or overriding them through specific application of the Bankruptcy Code; and
- convincing the court that the proposed plan is feasible and can be completed without default or conversion to another chapter of the Bankruptcy Code.