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An Overview of the Chapter 11 Reorganization Process

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Title: An Overview of the Chapter 11 Reorganization Process


1
An Overview of the Chapter 11 Reorganization
Process
  • THE SECOND FORUM FOR ASIAN INSOLVENCY REFORM
    (FAIR) Bangkok, Thailand December 16 17, 2002

Presented by George Kelakos, Co-Chair of the
International Committee of the American
Bankruptcy Institute
2
Introduction
  • Economic Premises of Chapter 11 (Reorganization)
  • Players
  • Strategic Objectives of Players
  • Valuation Issues

3
Phases Of A Chapter 11 Case
  • Prepetition
  • Initial Phase
  • Middle Phase
  • Final Phase

4
Economic Premises of Chapter 11 (Reorganization)
  • A business, even though not currently able to
    meet its obligations, can sometimes be
    restructured so that creditors receive more from
    future profits (or a sale of company) than the
    auction value of the assets excess of
    going-concern value of assets over auction
    value (going-concern premium) is usually
    divided between creditors and stockholders so
    that in a successful reorganization, both groups
    do better than they would under Chapter 7.

5
Economic Premises of Chapter 11 (Reorganization)
  • Chapter 11 case commenced when bankruptcy
    petition is filed with bankruptcy court
  • Voluntary petition can be filed by Debtor
  • Creditors (with certain requirements) and a
    foreign representative of a debtors estate in a
    foreign proceeding can file an involuntary
    petition

6
Who May Be A Debtor?
  • Bankruptcy remedies are available to all business
    entities in the U.S. (corporations, limited
    liability companies, sole proprietorships, and
    partnerships are all eligible for liquidation
    under chapter 7 or reorganization under chapter
    11)
  • Chapters 7 and 11 are also available to
    individuals

7
Who May Be A Debtor?
  • Other chapters include chapter 9 (reorganization
    of municipalities and other subdivisions of state
    government), chapter 12 (reorganization of family
    farms), and chapter 13 (a simplified
    reorganization available to individuals with
    regular income and limited debts)
  • Railroad reorganizations have specific
    requirements under chapter 11
  • Stock and commodity brokers cannot file chapter
    11, only chapter 7

8
Cast of Principal Characters
  • Debtor-in-possession (DIP) - debtor remains in
    control (fiduciary, no trustee appointed), and
    has possession of assets
  • DIP has rights, powers, and duties of a trustee
  • Bankruptcy judge (independent court /unit of
    U.S. District court given decision-making power
    over bankruptcy cases)-- primary role is to
    adjudicate disputes
  • U.S. Trustee - officer of department of justice
    administers cases and performs a number of
    statutory duties

9
Cast of Principal Characters
  • Committees watch dog for their constituents
    (may be multiple committees) (fiduciary role),
    and can file plan
  • Bank(s)
  • Trade creditors (single shot/long-term)
  • Machinery and equipment lender(s)
  • Landlord(s)
  • Equity security holders

10
Cast of Principal Characters Professionals
  • Legal advisors (Debtor/committee/bank/other
    creditors)
  • Financial advisors (Debtor/committee)
  • Accountants
  • Turnaround management/business advisors
  • Investment banker
  • Valuation/liquidation experts
  • Brokers

11
Strategic Objectives of Players
  • What are their goals?
  • The debtor keeps business alive (for benefit of
    equity holders)
  • Banks and ME lenders maximize return on
    disposition of collateral
  • Landlord
  • Rising real estate market oppose reorganization
    efforts
  • Falling real estate market may support
    reorganization efforts

12
Strategic Objectives of Players
  • What are their goals?
  • Unsecured creditors
  • Single shot no interest in long-term, oppose
    debtor
  • Long run retain debtor as a customer, support
    debtor
  • Equity holders keep business alive

13
Valuation Issues
  • Retail-value (fair market value?) at which
    collateral can be sold to ultimate user
  • Wholesale- value at which collateral can be
    sold to dealer
  • Forced Sale- quick and dirty value(necessary
    with perishables)
  • Going Concern or Enterprise value--essential
    operating assets are sold as an entity (calculate
    value by applying a multiple to projected profit)

14
Valuation Issues
  • Reorganization value - going concern value
    plus the upside (future expectation)
  • Combination of two or more of the foregoing
  • Source Queenan, James F., Standards for
    Valuation of Security
  • Interests in Chapter 11, 92 Commercial Law
    Journal at 19, et. seq.

15
Phases Of A U.S. Reorganization Case
  • Prepetition
  • Strategic considerations
  • Debtor
  • Lenders
  • Trade creditors

16
Phases Of A U.S. Reorganization Case
  • Initial phase
  • Petition/automatic stay
  • Cash collateral
  • Postpetition borrowing
  • Relief from the automatic stay

17
Phases Of A U.S. Reorganization Case
  • Middle phase
  • Executory contracts and unexpired leases
  • Assets sales (public/private)
  • Avoidance actions
  • Development of business plan (exclusivity
    extensions/bar date motion)

18
Phases Of A U.S. Reorganization Case
  • Final phase
  • Plan confirmation process
  • Elements of a plan of reorganization
  • Disclosure statement
  • Confirmation standards

19
Prepetition Strategic Considerations
  • Open lines of communication with parties may
    result in debtor filing case with support of bank
    and major creditors
  • Parties gain time to prepare voluminous paperwork
    required for a reorganization case (prenegotiated
    or prepackaged)

20
Prepetition Strategic Considerations
  • When events cause an emergency filing of a
    petition or where the major players (bank/key
    trade creditors) are not consulted, a number of
    issues may arise
  • Immediate cash crunch
  • Increased tensions/lost debtor credibility/diminis
    hed creditor confidence

21
Prepetition Strategic Considerations
  • When events cause an emergency filing of a
    petition or where the major players (bank/key
    trade creditors) are not consulted, a number of
    issues may arise
  • Creditors may take precipitous action (file an
    involuntary petition)
  • Emergency may be harmful to debtors
    business/operations

22
Prepetition Debtor
  • Does debtor have cash reserves? If so, what is
    the burn rate
  • How will case be funded? (cash collateral
    stipulation/motion/borrowing motion)
  • Are there sufficient funds to cover initial
    payroll? Can petition be timed to minimize
    unpaid prepetition wages?

23
Prepetition Debtor
  • Is an open line of communication maintained with
    key lender(s) and trade creditors?
  • Have the debtor and its reorganization team begun
    to prepare the documents and motions necessary
    for a bankruptcy filing?
  • Does the debtor have an exit strategy?

24
Prepetition Lender
  • Is lender receiving sufficient information from
    the debtor (is there an open line of
    communication)?
  • Does lender want out of the credit?
  • If so, lender may take aggressive action forcing
    debtor to file
  • Does lender want to continue financing a DIP?
  • If so, lender will seek to negotiate key terms of
    cash collateral/postpetition borrowing stipulation

25
Prepetition Trade Creditors
  • Strategy may depend on which side of the fence
    the creditor falls
  • Single shot creditors may not have an interest
    in pursuing a long term relationship with the
    debtor will aggressively pursue collection
    efforts
  • Long-term creditors may wish to maintain debtor
    as a future customer (make up losses through
    future sales) will cooperate with debtor and
    actively support reorganization (extend
    postpetition credit)?

26
Initial Phase
  • Petition/automatic stay
  • Cash collateral
  • Postpetition borrowing
  • Relief from automatic stay
  • Summary of strategic consideration
  • Valuation issues

27
Initial Phase Petition / Automatic Stay
  • Debtors (or creditors) run to court (castle) to
    seek relief (sanctuary/time/control of asset
    disposition)
  • Once debtor enters castle gate (bankruptcy
    petition filed/order of relief is entered), the
    gate is closed (automatic stay (moratorium) is
    imposed)
  • Automatic stay stops actions against debtor or
    property of the estate

28
Initial Phase Petition / Automatic Stay
  • Automatic stay (moratorium) freezes position of
    creditors and makes bankruptcy court the sole
    forum for dispute resolution
  • Relief from automatic stay is granted only upon
    leave of court

29
Initial Phase Cash Collateral
  • The problem
  • Debtors usually face a cash deficit at outset
    of case
  • Cash or cash equivalents are often a secured
    creditors cash collateral. They are
    collections of accounts subject to security
    interests or proceeds from the sale of pledged
    inventory or equipment.

30
Initial Phase Cash Collateral
  • The problem
  • Unless there is an agreement with creditor to use
    cash collateral, debtor must seek emergency
    relief to use cash collateral
  • Without court relief, there is no hope of a
    successful reorganization

31
Initial Phase Cash Collateral
  • The solution
  • Under U.S. Law, a prepetition security interest
    does not apply to postpetition property
    (exception proceeds)
  • Debtor is allowed to use non-cash collateral
    (real estate, ME, inventory) in the ordinary
    course of business
  • Secured creditor is entitled to ask court for
    adequate protection of its interest in the
    property

32
Initial Phase Postpetition Borrowing
  • Debtors often cannot operate (or reorganize)
    without new funding (even use of cash collateral
    may not be enough to keep business afloat)
  • In U.S., solution is for debtor to obtain a new
    loan (with court approval) from either the
    existing lender or a new lender (super priority
    loan)

33
Initial Phase Postpetition Borrowing
  • Postpetition Lenders in U.S. Often attempt to
    attach onerous terms to the new loan
  • Higher interest rates
  • Cross-collateralize prepetition debt with
    postpetition collateral
  • Sign off by all parties on validity/perfection
    issues/release of claims
  • Assignment of proceeds of avoidance actions
  • Bind future and successor trustees

34
Initial Phase Postpetition Borrowing
  • Courts in U.S. will often allow economic terms
    but will strike onerous terms from loan agreement
    (level the playing field)

35
Initial Phase Relief From Automatic Stay
  • For cause, including lack of adequate
    protection
  • Where debtor has no equity in property and
    property is not necessary to an effective
    reorganization

36
Initial Phase Relief From Automatic Stay
  • What is adequate protection?
  • Protection vs. decline in value
  • Common forms of adequate protection periodic
    cash payments replacement lien on postpetition
    assets

37
Initial Phase Summary of Strategic Considerations
  • For all - avoid crying wolf (your credibility
    is at stake). Seek and expect only the minimum
    relief necessary
  • For all - pick your fights carefully (attempt to
    resolve disputes out of court)
  • Bank - is lender satisfied with debtors
    projection? Does lender intend to continue
    funding debtor postpetition? Get budget from
    debtor

38
Initial Phase Summary of Strategic Considerations
  • Debtor - has the debtor team provided the
    necessary projections and budget information to
    lender and to parties in interest (cash
    collateral)? Has the debtors team prepared the
    necessary backup information for motion to pay
    prepetition wages and other first day motions
    (procedural motions / professional retention)?
  • Creditors - preserve creditors rights (Court may
    grant minimum relief -- to preserve balance in
    negotiating positions) / may want to file proof
    of claim

39
Initial Phase Valuation Issues
  • Automatic stay
  • Does debtor have equity in collateral above the
    lien?
  • Has collateral experienced a loss or diminution
    of value?
  • Is proposed adequate protection sufficient?

40
Initial Phase Valuation Issues
  • Use of cash collateral
  • Has collateral experienced a loss or diminution
    of value?
  • Is proposed adequate protection sufficient?

41
Initial Phase Valuation Issues
  • Postpetition borrowing
  • Valuation of new collateral for new loan (risk
    assessment)

42
Middle Phase
  • Executory contracts and Unexpired leases
  • Asset sales
  • Examination/pursuit of avoidance actions
  • Development of business plan
  • Valuation issues

43
Middle Phase Executory Contracts and Unexpired
Leases
  • Executory contracts or leases - are contracts
    or leases where performance, to some extent,
    remains due on both sides
  • If executory, debtor may assume or reject
  • Examples of executory contracts
  • Franchise or distributor agreements

44
Middle Phase Executory Contracts and Unexpired
Leases
  • Examples of non-executory contracts
  • Personal service contracts/contracts to make a
    loan or extend financing
  • Debtor may assume an executory contract or an
    unexpired lease under the following conditions
  • Debtor must cure defaults or provide adequate
    assurances that it will promptly cure defaults,
    and provide adequate assurances of future
    performance under the contract/lease

45
Middle Phase Executory Contracts and Unexpired
Leases
  • Once debtor assumes executory contract or
    unexpired lease, debtor may assign such
    contract/lease to a third party if such third
    party provides adequate assurances of future
    performance
  • Special rules for non-residential leases and
    other types of contracts

46
Middle Phase Asset Sales
  • Purpose
  • Dispose of non-essential assets in a manner
    generating highest possible return for debtors
    estate

47
Middle Phase Asset Sales
  • Sales of assets (public or private) outside of a
    plan of reorganization must be authorized by the
    court and may be permitted under following
    circumstances
  • Assets are rapidly deteriorating (boatload of
    fish)
  • Notice and opportunity for hearing must be
    provided
  • Courts require that sale motions provide
    sufficient background / disclosure to justify
    sale outside of a plan
  • Courts will test commercial reasonableness of
    proposed sale (method of sale, marketing and
    advertising)

48
Middle Phase Asset Sales
  • How will assets be sold (public vs. Private
    sale)?
  • Professionals (broker/liquidation/valuation
    expert/auctioneer) will often be employed to
    maximize return to debtors estate
  • How will parties (and court) know that method
    of sale/proposed sale will generate highest
    possible return?
  • Parties will seek advice of professional
    valuation expert to obtain fair market value,
    liquidation value appraisals to demonstrate that
    price/method of sale is commercially reasonable
    and is in best interest of debtors estate

49
Middle Phase Asset Sales
  • Benefits of Asset Sales
  • Finality (protection for good faith purchases, no
    unwinding of sale on appeal)
  • Speed
  • Costs/expenses are usually less than alternatives
  • Generally, clean title (sale free and clear of
    liens, encumbrances and attachments)
    (particularly in real estate transactions) is
    transferred

50
Middle Phase Avoidance Actions
  • U.S. law favors fair and equal treatment of
    similarly-situated creditors in proportion to
    their claims (as opposed to first come, first
    served)
  • Prepetition transactions may be avoided (set
    aside) for actual fraud, inadequate consideration
    (fraudulent transfers), or preference of one
    creditor over others

51
Middle Phase Avoidance Actions
  • Sometimes assets are transferred within the
    applicable avoidance period for less than fair
    value equivalent of assets may be recovered for
    benefit of debtors estate
  • DIP or trustee can bring avoidance actions

52
Middle Phase Development of Business Plan
  • The key to a successful consensual business
    reorganization case is a credible, viable
    business plan
  • Identify, evaluate
  • Assets and earning power of business
  • Secured and unsecured liabilities
  • Priority liabilities, including costs of
    proceeding

53
Middle Phase Development of Business Plan
  • Determine if business is viable
  • Consider structural approaches stand alone, sale
    or merger
  • Design business plan which business can perform
    and which addresses key economic requirements
  • Develop financial projections for plan model
  • Develop liquidation analysis (needed for plan of
    reorganization)

54
Middle Phase Valuation Issues
  • Asset sales
  • Fair market value and liquidation analyses will
    be required to support sale of assets outside of
    a plan
  • Avoidance actions
  • Parties may seek expert testimony concerning
    value of assets transferred within applicable
    avoidance period

55
Middle Phase Valuation Issues
  • Development of business plan
  • Plan proponent(s) will require professional
    assistance in order to generate a liquidation
    analysis for the plan of reorganization

56
Final Phase
  • Plan confirmation process
  • Disclosure statement
  • Elements of a plan of reorganization
  • Confirmation standards

57
Final Phase Plan Confirmation Process
  • The process
  • Plan proponent files disclosure statement and
    plan of reorganization
  • Court conducts hearing on disclosure statement
  • Plan proponent(s) disseminate(s) plan (and
    disclosure statement) to creditors and parties in
    interest along with (i) notice of confirmation
    hearing (deadline to object to plan) And (ii)
    voting ballot

58
Final Phase Plan Confirmation Process
  • The process
  • Court conducts hearing on confirmation of plan
  • Confirmation of plan discharges debtor from any
    debt that arose before confirmation (some
    exceptions)
  • Confirmed plan creates new contractual rights,
    replacing or superceding pre-bankruptcy contracts

59
Final Phase Disclosure Statement
  • The disclosure statement is a prospectus -- a
    document intended to provide adequate
    information (the debtors history, assets and
    liabilities, operations in the case, description
    of the business plan, the plan funding, pre and
    post-confirmation management, avoidance actions,
    tax issues, risk factors and alternatives to the
    plan) to creditors/parties in interest to assist
    them in determining whether to vote for or
    against the plan

60
Final Phase Disclosure Statement
  • In contrast to the (often) complex, technical
    plan of reorganization, a good disclosure
    statement will describe in plain language the
    business plan embodied in the plan of
    reorganization along with the risk factors and
    alternatives to the plan (detailed liquidation
    analysis)

61
Final Phase Elements of a Plan of Reorganization
  • Plan of reorganization must be drafted to embody
    key economic terms/requirements of the business
    plan
  • The plan of reorganization must provide for
  • Payment of priority claims (includes
    administrative costs of case)
  • Classification of claims

62
Final Phase Elements of a Plan of Reorganization
  • Plan of reorganization must be drafted to embody
    key economic terms/requirements of the business
    plan
  • The plan of reorganization must provide for
  • Satisfy best interests/liquidation equivalent
    requirement on unsecured claims
  • Treatment of equity security holders
  • Economic components (sale, capital infusions,
    debt modification, designation of plan
    administrator, prospective management)

63
Final Phase Confirmation Standards
  • Proposed in good faith
  • Plan and proponent in compliance with code
  • Best interest of creditors test plan provides
    creditors/interest holders with liquidation
    (Chapter 7) value or greater (valuation issues)
  • Feasibility test
  • Acceptance of plan by all classes

64
Final Phase Confirmation Standards
  • Cramdown
  • Requires acceptance by at least one impaired
    class (majority in number of allowed claims in
    class, 2/3 in amount for which ballots are
    cast)
  • Plan proponent must show plan treats
    non-accepting class fairly and equitably and
    does not unfairly discriminate vs.
    non-accepting class

65
Final Phase Confirmation Standards
  • Cramdown
  • Secured creditors must receive full value of
    their collateral either in immediate cash or in
    NPV of payments/time
  • Absolute value rule, no junior class will
    receive or retain property on account of its
    interest (new value exception?)

66
Final Phase Confirmation Standards
  • Plan not likely to be followed by liquidation or
    need for further financial reorganization

67
Concluding Observations
  • In an ideal reorganization case, parties will use
    the time afforded by the filing of the petition
    and the court (sanctuary) to arrive at a
    consensual plan so that the enterprise can be
    rehabilitated and emerge from the bankruptcy
    proceedings
  • Use time wisely (slow reorganization may result
    in a quick death)

68
Concluding Observations
  • Keep lines of communication open between
    constituent groups to arrive at a consensual plan
    of reorganization
  • Credibility - once lost, its almost impossible
    to regain
  • Pick your fights carefully

69
Concluding Observations
  • Only when there are points of contention which
    cannot be resolved through negotiation, should
    parties resort to the court for assistance
  • Bankruptcy forum affords a central place for the
    resolution of disputes but resources of the judge
    should be used wisely (use the judge as a
    facilitator)
  • Committees can play a very important role in the
    case, alternating between siding with the debtor
    or opposing the debtor to negotiate the best
    economic terms for their constituency (threat of
    a competing plan)

70
Presented by George M. Kelakos Heller Ehrman 601
S. Figueroa St. Los Angeles, California
90017 (213) 689-7652 gkelakos_at_hewm.com
71
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