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1. Introduction to Chapter 11
2. When is Chapter 11 Appropriate?
3. Pre-Filing Considerations
4. The Chapter 11 Players
5. Operating Inside Chapter 11
6. Reporting and Disclosure Requirements
7. Debtor-in-Possession Fiduciary Duties
8. Plan of Reorganization
9. Post-Confirmation
1. INTRODUCTION TO CHAPTER 11
These materials provide simple Chapter 11 operating guidelines for business managers and non-bankruptcy attorneys. Chapter 11 is one of two chapters of the Bankruptcy Code generally available to companies. The other, Chapter 7, is limited to situations where the business has stopped operating and wishes to announce to the world that it is defunct. Chapter 11, on the other hand, is generally used by companies to restructure debts in order to continue operating more profitably.
In the vast majority of cases, Chapter 11 allows a company to remain in possession of its property and run its own day-to-day affairs, while getting much needed relief from creditors. The mechanism by which a Chapter 11 provides this breathing room is the "automatic stay." The Bankruptcy Code provides that, immediately upon the filing of a Chapter 11 petition, virtually all formal and informal actions by creditors to collect what is owed to them are automatically stayed. This stay provides a company with much-needed time to make operating decisions, accumulate cash and to formulate a reorganization plan. Chapter 11 has been used as a powerful restructuring tool by many reputable companies, ranging from multi-billion dollar publicly-traded giants, to small sole-proprietorships. Although Chapter 11 is a form of bankruptcy, it lacks much of the stigma associated with personal bankruptcy filings. Rather, the decision to utilize Chapter 11 is more properly regarded as management aggressively pursuing options to save the company.
Chapter 11 is a complicated process. While it can provide extraordinary economic benefits to a financially distressed business, these benefits come at a cost. Chapter 11 can be expensive, in part because the fees and expenses incurred by many of the interested parties are eventually borne by the company in bankruptcy, known as the "debtor-in-possession" or the "DIP." The DIP's management must face additional issues, including negative responses of customers, trade suppliers and creditors. Effectively functioning during a Chapter 11 requires: (i) special management skills, (ii) constant contact with both business professionals and bankruptcy counsel, and (iii) personality traits, including, but not limited to, optimism, a strong will and a sense of humor.
2. WHEN IS CHAPTER 11 APPROPRIATE?
In the vast majority of cases, Chapter 11 allows a company to remain in possession of its property and run its own day-to-day affairs, while getting much needed relief from creditors. The mechanism by which a Chapter 11 provides this breathing room is the "automatic stay." The automatic stay provides a period of time during which virtually all creditors are prohibited from taking any action to collect on debts or claims that arose before the filing of the bankruptcy petition. This stay provides a company with time to make operating decisions, accumulate cash and formulate a reorganization plan.
An important first step when dealing with a financially-troubled company is to determine the nature of the problems confronting the business. While there may be a whole host of immediate concerns, the core of what is causing the financial difficulty can usually be reduced to one or very few significant issues. Experience indicates that the best way to gather the information necessary to diagnose the important issues is to engage the business owners and/or managers in a thorough discussion or interview process, as well as to carefully review current and historical financial and other business data. By both discussing the situation with management and exploring financial statements, one can begin to make the most important determination of all: Is this company viable?
While every situation is unique, most cases fall into one of the following general categories:
Companies With Temporary Cash Flow Problems
Some businesses are profitable but are having problems paying bills on a current basis. This may be due to inadequate capitalization, aged or bad accounts receivable or higher than tolerable debt payments. As the situation worsens and bills become delinquent, trade or other creditors may withdraw credit and/or place the company on a cash-in-advance or C.O.D. basis. Some creditors may start to sue for past due balances. Secured creditors may accelerate loans and begin foreclosure proceedings. In these situations, Chapter 11 may provide the temporary relief the business desperately needs, and also provide an opportunity to restructure debts to ensure future profitability.
Companies With Unprofitable Businesses Due To Management Problems
Some businesses are operating at a loss, but could be profitable if managed correctly. Management difficulties are often caused by disputes between current or former owners. If the management problem is one that can be solved, Chapter 11 may be an ideal way to stop creditors' collection efforts while the necessary business plan is formulated and implemented.
Companies With Special Problems
Cessation of collection actions and the opportunity to restructure debts may be a benefit to all financially-troubled companies, but some companies' circumstances make Chapter 11 an especially viable option. Some companies have special problems such as a need to cancel unfavorable leases or other contracts; a need to avoid foreclosure or reinstate defaulted loans; or the desire to resolve costly litigation. Chapter 11 is an attractive vehicle for addressing such issues.
Companies That Need To Continue Operating While Shutting Down
Inevitably, some companies fail. Whatever the reasons for the failure, it is sometimes preferable to continue running a company while effectuating an orderly closing, rather than abruptly locking the doors and walking away. Chapter 11 is often used for this purpose. Closing down a company inside a Chapter 11 case may provide the opportunity to: (i) maximize the value of the company's assets; (ii) finish work-in-process; (iii) give employees time to find other employment and possibly limit employment-related claims; (iv) continue paying management salaries during the shut-down; and (v) maintain some control over the manner in which the company is liquidated and the assets distributed.
3. PRE-FILING CONSIDERATIONS
Most Chapter 11 cases are filed in times of crisis. To the extent possible, a company should plan ahead for the need to reorganize. It is hard to overstate the degree to which the outcome of a Chapter 11 case can be improved if a company seeks restructuring advice before being faced with impending doom. Whatever the case, every company contemplating a Chapter 11 filing must consider the following critical issues:
The Automatic Stay and Guarantors
The filing of the Chapter 11 petition immediately triggers the automatic stay and stops nearly all actions by creditors to collect pre-petition debts or improve their pre-petition legal position. This typically means the cessation of law suits, collection efforts of any kind, set-offs, foreclosures, seizures and withholding deliveries until pre-petition debts are paid. However, the automatic stay typically does not stop creditors from demanding payment from any non-debtor guarantors.
In very limited circumstances, the Court may enjoin creditors from pursuing guarantors if such collection efforts would seriously and adversely affect: (i) management actively involved in the debtor's operations, (ii) essential operating property of the debtor, or (iii) the debtor's ability to effectively utilize people and property essential to achieving a successful business reorganization. If it is only inconvenient to the DIP or creates a hardship on the guarantors, it is unlikely that the Court will extend the protections of the automatic stay to non-debtor guarantors.
Operating Capital
Secured lenders, such as banks and other lending institutions may hold a lien on the company's cash and proceeds from collection of the company's receivables or sale of inventory and equipment. This cash is called "cash collateral." Prior to a Chapter 11 filing, the relationship between secured lenders and debtor companies is that the lenders authorize the business to use its cash collateral proceeds to pay its daily operating expenses.
However, when a Chapter 11 case is filed, the DIP must either obtain consent from the lender, or authority from the Court, to use cash collateral. In most cases, the DIP will either negotiate an agreement with the lender before the filing, or the DIP will ask the Court to authorize the temporary use of cash collateral on an expedited basis. If one of these is not done, the company will quickly run out of operating capital.
Attorney and Other Professional Fees
Bankruptcy attorneys will require a substantial retainer prior to becoming the debtor's Chapter 11 counsel. Initial retainers vary in size depending on the scope of the debtor's operations and the amount of time and effort expected to be needed. Before the filing, it is advisable for businesses to create a "war chest" of funds to pay the retainer and provide operating capital until court approval of the cash collateral agreement. If possible, the debtor's counsel's retainer should be paid from funds that are not subject to a secured lender's lien.
The court must approve the employment by the company of all professionals and all payments to professionals with the other interested parties given an opportunity to object. "Professionals" include: (i) bankruptcy counsel, (ii) non-bankruptcy legal counsel, (iii) accountants, (iv) consultants, (v) real estate agents, brokers or auctioneers, and (vi) business valuators or property appraisers.
Publicity
Many smaller companies will want to take measures to conceal their Chapter 11 filing from customers, employees and the public. While this may be technically possible in very small cases, it is usually naive to expect that the reorganization will remain a secret. The primary reason for this is that Chapter 11 is by its very nature a public event and all creditors will receive written notice of the filing.
Since it is unlikely that the Chapter 11 filing can be concealed, the best course of action is to embrace the reorganization and put a positive face on it. Employees and customers are much more likely to be supportive of the company's efforts if they are made to understand from the beginning that Chapter 11 is the vehicle by which the company's operations will be strengthened and profitability improved.
Immediately upon filing the Chapter 11 petition, the company should issue a press release in an effort to create the appropriate "spin." This initial press release should include: (i) the events leading up to the filing; (ii) any recent improvements in operations or personnel; (iii) the anticipated continuation of the company's operations; (iv) the anticipated ability to recover and strengthen operations; (v) that a Chapter 11 reorganization was filed rather than a Chapter 7 liquidation; (vi) the anticipated effects on the employees, customers, trade creditors and the local community; and (vii) management, shareholders, customers and any secured or trade creditor's statements of support for the company.
Employee Issues
Employees usually know that a business is in trouble before management officially tells them. After the Chapter 11 petition has been filed and the company becomes a debtor-in-possession, employees will be even more concerned about their future. The company should immediately inform its employees: (i) about the reasons for the filing; (ii) that the company has become stronger because it will be accumulating cash that was previously being used to service old debt; and (iii) that the company must stay current in all of its post-petition payments, including employee wages.
4: THE CHAPTER 11 PLAYERS
The Debtor-In-Possession Upon the filing of a Chapter 11 petition, the company becomes a debtor-in-possession, or DIP. The DIP is simply the company's management, which, after the filing, is imbued with the powers, and subject to the responsibilities, created under the Bankruptcy Code. Chief among the new responsibilities is the fiduciary obligation owed to the bankruptcy estate and all of the creditors. This is a significant departure from management's responsibilities prior to the filing when the only fiduciary duty owed was to the shareholders.
The Office of the United States Trustee ("OUST")
The OUST is part of the U.S. Justice Department which performs an oversight function in all bankruptcy cases filed in the district in which the office is located. The OUST is usually more active in cases filed under Chapter 11. Typically, one attorney and one accountant from the U.S. Trustee's office will be assigned to each Chapter 11 case. They will conduct the Initial Debtor Conference and the Meeting of Creditors, and take positions in Court when necessary.
Secured Creditors
Secured creditors are those whose claims are secured by a lien on the debtor's property by reason of the debtor's agreement, or an involuntary lien such as a judgment or tax lien. Generally a secured claim must be perfected under applicable state law to be treated as a secured claim in the bankruptcy.
The Unsecured Creditors Committee
In larger cases, the U.S. Trustee may appoint a committee of unsecured creditors to act on behalf of the entire unsecured creditor body. The Committee has a fiduciary obligation to all of the unsecured creditors and may have almost as much power as a secured creditor. The Committee is also specifically given a great deal of oversight responsibility, including the authority to: (i) investigate and audit the financial condition, operations and acts of the DIP, (ii) request the appointment of a trustee, (iii) request the appointment of a bankruptcy examiner who will be given power over, and the right to audit, the DIP, and (iv) help create the plan of reorganization. The DIP's management and attorneys should strive to maintain a cooperative relationship with the Committee and its counsel.
The Bankruptcy Judge
The Judge is the final arbiter of all disputes in Bankruptcy Court. In the end, it is the Judge that determines whether a reorganization plan will be approved and thus made binding on the creditors.
5. OPERATING INSIDE CHAPTER 11
Ordinary Course of Business
During a Chapter 11 case, the DIP's management does not have to seek Bankruptcy Court approval to operate its business in the customary manner, which is known as the "ordinary course of business." Although operations are subjected to enhanced scrutiny and reporting requirements, Court approval is only required for those activities "outside" the ordinary course of business. Some examples are: (i) settling any substantial claim or litigation, (ii) obtaining new credit, (iii) purchasing or selling equipment, old inventory and product lines, (iv) changes in senior management, or (v) leasing property or terminating leases. It is advisable to conservatively categorize changes as outside the ordinary course of business.
Bank Accounts
Immediately upon filing the Chapter 11 petition, the company must open a new bank account called the "Debtor-in-Possession account" or "DIP account." The checks for the DIP account must include the words "Debtor-in-Possession" and must also include the bankruptcy case number. If desired, the company may utilize up to three separate DIP accounts for operating, payroll and tax.
Executory Contracts and Unexpired Leases
An "executory contract" is generally defined as one where both parties must substantially perform in the future. Leases, employment contracts, supplier contracts and collective bargaining agreements are typical executory contracts. Section 365 of the Bankruptcy Code provides that the DIP may "assume, assume and assign, or reject" executory contracts.
If an executory contract is "assumed" during the Chapter 11 case, then the other party to the contract becomes an administrative claimant and will be granted priority over most pre-petition creditors. To assume a contract, the DIP must be current in it obligations under the contract or must promptly cure any defaults.
The DIP may "reject" the contract, give up its benefits, and the other party becomes a pre-petition unsecured creditor for any contractual damages. If the rejected contract is a commercial real estate lease, the "rejected" landlord's claim cannot exceed the greater of: (i) one year's rent, or (ii) 15% of the remaining term of the lease, but not to exceed three years. This can be used as an effective tool in landlord negotiations, particularly where unsecured creditors receive a small percentage of the dollar amount of their claim.
The DIP may also "assume and assign" an executory contract. However, to assume and assign, the DIP must be current in its obligations under the contract. Assumption and assignment occurs most often when the DIP is a party to a below-market lease or other contract and a third party wants to pay the DIP to take over the contract.
Executory contract creditors would prefer to quickly know the DIP's intentions with respect to their contract. Generally, the debtor can wait until confirmation of a plan of reorganization to assume, assume and assign or reject executory contracts, unless they are for non-residential real estate. One exception to this rule is that a commercial real estate lease must be assumed or rejected within sixty days of filing the petition, otherwise it is deemed rejected. The Court will usually extend the assumption period for good cause, over the objection of the lessor. However, any extension must be obtained prior to the end of the initial sixty days, or any extended, assumption period.
Utilities and Insurance
Utilities (electricity, gas, water, telephone, internet, paging, etc.) providers are prohibited from discontinuing, altering or refusing service following a Chapter 11 filing unless the DIP fails, with 20 days of the filing, to offer the utility company "adequate assurance of future payment." Typically, this will take the form of a cash deposit. Often the utility company will request a deposit equal to twice the highest previous monthly bill, but the court may order a lower utility deposit.
The debtor must maintain insurance coverage in the name of the debtor-in-possession. This may include: all risk property and casualty, automobile, director and officer liability, errors and omissions, and products liability, etc. All of the debtor's assets, employees and potential liabilities must be insured in a customary manner.
6. REPORTING AND DISCLOSURE REQUIREMENTS
Statements and Schedules
Within 15 days after the Chapter 11 filing, the DIP is required to file with the Court voluminous financial documents, known as the "Statement and Schedules." These documents are comprised of the Schedules, which are basically lists of assets, debts and other items, and the Statement of Financial Affairs, which include 25 specific questions about the company and its financial situation.
Monthly Operating Reports
Monthly operating reports, prepared on a cash basis, must be submitted monthly to the Court and OUST for each month the company remains in Chapter 11. The report is due by the 15th day of each month and includes information relating to the prior calendar month. The monthly operating report is basically a cash flow statement and detailed profit and loss statement. It contains a detailed listing of receipts and disbursements, a list of accounts receivable, accounts payable, insurance coverage, and a few other items.
The Initial Debtor Conference
Approximately two weeks after a Chapter 11 case is filed, an analyst from the OUST will arrange an initial meeting with the DIP's senior management and bankruptcy counsel. The meeting is informal and is used to introduce the company's management to the U.S. Trustee and discuss reporting requirements and other responsibilities of the DIP.
The Meeting of Creditors
The Meeting of Creditors ("MOC") usually takes place four to six weeks following the Chapter 11 filing. The MOC is usually the first public meeting in a Chapter 11 case and it affords creditors an opportunity to question the DIP's management about the status of the company and the prospects for reorganizing. All creditors will receive notice of the MOC and an attorney from the U.S. Trustee's Office presides. The debtor's senior management and bankruptcy counsel must attend and answer questions under oath. Typical questions include: (i) the location, description and value of assets, (ii) the extent and type of debts, (iii) what led to the financial difficulties and the filing, (iv) what improvements have already been made or will be initiated, (v) creditor, customer and employee responses to the filing, (vi) any intended management, personnel and responsibility changes, (vii) prospects and timing for filing a reorganization plan.
2004 Examinations
Any interested party can depose the debtor's: (i) employees, (ii) shareholders, (iii) insiders, (iv) affiliates, (v) lenders, and (vi) entities holding the debtor's property. During these periodically allowed depositions called "2004 examinations," interested parties may ask questions about any matter relevant to the case or to the progress toward a plan of reorganization.
7. DEBTOR-IN-POSSESSION FIDUCIARY DUTIES
The DIP and its management have a fiduciary duty to the creditors, employees, shareholders, company and court. This fiduciary duty extends to all of the debtor's controlling management, shareholders, officers and directors. Although a difficult concept to implement practically, the debtor has a legal responsibility to act in the best interests of its creditors, and not in its own best interest.
The debtor is obligated to: (i) maximize the value of the estate for the benefit of all creditors, (ii) protect and conserve its property, (iii) appropriately pay expenses of operations and the costs of maintenance, (iv) be cooperative and honest in its disclosure of the company's condition, (v) properly maintain books and records of all transactions, (vi) investigate prior acts, conduct and the financial condition of the debtor, (vii) investigate the desirability of continuing operations, (viii) refrain from performing acts which could damage the estate or hinder a successful reorganization, (ix) institute suits to recover "avoidable preferences" (where one creditor has received an advantage over other similar creditors, generally within 90 days of the bankruptcy filing unless it is a transfer to an "insider" of the debtor, in which case the period extends for one year prior to the bankruptcy filing), (x) disclose potential adversary proceedings or claims against creditors before asking them to vote on a plan of reorganization, (xi) negotiate in good faith and cooperate with creditors who may vote to accept or reject a plan of reorganization, and (xii) propose a plan of reorganization that satisfies all bankruptcy requirements.
The debtor's bankruptcy counsel represents only the company, acting by its management, but not the individual managers or shareholders. Often the primary shareholder is also the debtor's chairperson and chief executive officer. In some situations, it is advisable for the primary shareholder and senior management to engage their own bankruptcy counsel to defend their personal interests.
8. PLAN OF REORGANIZATION
The Plan of Reorganization ("Plan") is the culmination of the Chapter 11 business reorganization. The Plan must specify how the company intends to pay its creditors. It will typically specify: (i) which assets will be kept or sold, (ii) whether there will be new investors or a merger, (iii) which contracts, liens and debts will be satisfied, canceled or modified, and (iv) how much, and in what manner, will creditors be paid. The debtor is given the sole power to file the Plan during the first 120 days of the case. This is known as the "exclusivity period." Once the exclusivity period expires, other interested parties may a Plan. The exclusivity period may be extended with permission of the court.
The Disclosure Statement
The first step in getting a Plan approved is the preparation and filing of a Disclosure Statement. The Disclosure Statement is a substantial document, similar to an investment prospectus. It must contain sufficient information to enable creditors to make an informed decision about whether to vote in favor of the Plan. Among other things, Disclosure Statements will include:
(a) History of the company
(b) Description of business operations
(c) Disclosure of all assets
(d) Current and historical financial data
(e) Disclosure of the terms for the sale of any assets
(f) Classification of all creditors into classes (e.g., administrative, tax and other priority claimants, secured creditors, unsecured creditors)
(g) Detailed statement of how the various classes will be treated under the Plan
(h) Post-closing functions of the Debtor, including possible preference actions, etc.
(i) Procedures for voting for or against the Plan
(j) Alternatives to the Plan
The Plan
The Plan is the document that will become the new contract between the company and all of its creditors. Whereas the Disclosure Statement is designed to disclose information, the Plan will be the company's proposal for restructuring or liquidating. Plans will include such things as:
(a) Classification of claims and interests
(b) Treatment of claims
(c) Terms for the sale of any assets
(d) Provisions for continuing jurisdiction of the Bankruptcy Court
(e) Post-closing functions of the Debtor, including possible preference actions, etc.
Getting the Plan Confirmed
The Plan and Disclosure Statement are filed together. When the documents are filed, the Court sets a hearing to determine whether the Disclosure Statement should be approved. Following the hearing, the Court will, hopefully, approve the Disclosure Statement and will order that copies of the Disclosure Statement, Plan and a ballot for voting be mailed to all creditors. The Court will also set (i) a date for a hearing (the "Confirmation Hearing") to consider confirmation of the Plan, and (ii) deadlines for submitting ballots and for creditors to object to the Plan.
Copies of the Plan, Disclosure Statement and a ballot for voting are mailed to all creditors prior to the Confirmation Hearing. A class of creditors "accepts" the Plan, if two-thirds in amount, and more than one-half in number, vote to accept the payments they will receive under the plan. If these voting requirements are not met the class has "rejected" the Plan. However, creditors whose interests are not altered by the Plan ("unimpaired") are deemed to have accepted the Plan without voting.
There are many technical requirements for plan approval, including:
(a) It must be proposed in good faith and meet all Chapter 11 requirements
(b) Future managers of the debtor must be identified and their compensation described
(c) If any class of creditors is impaired, by receiving less than full payment, either the class must accept the Plan, or it must receive value (either monetary payments or an interest in the debtor's property) equal to what that class would have received if the debtor had liquidated in a chapter 7
(d) At least one impaired class must accept the Plan
(e) The Plan must be economically "feasible." This means that the debtor is not likely to: (i) need further reorganization, (ii) fail to make agreed upon payments, or (iii) liquidate
(f) The Plan must satisfy the "absolute priority rule." This means that a Plan is fair and equitable with respect to a class that has rejected the Plan (i) only if the rejecting class receives payment in full over time with interest, or (ii) as long as no class junior to it receives a distribution under the plan.
9. POST-CONFIRMATION
Immediately upon confirmation of the Plan, the debtor emerges from Chapter 11 as a new, reorganized entity. Once the Plan goes into effect (called the "Effective Date"), the company is required to start making payments to creditors and otherwise implement the terms of the Plan. In most cases, the Plan is said to be "substantially consummated" as soon as payments begin. When substantial consummation occurs, the company should ask the court to enter a "final decree" to formally close the case. Importantly, the necessity to pay U.S. Trustee quarterly fees ends when the final decree is entered.
For more information about this topic, please contact Bob Mendes (rjm@mglaw.net) or one of our other Insolvency attorneys. |
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