Bankruptcy Questionnaire

ANJ, Inc., a privately-held Delaware corporation with headquarters in Cambridge,
Massachusetts, develops machinery used to test products in the pharmaceutical industry. ANJ
markets its machinery exclusively through Phillips Industries. That is, Phillips purchases the
machinery from ANJ and resells it to pharmaceutical companies.
These companies recently have substantially expanded their operations in Cambridge, and
hence demand for ANJ’s products is very robust. Phillips is encouraging ANJ to increase its
output substantially to meet this demand. But, in order to do so, ANJ requires more space
than it presently occupies, must hire more employees, and needs to purchase additional
technology to develop its software. All of these needs mean that ANJ requires additional
capital.
You are part of the management team that will meet with ANJ’s lawyers and financial
advisers and your task it to prepare recommendations for acquiring the needed capital. In
preparation for that meeting, specify the advantages and disadvantages of ANJ securing that
capital in the form of:
a. unsecured credit
b. secured credit
c. through the issuance of more shares.
Further address the following:
a. What are the advantages and disadvantages, from the perspective of the suppliers of
capital, of investing in the various forms?
b. What are the advantages of distributing ANJ’s products exclusively through Phillips, and
what are the risks of doing so?
c. Suppose that after a substantial expansion, business turns down and, in fact, ANJ must file
for bankruptcy. What forms might that bankruptcy take, and what are the prospects of
recovery for unsecured creditors, secured creditors and shareholders?
MODULE 7: LESSON 1
BANKRUPTCY OVERVIEW
PURPOSE OF BANKRUPTCY
The purpose of bankruptcy is to allow an excessively indebted business to restructure its finances by
modifying or eliminating debt. It is based on the theory that it is better to preserve the jobs and
productive output of an otherwise viable business entity, which means spreading the economic loss
among the entity’s creditors.
Like contract law, bankruptcy law shapes the expectations of parties. Modern business
relationships are formed under the shadow of bankruptcy in that bankruptcy is a mechanism
whereby the debtor-creditor relationship can be modified. Since parties know at the outset of their
contractual relations that a future bankruptcy by a party is possible, bankruptcy law forms part of the
framework within which parties formulate their relationship. Bankruptcy law also provides a context
for debt negotiation and resolution outside of bankruptcy, because parties can reliably estimate what
their legal options will likely be in the event of bankruptcy. These aspects of bankruptcy—shaping
new contractual relations and influencing existing ones—apply regardless of the subject of the
relationship, whether employment, environmental, commercial, buy-sell agreements, intellectual
property, leases, licensing, or any other purpose or subject of a contract.
A Chapter 11 business bankruptcy case starts when an entity files the official bankruptcy
forms with a bankruptcy court. (See more on this below). In a Chapter 11 case, absent unusual
circumstances, the debtor is called the “debtor in possession” or DIP. The debtor is authorized to
retain control of its assets and operate its business as it proceeds with the reorganization.
Nevertheless, a business bankruptcy can take different forms. In a “traditional” reorganization, the
paradigm company “Old Co.” files a bankruptcy petition, and as part of the bankruptcy process, can
reduce or eliminate debt and other obligations, terminate unfavorable contracts or leases, sell old
assets and restructure operations. Eventually the debtor will obtain confirmation of a plan of
reorganization, and emerge as “New Co.”, with restructured finances. Sometimes the former
prepetition equity such as stock or partnership interests are eliminated and new owners take control
because bankruptcy law prohibits the former owners from receiving value under a Chapter 11 plan
unless all other creditors either agree or are paid in full.
But this is not the only model. Increasingly, using a bankruptcy strategy called “pre-pack,”
debtors negotiate all essential terms of the reorganization with major creditors before filing, then file
and exit bankruptcy quickly under a pre-packaged plan of reorganization. In other cases, debtors
may pursue a liquidating Chapter 11 in which the debtor files bankruptcy, but rather than work
toward a plan of reorganization, the debtor will sell its assets while in bankruptcy, and then confirm
a plan that simply distributes the cash proceeds to creditors. In a case in which the debtor has run
out of funds to remain in bankruptcy and confirm a plan, it may seek a structured dismissal of the
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bankruptcy, under which the dismissal order distributes whatever assets are left and closes the case.
Other hybrids to the traditional model continue to evolve.
BANKRUPTCY CODE
Bankruptcy in the United States is governed by Title 11 of the United States Code (11 USC
§101 et seq), commonly known as the Bankruptcy Code, or, more simply, the Code. Enacted in
1978, the Bankruptcy Code provides for individual (consumer) debt relief, business reorganization,
municipal bankruptcy, and cross-border insolvency. The Code has been amended numerous times
as new sections are added and others revised or deleted.
The Code contains nine chapters. Chapter 1 includes definitions and general provisions,
Chapter 3 addresses case administration, and Chapter 5 sets forth the duties and powers of the
parties in a bankruptcy case, including debtors, professionals employed by the estate, creditors, and
trustees. Chapters 7, 9, 11, 12, and 13 are each substantive chapters of relief. Chapter 7 provides for
individual and business liquidation, Chapter 9 is for municipal bankruptcy, Chapter 11 governs
business reorganization (including individual Chapter 11), and Chapter 13 provides for individual
adjustment of debt under a three- to five-year payment plan. Chapter 15 deals with cross-border
insolvency, and its purpose is to implement the United Nations Model Law on Cross-Border
Insolvency in the United States by facilitating cooperation between U.S. bankruptcy courts and
foreign insolvency administrative bodies in cases where the debtor has operations and/or assets both
in the United States and abroad.
Business bankruptcy and consumer bankruptcy are both governed by the Code, but their
respective purposes are fundamentally different. The objective of consumer bankruptcy (usually) is
for the debtor to obtain a financial “fresh start” through modification and/or discharge of personal
debt. The debtor is a natural person whose individual existence will continue irrespective of the
claims of creditors or the outcome of the case. Creditors typically play little or no role in a consumer
Chapter 7 or Chapter 13 case because most Chapter 7 cases are no-asset cases (no funds to distribute
to creditors) and creditors do not vote whether accept a debtor’s Chapter 13 plan. Overall, the
procedures in a consumer case are far less complicated and expensive than in a business case.
In contrast, a typical business bankruptcy case can involve hundreds or thousands of
creditors, who often play a highly active role in the case. The debtor has stringent monthly reporting
requirements, and must seek court approval for many key actions, up through soliciting its plan of
reorganization to creditors, and obtaining confirmation of the plan by the bankruptcy court.
Moreover, the Code is not concerned with whether or not a business entity or its pre-bankruptcy
equity survives the bankruptcy, which often they do not. In most cases, the cost and complexity of a
business bankruptcy are substantially greater than in consumer bankruptcy.
Although the Bankruptcy Code is a federal statute, state law can play a significant role in a
bankruptcy case. Among other reasons, a number of sections of the Code expressly incorporate state
law. For example, unless the Bankruptcy Code specifically provides otherwise, bankruptcy courts
look to state law to determine property rights. Thus, whether a creditor is properly secured and
perfected in personal property of a debtor will be determined by the state’s version of Article 9 of the
Uniform Commercial Code. Similarly, the validity of a mortgage or other secured interest against
real property is likewise subject to the law of the state in which the property is located.
BANKRUPTCY COURTS
The United States is divided geographically into 94 different federal districts. In each of
those 94 federal districts, there are one or more bankruptcy judges presiding over a U.S. bankruptcy
court.
Bankruptcy judges are appointed by the federal court of appeals that presides over the district
in which the bankruptcy court is located. They serve a 14-year term, which can be renewed, but they
can only be removed by the circuit judicial council (a body comprised of circuit court and district
court judges) “for cause.” A bankruptcy judge’s salary is 92 percent of that of a federal district
judge, and the expenses of facilities, staff, and operating the bankruptcy court are paid by the federal
judiciary.
Under the Judiciary Code, 28 U.S.C. §1134, U.S. district courts have original subject matter
jurisdiction over bankruptcy matters. However, bankruptcy courts are considered to be “units” of
the district courts, and bankruptcy cases are automatically “referred” to the bankruptcy court in each
district.
Because bankruptcy courts are established to adjudicate the Bankruptcy Code, they are said
to be Article I courts, meaning that they are authorized by Congress pursuant to its powers under
Article I of the Constitution. In this way they are different from Article III courts (federal district,
circuit courts, and the U.S. Supreme Court) that are provided for under Article III of the
Constitution. Only Article III courts may enter final orders that determine issues involving life,
liberty, or property rights. Therefore, this sometimes limits the powers of bankruptcy courts do
decide contract or other legal issues relating to a bankruptcy case. In such situations, the bankruptcy
court can hear the issue, but then refer it to the federal district court with its recommendations. The
federal district court may then enter a final order on the specific issue. Otherwise, all matters arising
under the Bankruptcy Code are typically heard only by bankruptcy courts.
FILING BANKRUPTCY
The Role of Lawyers and Other Professionals:
Attorneys and other professionals, such as accountants and financial advisors, may be hired
to represent the debtor and other parties in a bankruptcy case. A key qualification is that the
professional person must be “disinterested” and “not hold or represent an interest adverse to the
estate.” For example, the attorney may not also represent a creditor in the same case, shareholders
of the debtor, or have a direct financial interest in the debtor. The court must approve employment
of a professional to represent the debtor in a bankruptcy case. Prior to such employment, the
professional must disclose any potential conflict of interest with the debtor, such a prior
representation of a creditor in the case or some other adverse situation. Other parties in the case
may object to employment of a professional if he or she does not meet the disinterestedness
standard.
In a Chapter 11 case, if a creditors’ committee or other committees have been formed, such
committees, with the approval of the court, may employ attorneys to advise and represent them in
the case. The retention, qualifications, and other requirements for such professionals are the same as
with employment of professionals by the debtor.
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Petitions and Schedules:
As stated above, a Chapter 11 case is commenced by filing a petition with a bankruptcy court, along
with the filing fee, which is currently $550. In addition to the petition and a declaration of authority
to file signed by its officers, a Chapter 11 debtor must also file schedules of assets, liabilities, and
other business and financial disclosure documents.
All federal courts, including bankruptcy courts, are linked by electronic case filing (ECF). This is a
uniform electronic system for commencing cases, filing documents, entering orders, and otherwise
maintaining the official docket in the case. All documents related to the case are filed electronically.
The vast majority of bankruptcy cases are filed voluntarily, meaning the debtor itself (i.e., its
management) makes the decision to file for relief. But the Code also permit a debtor to be forced into
a Chapter 7 (liquidation) or Chapter 11 (reorganization) bankruptcy by creditors filing an
involuntary petition.
MODULE 7: LESSON 2, PART 1
KEY BANKRUPTCY CONCEPTS
AUTOMATIC STAY
Section 362(a) of the Code provides that the filing of a bankruptcy petition automatically
stays (stops) any action by a creditor to collect on an existing debt or any action by the creditor to
improve his position with respect to other creditors. This is one of the most powerful effects of
bankruptcy and is intended to retain the status quo as much as possible while the debtor reorganizes
its finances. Accordingly, the scope of the automatic stay is interpreted broadly by courts. Any
person or entity who violates the stay may be found in contempt of court, and the court may award
money damages to the debtor if violation of the stay was willful.
As provided in §362(a), the filing of a voluntary, involuntary, or joint bankruptcy petition
operates as a stay, applicable to all entities, against:
•
commencement or continuation of any action against the debtor to recover a claim that
arose before the case;
•
enforcement of any prepetition judgment against the debtor or against property of the estate;
•
any act to obtain possession of property of the estate or from the estate, or to exercise control
over such property;
•
any act to create, perfect, or enforce a security agreement or lien against property of the
estate.
There are a few exceptions to the stay, primarily dealing with actions by government to
enforce criminal or civil penalties, or to allow a creditor to perfect a security interest if the statutory
grace period for doing is still applicable at the time the bankruptcy case is filed.
Actions taken in violation of the stay are void and of no legal force and effect. Thus, if a
creditor obtains a judgment in state court against the debtor after the debtor filed bankruptcy, the
debtor is not required to prove in state court that the creditor was not entitled to judgment in order to
have the judgment nullified. The debtor need only show that the judgment was obtained in violation
of the stay. Similarly, if property of the estate is sold at a sheriff’s auction without knowledge that a
bankruptcy case was filed, even if just minutes after, the sale is void and no title passes to the buyer.
There is no innocent buyer protection if the sale was in violation of the stay. The stay of an act
against property of the estate continues until the property is no longer property of the estate, or until
the case is closed, dismissed, or an order granting or denying discharge is entered.
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Relief from Stay
Once the stay is in effect, creditors must look to bankruptcy procedures to pursue their
claims. A reorganization case can take many months—a long time for secured creditors with
collateral under the control of the debtor. One way for secured creditors to get out from under
bankruptcy court administration is to obtain relief from stay under §362(d).
Section 362(d) provides that upon request of a party in interest, and after notice and hearing,
the bankruptcy court “shall grant relief from stay … such as by terminating, annulling, modifying or
conditioning the stay….” A request for relief from stay is made by filing a motion with the court.
There are several permissible grounds for lifting the stay, but two are particularly important in
business cases.
First, under §362(d)(1), the bankruptcy court must grant relief from stay “for cause,”
including lack of “adequate protection” of an interest in property by a secured creditor. Generally,
secured creditors are protected in their claims by the value of their collateral. The automatic stay
does not deprive creditors of their interest in the collateral, but it does prevent them from pursuing
legal remedies outside of bankruptcy to enforce their claims. The debtor’s retention and continued
use of the collateral when the stay is in effect can result in a loss of the value of the creditor’s security
interest. This progressive loss of value is called lack of adequate protection. As you might expect,
loss of value and lack of adequate protection is of great concern to creditors, and in most instances
will cause them to vigorously pursue any and all possible action to obtain control over the collateral.
Second, with respect to an action stayed against property of the estate, §362(d)(2) requires
the court to lift the stay if the debtor does not have equity in the property and the property is not
necessary to an effective reorganization. For example, if, as part of its restructuring efforts, the
debtor has shut down certain production lines, any equipment or other assets associated with that
production is clearly not necessary to the debtor’s reorganization, and may permit a secured creditor
to obtain relief from stay to foreclose on the property.
MODULE 7: LESSON 2, PART 2
KEY BANKRUPTCY CONCEPTS
CREDITORS AND CLAIMS
A claim in bankruptcy is a right to payment, including a right that arises because of a
contract or legal judgment, potential legal claim, as well as a right to payment that may be
unliquidated, contingent, unmatured, disputed, etc. It can also include equitable rights, such as the
right to specific performance of a contract. In short, a claim is intended to include all existing and
potential grounds for liability against the debtor.
In order to receive any payment for its claim, a creditor should file a “proof of claim.” A
proof of claim is a written statement setting forth the creditor’s claim. The proof of claim serves as
formal notice of the creditor’s right to a distribution from assets of the estate. A proof of claim is filed
on an official form called Bankruptcy Form 10. The proof of claim form must be completed by the
creditor, signed, and mailed or delivered to the bankruptcy court clerk or the bankruptcy trustee or
both, as the form directs. If the claim is based on a writing (e.g., promissory note, written contract,
security agreement, mortgage), a copy of the writing must be attached to the proof of claim.
SECURED CREDITORS
As a general rule, a secured creditor is entitled to the value of its collateral. A creditor is fully secured
if the dollar value of its collateral is at least as much as the dollar amount of the claim. A creditor is
oversecured if the dollar value of the collateral exceeds the dollar amount of the claim. A creditor is
undersecured (also called partially secured) if the dollar value of the collateral is less than the dollar
amount of the claim. For example, assume that Creditor #1 has a prepetition secured claim against
the debtor in the amount of $1,000,000 and the property in which it is secured has a value of
$1,000,000. The creditor is fully secured. Creditor #2 has a prepetition secured claim against the
debtor in the amount of $1,000,000 and the property in which it is secured has a value of $1,250,000.
That creditor is oversecured. The amount by which the creditor is oversecured is sometimes called
an equity cushion, so this creditor has an equity cushion of $250,000. Creditor #3 has a prepetition
secured claim against the debtor in the amount of $1,000,000 and the property in which it is secured
has a value of $750,000. That creditor is undersecured, or only partially secured. Colloquially, the
creditor can be said to be “underwater.”
Section 506(a)(1) of the Code provides that a secured claim in bankruptcy is only secured up to the
value of the collateral at the time the petition is filed. For a wholly secured and oversecured creditor
that presents no problem—its secured claim will be valued at the full amount of the indebtedness.
But for an undersecured creditor that means its secured claim will be allowed only up to the value of
the collateral. For the balance of what it is owed over the value of the collateral, its claim will be
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unsecured. Thus, an undersecured claim can be bifurcated or split into secured and unsecured
portions. Therefore, Creditor #3, above, has a secured claim for $750,000 and an unsecured claim
for $250,000. Practitioners sometimes refer to this bifurcation as a “strip down” or “write down.”
The undersecured creditor does not forfeit the unsecured portion of its claim, but it can only pursue
that claim through the bankruptcy process as an unsecured claim. Bifurcation of secured claims is a
key component of many Chapter 11 Cases.
UNSECURED CREDITORS
If the debt owed a creditor is not secured by any real or personal property of the debtor, and there is no
additional security provided by a co-signer, surety, or guarantor, the debt is unsecured. As a general rule,
most unsecured creditors usually have the same priority and share “pro rata” (equal percentage of their
claim) in any distribution of the debtor’s assets.
There can be many other types of unsecured creditors in a business bankruptcy, such as unpaid wages or
salaries, claims for breach of contract, unpaid lease payments, sale taxes, payroll taxes, tort liabilities, etc.
Bankruptcy practitioners often use the term “trade creditors,” which refers broadly to vendors and
suppliers that provided goods, supplies, services, materials, inventory, and other forms of value to the
debtor prepetition and in the ordinary course of business, and for which payment was owed at the time the
debtor filed bankruptcy. It is common practice in many industries for a vendor or supplier to deliver
goods or services to a customer, and then for payment to be made at a time thereafter without any security
agreement. As a result, between the time of delivery and time of payment, the vendor or supplier is an
unsecured creditor.
For example, Tool Co. manufactures and delivers precision tool parts to Dover Manufacturing, Inc. on a
weekly basis. An invoice is included with each delivery, specifying payment terms of net 60 days,
meaning that Dover must pay the invoice within 60 days after each delivery. Assume that Dover
Manufacturing filed bankruptcy on June 1. Tool Co. is an unsecured trade creditor for all outstanding,
unpaid invoices. Assume further that immediately before it filed, Dover also terminated certain
employees whose employment contracts included severance packages. The employee claims for
severance benefits are also unsecured claims.
There is a special type of unsecured claim called an administrative claim. This includes unsecured claims
incurred by the debtor postpetition (during the bankruptcy), and can include legal and professional fees,
new borrowing made while in bankruptcy, cost of goods and services provided to the debtor, etc.
Administrative claims have priority over all other unsecured claims and must be paid in full before any
other claims may be paid. For example, if all the available assets are exhausted in paying administrative
claims, general unsecured creditors will receive nothing.
In larger cases in which there are many unsecured creditors, an Official Committee of Unsecured
Creditors (also called a “creditors’ committee”) may be appointed to represent the interests of all
unsecured creditors. Creditors can play a critical role in a Chapter 11 reorganization. While the exact
composition of the creditors’ committee can be flexible, members must be representative of the different
kinds of claims.
LEASES AND EXECUTORY CONTRACTS
Almost every business is a party to one or more contracts or leases, and many businesses are parties to
hundreds or thousands of them. These can include real property leases for office, commercial, or retail
space; personal property leases for equipment or vehicles; and contracts for almost any type of endeavor,
such as purchase and sale agreements, supply agreements, employment contracts, IP licenses, and so on.
Parties enter into leases and contracts usually because they expect the relationship to be profitable. But
sometimes, for any number of reasons, the lease or contract can become unprofitable, and create the
incentive for a party to want to terminate or breach the contract. To do so would normally expose the
party in breach to possible damages under applicable contract law. But for a debtor in bankruptcy, the
status of contracts and leases is quite different.
Section 365 of the Code governs “executory contracts and unexpired leases,” and grants the debtor certain
powers that are not available outside of bankruptcy. Specifically, §365(a) allows the debtor to assume or
reject (continue performing or terminate) a contract, cure (pay) a contract default with no further penalty,
or assign (sell or transfer) a contract to an assignee, even over the objections of the non-debtor party. If
the debtor properly rejects a contract pursuant to §365, the rejection is treated as a prepetition breach, and
the other party to the contract will have an unsecured claim for any prepetition amounts owed by the
debtor, and any other damages resulting from that breach.
The option to assume, reject, and/or assign can be extremely beneficial to a debtor in restructuring its
business. Consider the following examples:
1. The debtor is the buyer under a contract to buy widgets at a price of $47 per ton. If the spot
price (current market price) rises to $52 per ton, the contract is valuable to the debtor because
the contract price for widgets is less than the debtor would have to pay on the open market.
Therefore, the debtor will assume the contract.
2. Assume the same facts as above, except that the spot price has dropped to $42 per ton. The
debtor is likely to reject the contract because it can buy widgets for a lower price on the open
market.
3. Now assume that the debtor is the seller under an agreement to sell widgets at a price of $47
per ton. If the spot price of widgets rises to $52 per ton, the seller will reject the contract
because it can sell widgets for a higher price on the open market that it could under the
contract.
4. Same facts as #3, except that the spot price has gone down to $42 per ton. In this case the
debtor is likely to assume the contract because the price it gets for widgets under the contract
is more than it could get on the open market.
Because of §365, the debtor is allowed to pick and choose which contracts it wants to retain, and which
ones it wants to terminate or assign. But what if the nondebtor party becomes dissatisfied and wants to
terminate the contract? In most instances, unilateral termination of the contract postpetition by the
nondebtor party will be deemed in violation of the automatic stay, and can result in substantial damages.
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AVOIDING CERTAIN PREPETITION TRANSFERS
A Chapter 11 debtor has power to set aside certain voluntary and involuntary transfers of the
debtor’s property that occurred before the petition was filed. In bankruptcy language, the debtor can
“avoid” these prepetition transfers. Accordingly, these are called the debtors “avoidance powers.”
There are several types of avoidance powers. Here we will look at preferential transfers under
§547 and fraudulent transfers under §548. Note that any value recovered by avoidance actions is returned
to the estate for the benefit of all creditors.
Preferential Transfers:
One of the most potent powers of a Chapter 11 debtor is avoiding “preferential transfers” under
§547. Section 547(b) allows the debtor to set aside any transfer of the debtor’s property made:
•
to or for the benefit of a creditor
•
for or on account of a preexisting debt
•
made while the debtor was insolvent
•
on or within 90 days before the petition date (one year if the transfer was to an insider) and
•
that enables the creditor to receive more than it would receive in a chapter 7 liquidation
Basically the rules against preferential transfers are intended to prevent a debtor from favoring a
specific creditor by paying (or being forced to pay) the creditor right before it files bankruptcy, and
thereby leaving other creditors to be unpaid or paid less after the debtor has filed.
A preferential transfer need not involve the payment of money by the debtor. The transfer of
any property interest of the debtor, such as granting a lien or security interest, within 90 days of filing
may trigger a claim of preference if the other elements of §547 are satisfied. If a preferential transfer
is avoided, the trustee may recover the property that was transferred or the value of the property
from the transferee. Depending on the case, this can result in substantial sums being paid back to
the estate.
There are several potential defenses to preference that a creditor may assert. For example, if
the creditor continues to provide goods to the debtor during the 90 days leading up to bankruptcy,
the value of those goods can, in some instances, be used to offset any preference amounts owed. Or,
alleged preferential transfers that are consistent with a pattern of sales and payments between the
debtor and the creditor in the months or years prior to the bankruptcy may also be shielded from
recovery by the debtor. Defenses to preference can be very complicated, and we will not cover them
any further in this course. It is sufficient that you know they exist.
Fraudulent Transfers:
Section 548 (a) authorizes the debtor to avoid (recover) any transfer of the debtor’s property made
within two years preceding the filing of the petition under either of two conditions. First, it allows
the debtor to avoid a transfer made with “actual intent to hinder, delay or defraud” a creditor. This
is the “actual intent” test, and can be difficult for the debtor to prove without direct evidence. The
more common alternative is the “constructive fraud” test. This requires a showing that the transfer
was made for “less than reasonably equivalent value,” and that the debtor was either insolvent when
the transfer was made, or, because of the transfer, the debtor was unable to pay its debts to its
creditors. For example, suppose that a year before filing bankruptcy, Acme Company sold certain
real estate to a creditor, Continental Credit Corporation, for $2 million dollars. At the time of sale,
the debtor owed other creditors a total $10 million, but had assets of less than $5 million. After the
bankruptcy was filed it was discovered that the real estate sold to Continental Credit Corporation
had a market value of $12 million. The debtor could recover the real estate because the sale price
was for less than reasonable value, and depleted the assets of the estate to the detriment of the other
creditors.
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MODULE 7: LESSON 2, PART 3
KEY BANKRUPTCY CONCEPTS
POST PETITION FINANCING
Postpetition Financing
Operating a business after the Chapter 11 petition has been filed will typically require the
debtor to incur new or additional debt, either by purchasing on credit or borrowing funds. For
example, a debtor operating grocery stores will need to order foodstuffs and sundries from wholesale
suppliers on a daily basis. A debtor operating retail stores will need to order new inventory weekly.
A debtor in manufacturing has orders to fill and will need to purchase materials to fill those orders.
If suppliers of any of these debtors will not sell to them on credit as they ordinarily would
prepetition, the debtors will need to borrow money in order to stay in business.
Postpetition debt incurred in the ordinary course of business
The debtor may incur unsecured debt postpetition in the form of a loan or extension of credit
without court approval so long as the debt is incurred in the ordinary course of the debtor’s business.
Such debt is treated as an administrative expense. So, in the last example, as long as the purchases of
produce by the grocery chain, inventory by the retail chain, and materials by the manufacturer are
done in the ordinary course of debtor’s business, they will not need court approval for them. If a
debtor has ordinarily done business with its suppliers on credit, continuing to do so will be within its
ordinary course of business.
Postpetition debt incurred other than in the ordinary course of business
If the debtor needs to incur unsecured debt other than in the ordinary course of its business,
§364(b) requires that a motion for authorization to incur the debt or obtain credit be filed. The
motion may only be granted “after notice and a hearing.” Assume, for example, that debtor’s
suppliers, who normally sold to it on credit terms of net 60 days, now demand cash on delivery.
That will drain debtor of its cash on hand, so the debtor arranges an unsecured line of credit with
New Era Capital in order to pay its suppliers. The debtor must receive court approval to obtain the
loan, since this is not the way the debtor has ordinarily done business.
Postpetition debt incurred in other than the ordinary course of the debtor’s business also
receives priority treatment as an administrative expense. That may be sufficient to induce to the
creditor make the loan or extend the credit. But what if a potential creditor concludes it is not a
sufficient inducement? The Code allows the debtor, with court permission, to grant the creditor a
“superpriority” position over all other administrative expense claims. A superpriority administrative
expense must be paid before any other priority administrative expenses. Since all postpetition
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expenses have priority as administrative expenses, this approach may induce the creditor to extend
unsecured postpetition credit to the debtor by granting it a first-among-equals priority status as to its
claim.
Postpetition Secured Debt
Potential creditors may refuse to extend postpetition loans or credit unless they receive a
security interest in property of the estate. A postpetition debt arrangement involving the granting of a
security interest to the creditor always requires court approval. Whether the proposed transaction
will receive court approval depends in large part on how it is structured. A particular concern is how
the proposed post-transaction debt arrangement will impact the debtor’s prepetition creditors.
The court may approve a transaction giving the postpetition creditor a security interest in
property that is not presently encumbered. For example, assume that New Era Bank refuses to
make a loan to the debtor, Energy Holdings, Inc., unless it is granted a security interest in some
property of sufficient value to secure the loan amount. To obtain approval for the loan, Energy
Holdings would have to establish that it is unable to otherwise obtain the loan and that it is able to
grant New Era a security interest in some property that is not already encumbered as collateral for
another debt.
A court may also approve a transaction giving a creditor a junior security interest in property
that is presently encumbered. So, if Energy Holdings in the above example has no unencumbered
assets, but New Era is willing to lend in return for a second secured position in property of the
debtor, the court can approve the transaction.
Now assume that Energy Holdings has no unencumbered property, and New Era is
unwilling to accept a junior lien. Section 364(d) authorizes the court to approve a postpetition debt
arrangement that grants New Era a secured position senior to that of an existing prepetition secured
creditor. This type of postpetition lien is sometimes referred to as a priming lien because it primes (is
deemed senior to) prepetition liens and primes the pump for the postpetition loan. Another common
term is a superpriority lien. Granting a priming or superpriority lien to a postpetition creditor is
obviously a dramatic step for a court to take and it is rarely granted. In fact, it can only be granted
where:
•
The debtor-in-possession (DIP) is unable to obtain postpetition unsecured debt or credit; and
•
The secured creditor whose prepetition lien is impaired is given adequate protection for its
loss as by being granted an additional lien in other property or cash payments.
In this video the instructor discusses the informal practice of obtaining support from unsecured
credit.
MODULE 7: LESSON 1
BANKRUPTCY OVERVIEW
PURPOSE OF BANKRUPTCY
The purpose of bankruptcy is to allow an excessively indebted business to restructure its finances by
modifying or eliminating debt. It is based on the theory that it is better to preserve the jobs and
productive output of an otherwise viable business entity, which means spreading the economic loss
among the entity’s creditors.
Like contract law, bankruptcy law shapes the expectations of parties. Modern business
relationships are formed under the shadow of bankruptcy in that bankruptcy is a mechanism
whereby the debtor-creditor relationship can be modified. Since parties know at the outset of their
contractual relations that a future bankruptcy by a party is possible, bankruptcy law forms part of the
framework within which parties formulate their relationship. Bankruptcy law also provides a context
for debt negotiation and resolution outside of bankruptcy, because parties can reliably estimate what
their legal options will likely be in the event of bankruptcy. These aspects of bankruptcy—shaping
new contractual relations and influencing existing ones—apply regardless of the subject of the
relationship, whether employment, environmental, commercial, buy-sell agreements, intellectual
property, leases, licensing, or any other purpose or subject of a contract.
A Chapter 11 business bankruptcy case starts when an entity files the official bankruptcy
forms with a bankruptcy court. (See more on this below). In a Chapter 11 case, absent unusual
circumstances, the debtor is called the “debtor in possession” or DIP. The debtor is authorized to
retain control of its assets and operate its business as it proceeds with the reorganization.
Nevertheless, a business bankruptcy can take different forms. In a “traditional” reorganization, the
paradigm company “Old Co.” files a bankruptcy petition, and as part of the bankruptcy process, can
reduce or eliminate debt and other obligations, terminate unfavorable contracts or leases, sell old
assets and restructure operations. Eventually the debtor will obtain confirmation of a plan of
reorganization, and emerge as “New Co.”, with restructured finances. Sometimes the former
prepetition equity such as stock or partnership interests are eliminated and new owners take control
because bankruptcy law prohibits the former owners from receiving value under a Chapter 11 plan
unless all other creditors either agree or are paid in full.
But this is not the only model. Increasingly, using a bankruptcy strategy called “pre-pack,”
debtors negotiate all essential terms of the reorganization with major creditors before filing, then file
and exit bankruptcy quickly under a pre-packaged plan of reorganization. In other cases, debtors
may pursue a liquidating Chapter 11 in which the debtor files bankruptcy, but rather than work
toward a plan of reorganization, the debtor will sell its assets while in bankruptcy, and then confirm
a plan that simply distributes the cash proceeds to creditors. In a case in which the debtor has run
out of funds to remain in bankruptcy and confirm a plan, it may seek a structured dismissal of the
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bankruptcy, under which the dismissal order distributes whatever assets are left and closes the case.
Other hybrids to the traditional model continue to evolve.
BANKRUPTCY CODE
Bankruptcy in the United States is governed by Title 11 of the United States Code (11 USC
§101 et seq), commonly known as the Bankruptcy Code, or, more simply, the Code. Enacted in
1978, the Bankruptcy Code provides for individual (consumer) debt relief, business reorganization,
municipal bankruptcy, and cross-border insolvency. The Code has been amended numerous times
as new sections are added and others revised or deleted.
The Code contains nine chapters. Chapter 1 includes definitions and general provisions,
Chapter 3 addresses case administration, and Chapter 5 sets forth the duties and powers of the
parties in a bankruptcy case, including debtors, professionals employed by the estate, creditors, and
trustees. Chapters 7, 9, 11, 12, and 13 are each substantive chapters of relief. Chapter 7 provides for
individual and business liquidation, Chapter 9 is for municipal bankruptcy, Chapter 11 governs
business reorganization (including individual Chapter 11), and Chapter 13 provides for individual
adjustment of debt under a three- to five-year payment plan. Chapter 15 deals with cross-border
insolvency, and its purpose is to implement the United Nations Model Law on Cross-Border
Insolvency in the United States by facilitating cooperation between U.S. bankruptcy courts and
foreign insolvency administrative bodies in cases where the debtor has operations and/or assets both
in the United States and abroad.
Business bankruptcy and consumer bankruptcy are both governed by the Code, but their
respective purposes are fundamentally different. The objective of consumer bankruptcy (usually) is
for the debtor to obtain a financial “fresh start” through modification and/or discharge of personal
debt. The debtor is a natural person whose individual existence will continue irrespective of the
claims of creditors or the outcome of the case. Creditors typically play little or no role in a consumer
Chapter 7 or Chapter 13 case because most Chapter 7 cases are no-asset cases (no funds to distribute
to creditors) and creditors do not vote whether accept a debtor’s Chapter 13 plan. Overall, the
procedures in a consumer case are far less complicated and expensive than in a business case.
In contrast, a typical business bankruptcy case can involve hundreds or thousands of
creditors, who often play a highly active role in the case. The debtor has stringent monthly reporting
requirements, and must seek court approval for many key actions, up through soliciting its plan of
reorganization to creditors, and obtaining confirmation of the plan by the bankruptcy court.
Moreover, the Code is not concerned with whether or not a business entity or its pre-bankruptcy
equity survives the bankruptcy, which often they do not. In most cases, the cost and complexity of a
business bankruptcy are substantially greater than in consumer bankruptcy.
Although the Bankruptcy Code is a federal statute, state law can play a significant role in a
bankruptcy case. Among other reasons, a number of sections of the Code expressly incorporate state
law. For example, unless the Bankruptcy Code specifically provides otherwise, bankruptcy courts
look to state law to determine property rights. Thus, whether a creditor is properly secured and
perfected in personal property of a debtor will be determined by the state’s version of Article 9 of the
Uniform Commercial Code. Similarly, the validity of a mortgage or other secured interest against
real property is likewise subject to the law of the state in which the property is located.
BANKRUPTCY COURTS
The United States is divided geographically into 94 different federal districts. In each of
those 94 federal districts, there are one or more bankruptcy judges presiding over a U.S. bankruptcy
court.
Bankruptcy judges are appointed by the federal court of appeals that presides over the district
in which the bankruptcy court is located. They serve a 14-year term, which can be renewed, but they
can only be removed by the circuit judicial council (a body comprised of circuit court and district
court judges) “for cause.” A bankruptcy judge’s salary is 92 percent of that of a federal district
judge, and the expenses of facilities, staff, and operating the bankruptcy court are paid by the federal
judiciary.
Under the Judiciary Code, 28 U.S.C. §1134, U.S. district courts have original subject matter
jurisdiction over bankruptcy matters. However, bankruptcy courts are considered to be “units” of
the district courts, and bankruptcy cases are automatically “referred” to the bankruptcy court in each
district.
Because bankruptcy courts are established to adjudicate the Bankruptcy Code, they are said
to be Article I courts, meaning that they are authorized by Congress pursuant to its powers under
Article I of the Constitution. In this way they are different from Article III courts (federal district,
circuit courts, and the U.S. Supreme Court) that are provided for under Article III of the
Constitution. Only Article III courts may enter final orders that determine issues involving life,
liberty, or property rights. Therefore, this sometimes limits the powers of bankruptcy courts do
decide contract or other legal issues relating to a bankruptcy case. In such situations, the bankruptcy
court can hear the issue, but then refer it to the federal district court with its recommendations. The
federal district court may then enter a final order on the specific issue. Otherwise, all matters arising
under the Bankruptcy Code are typically heard only by bankruptcy courts.
FILING BANKRUPTCY
The Role of Lawyers and Other Professionals:
Attorneys and other professionals, such as accountants and financial advisors, may be hired
to represent the debtor and other parties in a bankruptcy case. A key qualification is that the
professional person must be “disinterested” and “not hold or represent an interest adverse to the
estate.” For example, the attorney may not also represent a creditor in the same case, shareholders
of the debtor, or have a direct financial interest in the debtor. The court must approve employment
of a professional to represent the debtor in a bankruptcy case. Prior to such employment, the
professional must disclose any potential conflict of interest with the debtor, such a prior
representation of a creditor in the case or some other adverse situation. Other parties in the case
may object to employment of a professional if he or she does not meet the disinterestedness
standard.
In a Chapter 11 case, if a creditors’ committee or other committees have been formed, such
committees, with the approval of the court, may employ attorneys to advise and represent them in
the case. The retention, qualifications, and other requirements for such professionals are the same as
with employment of professionals by the debtor.
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Petitions and Schedules:
As stated above, a Chapter 11 case is commenced by filing a petition with a bankruptcy court, along
with the filing fee, which is currently $550. In addition to the petition and a declaration of authority
to file signed by its officers, a Chapter 11 debtor must also file schedules of assets, liabilities, and
other business and financial disclosure documents.
All federal courts, including bankruptcy courts, are linked by electronic case filing (ECF). This is a
uniform electronic system for commencing cases, filing documents, entering orders, and otherwise
maintaining the official docket in the case. All documents related to the case are filed electronically.
The vast majority of bankruptcy cases are filed voluntarily, meaning the debtor itself (i.e., its
management) makes the decision to file for relief. But the Code also permit a debtor to be forced into
a Chapter 7 (liquidation) or Chapter 11 (reorganization) bankruptcy by creditors filing an
involuntary petition.
MODULE 7: LESSON 2, PART 1
KEY BANKRUPTCY CONCEPTS
AUTOMATIC STAY
Section 362(a) of the Code provides that the filing of a bankruptcy petition automatically
stays (stops) any action by a creditor to collect on an existing debt or any action by the creditor to
improve his position with respect to other creditors. This is one of the most powerful effects of
bankruptcy and is intended to retain the status quo as much as possible while the debtor reorganizes
its finances. Accordingly, the scope of the automatic stay is interpreted broadly by courts. Any
person or entity who violates the stay may be found in contempt of court, and the court may award
money damages to the debtor if violation of the stay was willful.
As provided in §362(a), the filing of a voluntary, involuntary, or joint bankruptcy petition
operates as a stay, applicable to all entities, against:
•
commencement or continuation of any action against the debtor to recover a claim that
arose before the case;
•
enforcement of any prepetition judgment against the debtor or against property of the estate;
•
any act to obtain possession of property of the estate or from the estate, or to exercise control
over such property;
•
any act to create, perfect, or enforce a security agreement or lien against property of the
estate.
There are a few exceptions to the stay, primarily dealing with actions by government to
enforce criminal or civil penalties, or to allow a creditor to perfect a security interest if the statutory
grace period for doing is still applicable at the time the bankruptcy case is filed.
Actions taken in violation of the stay are void and of no legal force and effect. Thus, if a
creditor obtains a judgment in state court against the debtor after the debtor filed bankruptcy, the
debtor is not required to prove in state court that the creditor was not entitled to judgment in order to
have the judgment nullified. The debtor need only show that the judgment was obtained in violation
of the stay. Similarly, if property of the estate is sold at a sheriff’s auction without knowledge that a
bankruptcy case was filed, even if just minutes after, the sale is void and no title passes to the buyer.
There is no innocent buyer protection if the sale was in violation of the stay. The stay of an act
against property of the estate continues until the property is no longer property of the estate, or until
the case is closed, dismissed, or an order granting or denying discharge is entered.
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Relief from Stay
Once the stay is in effect, creditors must look to bankruptcy procedures to pursue their
claims. A reorganization case can take many months—a long time for secured creditors with
collateral under the control of the debtor. One way for secured creditors to get out from under
bankruptcy court administration is to obtain relief from stay under §362(d).
Section 362(d) provides that upon request of a party in interest, and after notice and hearing,
the bankruptcy court “shall grant relief from stay … such as by terminating, annulling, modifying or
conditioning the stay….” A request for relief from stay is made by filing a motion with the court.
There are several permissible grounds for lifting the stay, but two are particularly important in
business cases.
First, under §362(d)(1), the bankruptcy court must grant relief from stay “for cause,”
including lack of “adequate protection” of an interest in property by a secured creditor. Generally,
secured creditors are protected in their claims by the value of their collateral. The automatic stay
does not deprive creditors of their interest in the collateral, but it does prevent them from pursuing
legal remedies outside of bankruptcy to enforce their claims. The debtor’s retention and continued
use of the collateral when the stay is in effect can result in a loss of the value of the creditor’s security
interest. This progressive loss of value is called lack of adequate protection. As you might expect,
loss of value and lack of adequate protection is of great concern to creditors, and in most instances
will cause them to vigorously pursue any and all possible action to obtain control over the collateral.
Second, with respect to an action stayed against property of the estate, §362(d)(2) requires
the court to lift the stay if the debtor does not have equity in the property and the property is not
necessary to an effective reorganization. For example, if, as part of its restructuring efforts, the
debtor has shut down certain production lines, any equipment or other assets associated with that
production is clearly not necessary to the debtor’s reorganization, and may permit a secured creditor
to obtain relief from stay to foreclose on the property.
MODULE 7: LESSON 2, PART 2
KEY BANKRUPTCY CONCEPTS
CREDITORS AND CLAIMS
A claim in bankruptcy is a right to payment, including a right that arises because of a
contract or legal judgment, potential legal claim, as well as a right to payment that may be
unliquidated, contingent, unmatured, disputed, etc. It can also include equitable rights, such as the
right to specific performance of a contract. In short, a claim is intended to include all existing and
potential grounds for liability against the debtor.
In order to receive any payment for its claim, a creditor should file a “proof of claim.” A
proof of claim is a written statement setting forth the creditor’s claim. The proof of claim serves as
formal notice of the creditor’s right to a distribution from assets of the estate. A proof of claim is filed
on an official form called Bankruptcy Form 10. The proof of claim form must be completed by the
creditor, signed, and mailed or delivered to the bankruptcy court clerk or the bankruptcy trustee or
both, as the form directs. If the claim is based on a writing (e.g., promissory note, written contract,
security agreement, mortgage), a copy of the writing must be attached to the proof of claim.
SECURED CREDITORS
As a general rule, a secured creditor is entitled to the value of its collateral. A creditor is fully secured
if the dollar value of its collateral is at least as much as the dollar amount of the claim. A creditor is
oversecured if the dollar value of the collateral exceeds the dollar amount of the claim. A creditor is
undersecured (also called partially secured) if the dollar value of the collateral is less than the dollar
amount of the claim. For example, assume that Creditor #1 has a prepetition secured claim against
the debtor in the amount of $1,000,000 and the property in which it is secured has a value of
$1,000,000. The creditor is fully secured. Creditor #2 has a prepetition secured claim against the
debtor in the amount of $1,000,000 and the property in which it is secured has a value of $1,250,000.
That creditor is oversecured. The amount by which the creditor is oversecured is sometimes called
an equity cushion, so this creditor has an equity cushion of $250,000. Creditor #3 has a prepetition
secured claim against the debtor in the amount of $1,000,000 and the property in which it is secured
has a value of $750,000. That creditor is undersecured, or only partially secured. Colloquially, the
creditor can be said to be “underwater.”
Section 506(a)(1) of the Code provides that a secured claim in bankruptcy is only secured up to the
value of the collateral at the time the petition is filed. For a wholly secured and oversecured creditor
that presents no problem—its secured claim will be valued at the full amount of the indebtedness.
But for an undersecured creditor that means its secured claim will be allowed only up to the value of
the collateral. For the balance of what it is owed over the value of the collateral, its claim will be
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unsecured. Thus, an undersecured claim can be bifurcated or split into secured and unsecured
portions. Therefore, Creditor #3, above, has a secured claim for $750,000 and an unsecured claim
for $250,000. Practitioners sometimes refer to this bifurcation as a “strip down” or “write down.”
The undersecured creditor does not forfeit the unsecured portion of its claim, but it can only pursue
that claim through the bankruptcy process as an unsecured claim. Bifurcation of secured claims is a
key component of many Chapter 11 Cases.
UNSECURED CREDITORS
If the debt owed a creditor is not secured by any real or personal property of the debtor, and there is no
additional security provided by a co-signer, surety, or guarantor, the debt is unsecured. As a general rule,
most unsecured creditors usually have the same priority and share “pro rata” (equal percentage of their
claim) in any distribution of the debtor’s assets.
There can be many other types of unsecured creditors in a business bankruptcy, such as unpaid wages or
salaries, claims for breach of contract, unpaid lease payments, sale taxes, payroll taxes, tort liabilities, etc.
Bankruptcy practitioners often use the term “trade creditors,” which refers broadly to vendors and
suppliers that provided goods, supplies, services, materials, inventory, and other forms of value to the
debtor prepetition and in the ordinary course of business, and for which payment was owed at the time the
debtor filed bankruptcy. It is common practice in many industries for a vendor or supplier to deliver
goods or services to a customer, and then for payment to be made at a time thereafter without any security
agreement. As a result, between the time of delivery and time of payment, the vendor or supplier is an
unsecured creditor.
For example, Tool Co. manufactures and delivers precision tool parts to Dover Manufacturing, Inc. on a
weekly basis. An invoice is included with each delivery, specifying payment terms of net 60 days,
meaning that Dover must pay the invoice within 60 days after each delivery. Assume that Dover
Manufacturing filed bankruptcy on June 1. Tool Co. is an unsecured trade creditor for all outstanding,
unpaid invoices. Assume further that immediately before it filed, Dover also terminated certain
employees whose employment contracts included severance packages. The employee claims for
severance benefits are also unsecured claims.
There is a special type of unsecured claim called an administrative claim. This includes unsecured claims
incurred by the debtor postpetition (during the bankruptcy), and can include legal and professional fees,
new borrowing made while in bankruptcy, cost of goods and services provided to the debtor, etc.
Administrative claims have priority over all other unsecured claims and must be paid in full before any
other claims may be paid. For example, if all the available assets are exhausted in paying administrative
claims, general unsecured creditors will receive nothing.
In larger cases in which there are many unsecured creditors, an Official Committee of Unsecured
Creditors (also called a “creditors’ committee”) may be appointed to represent the interests of all
unsecured creditors. Creditors can play a critical role in a Chapter 11 reorganization. While the exact
composition of the creditors’ committee can be flexible, members must be representative of the different
kinds of claims.
LEASES AND EXECUTORY CONTRACTS
Almost every business is a party to one or more contracts or leases, and many businesses are parties to
hundreds or thousands of them. These can include real property leases for office, commercial, or retail
space; personal property leases for equipment or vehicles; and contracts for almost any type of endeavor,
such as purchase and sale agreements, supply agreements, employment contracts, IP licenses, and so on.
Parties enter into leases and contracts usually because they expect the relationship to be profitable. But
sometimes, for any number of reasons, the lease or contract can become unprofitable, and create the
incentive for a party to want to terminate or breach the contract. To do so would normally expose the
party in breach to possible damages under applicable contract law. But for a debtor in bankruptcy, the
status of contracts and leases is quite different.
Section 365 of the Code governs “executory contracts and unexpired leases,” and grants the debtor certain
powers that are not available outside of bankruptcy. Specifically, §365(a) allows the debtor to assume or
reject (continue performing or terminate) a contract, cure (pay) a contract default with no further penalty,
or assign (sell or transfer) a contract to an assignee, even over the objections of the non-debtor party. If
the debtor properly rejects a contract pursuant to §365, the rejection is treated as a prepetition breach, and
the other party to the contract will have an unsecured claim for any prepetition amounts owed by the
debtor, and any other damages resulting from that breach.
The option to assume, reject, and/or assign can be extremely beneficial to a debtor in restructuring its
business. Consider the following examples:
1. The debtor is the buyer under a contract to buy widgets at a price of $47 per ton. If the spot
price (current market price) rises to $52 per ton, the contract is valuable to the debtor because
the contract price for widgets is less than the debtor would have to pay on the open market.
Therefore, the debtor will assume the contract.
2. Assume the same facts as above, except that the spot price has dropped to $42 per ton. The
debtor is likely to reject the contract because it can buy widgets for a lower price on the open
market.
3. Now assume that the debtor is the seller under an agreement to sell widgets at a price of $47
per ton. If the spot price of widgets rises to $52 per ton, the seller will reject the contract
because it can sell widgets for a higher price on the open market that it could under the
contract.
4. Same facts as #3, except that the spot price has gone down to $42 per ton. In this case the
debtor is likely to assume the contract because the price it gets for widgets under the contract
is more than it could get on the open market.
Because of §365, the debtor is allowed to pick and choose which contracts it wants to retain, and which
ones it wants to terminate or assign. But what if the nondebtor party becomes dissatisfied and wants to
terminate the contract? In most instances, unilateral termination of the contract postpetition by the
nondebtor party will be deemed in violation of the automatic stay, and can result in substantial damages.
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MODULE 7: LESSON 2, PART 3
KEY BANKRUPTCY CONCEPTS
POST PETITION FINANCING
Postpetition Financing
Operating a business after the Chapter 11 petition has been filed will typically require the
debtor to incur new or additional debt, either by purchasing on credit or borrowing funds. For
example, a debtor operating grocery stores will need to order foodstuffs and sundries from wholesale
suppliers on a daily basis. A debtor operating retail stores will need to order new inventory weekly.
A debtor in manufacturing has orders to fill and will need to purchase materials to fill those orders.
If suppliers of any of these debtors will not sell to them on credit as they ordinarily would
prepetition, the debtors will need to borrow money in order to stay in business.
Postpetition debt incurred in the ordinary course of business
The debtor may incur unsecured debt postpetition in the form of a loan or extension of credit
without court approval so long as the debt is incurred in the ordinary course of the debtor’s business.
Such debt is treated as an administrative expense. So, in the last example, as long as the purchases of
produce by the grocery chain, inventory by the retail chain, and materials by the manufacturer are
done in the ordinary course of debtor’s business, they will not need court approval for them. If a
debtor has ordinarily done business with its suppliers on credit, continuing to do so will be within its
ordinary course of business.
Postpetition debt incurred other than in the ordinary course of business
If the debtor needs to incur unsecured debt other than in the ordinary course of its business,
§364(b) requires that a motion for authorization to incur the debt or obtain credit be filed. The
motion may only be granted “after notice and a hearing.” Assume, for example, that debtor’s
suppliers, who normally sold to it on credit terms of net 60 days, now demand cash on delivery.
That will drain debtor of its cash on hand, so the debtor arranges an unsecured line of credit with
New Era Capital in order to pay its suppliers. The debtor must receive court approval to obtain the
loan, since this is not the way the debtor has ordinarily done business.
Postpetition debt incurred in other than the ordinary course of the debtor’s business also
receives priority treatment as an administrative expense. That may be sufficient to induce to the
creditor make the loan or extend the credit. But what if a potential creditor concludes it is not a
sufficient inducement? The Code allows the debtor, with court permission, to grant the creditor a
“superpriority” position over all other administrative expense claims. A superpriority administrative
expense must be paid before any other priority administrative expenses. Since all postpetition
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expenses have priority as administrative expenses, this approach may induce the creditor to extend
unsecured postpetition credit to the debtor by granting it a first-among-equals priority status as to its
claim.
Postpetition Secured Debt
Potential creditors may refuse to extend postpetition loans or credit unless they receive a
security interest in property of the estate. A postpetition debt arrangement involving the granting of a
security interest to the creditor always requires court approval. Whether the proposed transaction
will receive court approval depends in large part on how it is structured. A particular concern is how
the proposed post-transaction debt arrangement will impact the debtor’s prepetition creditors.
The court may approve a transaction giving the postpetition creditor a security interest in
property that is not presently encumbered. For example, assume that New Era Bank refuses to
make a loan to the debtor, Energy Holdings, Inc., unless it is granted a security interest in some
property of sufficient value to secure the loan amount. To obtain approval for the loan, Energy
Holdings would have to establish that it is unable to otherwise obtain the loan and that it is able to
grant New Era a security interest in some property that is not already encumbered as collateral for
another debt.
A court may also approve a transaction giving a creditor a junior security interest in property
that is presently encumbered. So, if Energy Holdings in the above example has no unencumbered
assets, but New Era is willing to lend in return for a second secured position in property of the
debtor, the court can approve the transaction.
Now assume that Energy Holdings has no unencumbered property, and New Era is
unwilling to accept a junior lien. Section 364(d) authorizes the court to approve a postpetition debt
arrangement that grants New Era a secured position senior to that of an existing prepetition secured
creditor. This type of postpetition lien is sometimes referred to as a priming lien because it primes (is
deemed senior to) prepetition liens and primes the pump for the postpetition loan. Another common
term is a superpriority lien. Granting a priming or superpriority lien to a postpetition creditor is
obviously a dramatic step for a court to take and it is rarely granted. In fact, it can only be granted
where:
•
The debtor-in-possession (DIP) is unable to obtain postpetition unsecured debt or credit; and
•
The secured creditor whose prepetition lien is impaired is given adequate protection for its
loss as by being granted an additional lien in other property or cash payments.
In this video the instructor discusses the informal practice of obtaining support from unsecured
credit.
MODULE 7: LESSON 2, PART 4
KEY BANKRUPTCY CONCEPTS
THE USE AND SALE OF ASSETS DURING THE BANKRUPTCY CASE
Sale or Use in the Ordinary Course
Section 363(c) of the Code provides that the debtor may use, sell, or lease property of the
estate postpetition “in the ordinary course” without permission of the court. For example,
Consolidated Equipment, Inc. leases and sells heavy construction equipment such as backhoes,
cranes, and bulldozers. After filing bankruptcy, Consolidated may continue to lease and sell
construction equipment just as it did before bankruptcy without getting permission from the court
each time it does so. Because Consolidated was in the business of leasing and selling equipment
prior to filing bankruptcy, continuing to do so after bankruptcy is considered to be doing business
“in the ordinary course.” Another company, a furniture manufacturing company called Union
Furniture Co. is also in Chapter 11. During the pendency of the case, Union may continue to use its
lathes, routers, vehicles, manufacturing plant, and all other machines and equipment to make
furniture. In addition, Union can continue to sell the furniture it makes, all without court permission
because this activity is consistent with the normal operation of the debtor before it filed bankruptcy.
Sale or Use Outside of the Ordinary Course
However, suppose Consolidated wants to sell its office building, or Union decides to raise
cash by selling its plant or some of its equipment. Section 363(c) does not allow for this.
Consolidated was not in the business of selling real estate before filing bankruptcy, so selling its
office building is not in the ordinary course. Likewise, Union was not in the business of selling
industrial real estate or equipment before it filed bankruptcy. Selling such assets, sometimes called
capital assets (assets with a useful life of more than one year and not usually sold in the normal
course of business), could potentially reconfigure the debtor’s operations and financial structure
without oversight or input by the court, creditors, or other parties in interest.
Yet selling or transferring capital assets may be essential for the debtor’s survival, for
example, to get rid of poorly performing assets, accomplish strategic restructuring, or simply to raise
cash. Accordingly, §363(b) provides that the debtor, “after notice and a hearing, may use to use, sell
or lease, other than in the ordinary course of business, property of the estate….” In this way, the
Code grants the debtor an important option for restructuring, but only with court approval and the
opportunity for participation and input from interested parties. Using the example above, Union
Furniture Co. might decide to sell unprofitable furniture lines and related equipment in order to
invest in newer and more promising products. Or, Consolidated might decide to sell its office
building or even liquidate its assets entirely.
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Credit Bidding
Assume that a debtor such as Consolidated Equipment obtains bankruptcy court permission
to sell its office building outside the ordinary course under §365(b). A common form of such sale is
a public auction at which bidders compete by making increasingly higher bids. Assume further than
a secured creditor, Midland Bank, is owed $10 million secured by a senior lien against Continental’s
office building and adjoining real estate. Consolidated may sell the building and property to the
highest bidder, as per the bankruptcy court order, but Midland Bank, as the secured creditor, is
entitled to the proceeds of the sale until it recovers the amount of its security interest ($10 million).
But what if the Midland itself wants to bid at the auction? In fact, in real life, the debtor’s
senior secured creditor is sometimes the only party who is interested bidding on secured assets. Let’s
assume that at the public auction of Consolidated’s real estate, Midland is the successful bidder with
a winning bid of $8 million. Is Midland required to pay the auctioneer $6 million in cash, even
though Midland is entitled to receive the money right back? In order to avoid the time and cost of
what amounts to the creditor paying itself, §363(k) allows the creditor to bid up to the amount of its
security interest at a sale of its collateral, without having to actually pay that amount with real
money. In other words, rather than bid with actual money, a secured creditor may bid the amount it
is owed to purchase the collateral. This is called credit bidding. So, rather than pay the auctioneer
actual money, Midland can credit bid against other potential buyers at the auction, up to the amount
of its security interest. Assuming it had the winning bid of $6 million, Midland will have purchased
Consolidated’s office and real estate for that amount, but does not have to pay any anything to the
auctioneer or Consolidated. Midland will deduct $6 million from its claim against Consolidated,
and may file an unsecured claim for the remaining amount. However, what if the bidding had gone
over $10 million? For any bids over the value of its collateral, Midland would have to pay the
additional amount in cash. For example, if Midland had the high bid of $12 million, it would have
to pay $2 million to Consolidated, and the debt owed by Consolidated to Midland would be fully
satisfied.
CONCEPT CHECK QUESTIONS:
Rover Equipment Co. (Rover) is a cash-strapped manufacturer of heavy machinery for
construction and other uses. It wants to file bankruptcy in order to stop a litany of lawsuits
and collection actions by trade creditors claiming unpaid bills. Rover also wants to
terminate a large number of its dealership agreements, so that it will have fewer dealerships
to support. However, the affected dealers will vigorously oppose any such efforts. How will
filing bankruptcy help address these concerns?
(1) The automatic stay will halt any on-going collection and enforcement
measures by trade creditors, and transform their claims into unsecured claims.
In addition, Rover will be able to terminate unfavorable dealership contracts
as part of its reorganization efforts.
The automatic stay will temporarily halt collection efforts by trade creditors,
but only until the court grants relief from stay “for cause.” In addition, the
bankruptcy court will most likely require Rover to affirm at least some of the
dealership agreements, since it would be very unfair to suddenly terminate so
many of them.
The automatic stay will not stop creditors from enforcing debts that they are
legitimately owed. In addition, the bankruptcy court will permit Rover to
reject a dealership agreement only if Rover can prove that the benefit to the
debtor will outweigh the harm caused to the dealer from the rejection.
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MODULE 7: LESSON 3, PART 1
THE CHAPTER 11 PLAN:
Except in unusual circumstances, Chapter 11 is like a quest in which the ultimate destination is a confirmed plan
of reorganization. Plans are usually the product of negotiation between the debtor and its primary secured
creditors. Depending upon the specifics of the case, unsecured creditors, as represented by the Creditors’
Committee, as well as other parties in the case can also play an important role in formulating the plan. While
the Code mandates certain elements in a plan, customary practice and usage by practitioners and courts over
time have given rise to standard plan formats and common verbiage used in Chapter 11 plans.
A key requirement of a Chapter 11 plan is that it must organize claims into separate classes. Claims that are
similar in nature, such as unsecured trade claims, must be placed into the same class. Different types of
unsecured claims, for example, claims arising from rejected contracts, would usually go into a separate class.
Claims of secured creditors are typically organized into different classes based on the creditor and collateral that
secures their claims. In large business bankruptcies, bondholder claims are a separate class, and these may be
further divided if there are different types of bonds. Administrative claims are usually placed in their own class,
as are insurance claims, utility claims, and tort claims. Finally, the claims of shareholders (called “interests”),
are likewise grouped into a separate class.
PLAN CONTENTS
Section 1123 governs the contents of a plan of reorganization, and sets forth certain
mandatory as well as optional provisions. Plan formulation can be very complex, and we will
discuss only some basics here.
A chapter 11 plan of reorganization may include a variety of provisions, such as:
•
Arrearages on debt to be paid in full, in part, or not at all;
•
Property be retained by the debtor, abandoned, or transferred to another person or entity;
•
Security interests be retained, satisfied, or modified;
•
New shares of a corporate debtor be issued or that the corporation merge or consolidate with
another;
•
Maturity dates on debt be extended or installment payments reduced and extended;
•
Unsecured debt be paid in full, in part, or discharged;
•
Members of a class receive a transfer of designated property in satisfaction of their claims; or
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•
Any other proposal not inconsistent with the Code be allowed.
One of the most powerful tools at the debtor’s disposal deals with secured claims in a
Chapter 11 plan. Section 1123(b)(5) allows the debtor to leave a secured claim unaffected or to
modify it. Therefore, the plan may propose to:
•
cure an arrearage on a secured debt during the term of the plan, make all future scheduled
payments, and retain the collateral;
•
pay an undersecured creditor the value of the collateral and treat the balance as unsecured
debt in the plan;
•
pay the amount owed a secured creditor in full but lower the rate of interest and/or extend
the term of the installments as long as the present value of the secured creditor’s claim is paid
during the term of the plan;
•
surrender collateral to the secured creditor and leave the creditor with an unsecured claim for
the balance owed over the value of the collateral;
•
In short, the debtor can rewrite the loan so long as the present value of the secured claim is
paid.
As you can see, a debtor has many possibilities and choices for how it deals with debt to
restructure its business.
PLAN VOTING
Section 1126(a) provides that creditors and equity security holders (such as shareholders) are
entitled to vote to accept or reject a proposed plan of reorganization. Proponents and opponents of
the plan may solicit those entitled to vote. Such solicitation must be done in good faith. A class that
is not impaired (meaning that its claims are paid in full) is presumed to have accepted the plan and is
not entitled to vote. Conversely, a class that will not receive any distribution under the plan is
deemed to have rejected the plan, and is likewise, not entitled to vote. So, solicitation of acceptances
from these classes of creditors is not required.
Each creditor or equity interest in a class that is entitled to vote receives a ballot along with
the other materials provided to them after the hearing on the disclosure statement. They must mark
the ballot indicating an acceptance or rejection of the plan and return it by the deadline prescribed by
the court.
Voting to accept or reject a Chapter 11 plan is by classes, and is not by vote of individual
members of the class. In other words, the votes of each class member are tallied to determine if the
class as a single unit has accepted or rejected the plan. A class of claims accepts a plan if it is
accepted by
•
at least two-thirds of the dollar amount and
•
more than one-half of the creditors.
of the allowed claims that vote on the plan. This means that an affirmative vote of a class is
calculated based on the members of the class who vote on the plan, and requires a majority of claims
that collectively hold two-thirds of dollar amount of all claims that voted. For example, if a class of
claims has 100 members but only 60 of them voted on the plan, an affirmative vote for the class
requires that at least 31 of the votes are to accept the plan, and that collective value of the claims
held by the 31 who voted to accept the plan equals at least two-thirds of the total combined value of
claims held by the 60 members who returned ballots. For voting purposes, we do not care about the
40 class members who did not return ballots.
PLAN VOTING
Section 1126(a) provides that creditors and equity security holders (such as shareholders) are
entitled to vote to accept or reject a proposed plan of reorganization. Proponents and opponents of
the plan may solicit those entitled to vote. Such solicitation must be done in good faith. A class that
is not impaired (meaning that its claims are paid in full) is presumed to have accepted the plan and is
not entitled to vote. Conversely, a class that will not receive any distribution under the plan is
deemed to have rejected the plan, and is likewise, not entitled to vote. So, solicitation of acceptances
from these classes of creditors is not required.
Each creditor or equity interest in a class that is entitled to vote receives a ballot along with
the other materials provided to them after the hearing on the disclosure statement. They must mark
the ballot indicating an acceptance or rejection of the plan and return it by the deadline prescribed by
the court.
Voting to accept or reject a Chapter 11 plan is by classes, and is not by vote of individual
members of the class. In other words, the votes of each class member are tallied to determine if the
class as a single unit has accepted or rejected the plan. A class of claims accepts a plan if it is
accepted by
•
at least two-thirds of the dollar amount and
•
more than one-half of the creditors.
of the allowed claims that vote on the plan. This means that an affirmative vote of a class is
calculated based on the members of the class who vote on the plan, and requires a majority of claims
that collectively hold two-thirds of dollar amount of all claims that voted. For example, if a class of
claims has 100 members but only 60 of them voted on the plan, an affirmative vote for the class
requires that at least 31 of the votes are to accept the plan, and that collective value of the claims
held by the 31 who voted to accept the plan equals at least two-thirds of the total combined value of
claims held by the 60 members who returned ballots. For voting purposes, we do not care about the
40 class members who did not return ballots.
Section 1123 governs the contents of a plan of reorganization, and sets forth certain
mandatory as well as optional provisions. Plan formulation can be very complex, and we will
discuss only some basics here.
A chapter 11 plan of reorganization may include a variety of provisions, such as:
•
Arrearages on debt to be paid in full, in part, or not at all;
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•
Property be retained by the debtor, abandoned, or transferred to another person or entity;
•
Security interests be retained, satisfied, or modified;
•
New shares of a corporate debtor be issued or that the corporation merge or consolidate with
another;
•
Maturity dates on debt be extended or installment payments reduced and extended;
•
Unsecured debt be paid in full, in part, or discharged;
•
Members of a class receive a transfer of designated property in satisfaction of their claims; or
•
Any other proposal not inconsistent with the Code be allowed.
One of the most powerful tools at the debtor’s disposal deals with secured claims in a
Chapter 11 plan. Section 1123(b)(5) allows the debtor to leave a secured claim unaffected or to
modify it. Therefore, the plan may propose to:
•
cure an arrearage on a secured debt during the term of the plan, make all future scheduled
payments, and retain the collateral;
•
pay an undersecured creditor the value of the collateral and treat the balance as unsecured
debt in the plan;
•
pay the amount owed a secured creditor in full but lower the rate of interest and/or extend
the term of the installments as long as the present value of the secured creditor’s claim is paid
during the term of the plan;
•
surrender collateral to the secured creditor and leave the creditor with an unsecured claim for
the balance owed over the value of the collateral;
•
In short, the debtor can rewrite the loan so long as the present value of the secured claim is
paid.
MODULE 7: LESSON 3, PART 2
THE CHAPTER 11 PLAN
CHAPTER 11 PLAN CONFIRMATION
Section 1129 governs the requirements for court confirmation of a plan of reorganization. Plan
confirmation is often complicated, and we will only give a basic introduction here.
There are two alternative methods of confirmation set forth in that section. Confirmation under
§1129(a) contemplates that all classes of creditors and claims, including any impaired class, accept
the plan. This is known as “consensual confirmation.” Confirmation under §1129(b), known as
“cramdown confirmation,” may be permitted if at least one impaired class has accepted the plan,
even if all other impaired classes vote to reject, and the other provisions of §1129(b) are satisfied.
Plan negotiation is often a delicate balance: Creditors are aware that the debtor may be able to get a
cramdown plan approved, while debtors recognize that most bankruptcy courts are loath to confirm
a plan over the vociferous objections of creditors. After the contention subsides, even though plan
negotiations take place in the shadow of cramdown, most plans are confirmed as consensual plans
under §1129(a).
Consensual confirmation
A plan may be confirmed under §1129(a) if all classes of impaired claims accept the plan, and certain
other requirements are met.
Cramdown
Most Chapter 11 plans are successfully negotiated so that all classes vote to accept the plan and
confirmation is accomplished by consent. Cramdown confirmation becomes necessary only when
one or more impaired classes have voted to reject the proposed plan. Even with cramdown under
§1129(b), however, at least one class must have voted to accept the plan.
Under a §1129(b) confirmation, we are concerned only with those objecting classes because the other
classes have voted to accept the plan. One of the key requirements is that the plan must be “fair and
equitable” to any class that has rejected the plan. The Code sets forth what this means when applied
to secured and to unsecured creditors.
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Secured creditors
In order to meet the fair and equitable requirement for cramdown confirmation, the plan must
ensure that an impaired secured claim in a class objecting to the plan receives the full amount of the
allowed secured claim. Recall that the amount of the secured claim is limited to the value of the
collateral. The plan can ensure that the objecting secured creditor receives the full amount of its
secured claim in one of three ways:
1. The secured creditor will retain its lien on the property and receive deferred cash payments
equal to the present value (as of the plan confirmation date) of its allowed secured claim;
2. the property will be sold free and clear of the lien, with the lien to attach to the proceeds of
sale up to the value of its secured claim; or
3. the secured creditor will receive the “indubitable equivalent” of its claim.
If the debtor chooses #1 and pays the creditor deferred cash payments over time, the debtor must
pay interest on the claim so that the deferred payments add up to the value of the creditor’s claim. If
the property is sold as per #2, but the proceeds are insufficient to pay the claim, the creditor may
assert an unsecured claim for the deficiency. As for #3, the Code does not state exactly what
“indubitable equivalent” means, but a debtor may compel a secured creditor to accept substitute
collateral with the same value in place of its original collateral.
Unsecured creditors
A plan will be fair and equitable to a class unsecured creditors if it pays all unsecured claims in full,
or if the holders of claims or interests junior to the dissenting class do not receive or retain any
property under the plan. This is known as the “absolute priority rule.” It means that if the
unsecured claims in the objecting class are not paid in full, “then any claim or interest that is junior”
to the claims of the impaired objecting class may not receive any property “on account of such claim
or interest.”
In most cases, the only interests junior to unsecured claims are the equity interest of the owners, so
the effect of this rule is that the owners of the debtor must forfeit their ownership interest in the
debtor if unsecured creditors are not paid in full and they do not accept the plan.
For example, assume that Central Manufacturing Corporation proposes a plan in which a class of
trade creditors holding unsecured debt will receive 50 percent of what they are owed. The class is
thus impaired. Assume that the plan also provides that the shareholders will retain their equity
interests in Central Manufacturing. If the class of trade creditors votes to reject the plan, then the
plan does not satisfy the fair and equitable requirement because the creditors in the objecting
impaired class have not received 100 percent of their claims over the term of the plan. To satisfy the
absolute priority rule, the plan must provide that existing shares in Central be voided. Shareholders
cannot receive any distribution as owners under the plan, and they cannot retain an ownership
interest in debtor. The plan would have to call for cancelation of the shares and for new ownership
or for the bidding off of the ownership interest with the proceeds going to the debtor, not its existing
shareholders.
An exception to the absolute priority rule would be allowed if the shareholders agreed to contribute
new value (money or property that was equal in value to any ownership interest they would retain.
In this way, shareholders can sometimes buy their way back into ownership of a reorganized debtor.
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