An Overview of the Chapter 11 Reorganization Process

1
An Overview of the Chapter 11 Reorganization
Process

• THE SECOND FORUM FOR ASIAN INSOLVENCY REFORM
  (FAIR)Bangkok, ThailandDecember 16 17, 2002

Presented by George Kelakos, Co-Chair of the
International Committee of the American
Bankruptcy Institute
2
Introduction

• Economic Premises of Chapter 11 (Reorganization)
• Players
• Strategic Objectives of Players
• Valuation Issues

3
Phases Of A Chapter 11 Case

• Prepetition
• Initial Phase
• Middle Phase
• Final Phase

4
Economic Premises of Chapter 11 (Reorganization)

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

5
Economic Premises of Chapter 11 (Reorganization)

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

6
Who May Be A Debtor?

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

7
Who May Be A Debtor?

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

8
Cast of Principal Characters

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

9
Cast of Principal Characters

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

10
Cast of Principal Characters Professionals

• Legal advisors (Debtor/committee/bank/other
  creditors)
• Financial advisors (Debtor/committee)
• Accountants
• Turnaround management/business advisors
• Investment banker
• Valuation/liquidation experts
• Brokers

11
Strategic Objectives of Players

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

12
Strategic Objectives of Players

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

13
Valuation Issues

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

14
Valuation Issues

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

15
Phases Of A U.S. Reorganization Case

• Prepetition
• Strategic considerations
• Debtor
• Lenders
• Trade creditors

16
Phases Of A U.S. Reorganization Case

• Initial phase
• Petition/automatic stay
• Cash collateral
• Postpetition borrowing
• Relief from the automatic stay

17
Phases Of A U.S. Reorganization Case

• Middle phase
• Executory contracts and unexpired leases
• Assets sales (public/private)
• Avoidance actions
• Development of business plan (exclusivity
  extensions/bar date motion)

18
Phases Of A U.S. Reorganization Case

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

19
PrepetitionStrategic Considerations

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

20
PrepetitionStrategic Considerations

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

21
PrepetitionStrategic Considerations

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

22
Prepetition Debtor

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

23
Prepetition Debtor

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

24
Prepetition Lender

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

25
Prepetition Trade Creditors

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

26
Initial Phase

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

27
Initial PhasePetition / Automatic Stay

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

28
Initial PhasePetition / Automatic Stay

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

29
Initial PhaseCash Collateral

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

30
Initial PhaseCash Collateral

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

31
Initial PhaseCash Collateral

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

32
Initial PhasePostpetition Borrowing

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

33
Initial PhasePostpetition Borrowing

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

34
Initial PhasePostpetition Borrowing

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

35
Initial PhaseRelief From Automatic Stay

• For cause, including lack of adequate
  protection
• Where debtor has no equity in property and
  property is not necessary to an effective
  reorganization

36
Initial PhaseRelief From Automatic Stay

• What is adequate protection?
• Protection vs. decline in value
• Common forms of adequate protection periodic
  cash payments replacement lien on postpetition
  assets

37
Initial PhaseSummary of Strategic Considerations

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

38
Initial PhaseSummary of Strategic Considerations

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

39
Initial PhaseValuation Issues

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

40
Initial PhaseValuation Issues

• Use of cash collateral
• Has collateral experienced a loss or diminution
  of value?
• Is proposed adequate protection sufficient?

41
Initial PhaseValuation Issues

• Postpetition borrowing
• Valuation of new collateral for new loan (risk
  assessment)

42
Middle Phase

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

43
Middle PhaseExecutory Contracts and Unexpired
Leases

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

44
Middle PhaseExecutory Contracts and Unexpired
Leases

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

45
Middle PhaseExecutory Contracts and Unexpired
Leases

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

46
Middle PhaseAsset Sales

• Purpose
• Dispose of non-essential assets in a manner
  generating highest possible return for debtors
  estate

47
Middle PhaseAsset Sales

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

48
Middle PhaseAsset Sales

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

49
Middle PhaseAsset Sales

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

50
Middle PhaseAvoidance Actions

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

51
Middle PhaseAvoidance Actions

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

52
Middle PhaseDevelopment of Business Plan

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

53
Middle PhaseDevelopment of Business Plan

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

54
Middle PhaseValuation Issues

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

55
Middle PhaseValuation Issues

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

56
Final Phase

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

57
Final PhasePlan Confirmation Process

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

58
Final PhasePlan Confirmation Process

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

59
Final PhaseDisclosure Statement

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

60
Final PhaseDisclosure Statement

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

61
Final PhaseElements of a Plan of Reorganization

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

62
Final PhaseElements of a Plan of Reorganization

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

63
Final PhaseConfirmation Standards

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

64
Final PhaseConfirmation Standards

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

65
Final PhaseConfirmation Standards

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

66
Final PhaseConfirmation Standards

• Plan not likely to be followed by liquidation or
  need for further financial reorganization

67
Concluding Observations

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

68
Concluding Observations

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

69
Concluding Observations

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

70
Presented by George M. KelakosHeller Ehrman601
S. Figueroa St.Los Angeles, California
90017(213) 689-7652gkelakos_at_hewm.com
71
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