A Step-by-Step Look at Chapter 11 Richard L. Wasserman Partner Venable LLP
Introduction Chapter 11 bankruptcy practice is a very diverse practice. One day you are a business lawyer addressing the business law questions of a troubled company, advising the board of directors as to its fiduciary duties, negotiating the sale or purchase of a business or important asset, advising a creditor as to its rights against a troubled company already in bankruptcy or on the verge of filing, and many other scenarios often encountered by corporate lawyers. The next day you are a litigator, drafting pleadings and going to court to represent your client, the Chapter 11 debtor-in-possession, a creditor or other party in interest seeking relief in a bankruptcy case. The practice is ever-changing and very fast paced. The nature of the practice varies considerably depending upon whom you are representing the Chapter 11 debtor-in-possession, a creditors committee, a trustee in a Chapter 11 or Chapter 7 bankruptcy case, a secured creditor trying to protect its interests in collateral, a creditor who has reclamation rights against the debtor, the landlord of the debtor, a party who has an important license agreement or executory contract with a debtor, or a party who is interested in purchasing assets from the debtor. This chapter will focus principally on the challenges of representing a company in Chapter 11 and some of the lessons learned along the way in that practice. Facing the Prospect of a Chapter 11 Filing A company considering a corporate restructuring in Chapter 11 most typically is a company in crisis. The nature and causes of the crisis will vary from case to case. There may have been one unexpected, precipitating event causing financial reversal for the company. There may be longer term, accumulated financial losses as sales have fallen and the company has been unable to cut costs commensurate with the decline in revenue. There may be fraud and diversion of assets; there may have been expected or unexpected aggressive creditor activity against the company. There may be a loss of confidence in management. Most typically there are multiple causes of the company s distressed situation. There is likely to be both an internal component to the crisis, conflict within the company, and an external component, conflict with one or more of the key outside stakeholder constituencies. One of the first challenges will be deciding whether the company s traditional counsel should represent the company as it considers a possible Chapter 11 filing. Should outside counsel with substantial Chapter 11 expertise be consulted and retained to work as new general counsel or
bankruptcy counsel for the company? The answer to this question may be driven by management changes at the troubled company, other professionals advising the company, or bankruptcy conflict rules relating to the employment of bankruptcy counsel. To represent a sizeable company in a Chapter 11 case requires an experienced law firm with a sufficient number of lawyers to handle the bankruptcy, business and litigation issues that can be expected to arise in the case. Advising the Troubled Company Recognizing that ultimately it will be the attorney s responsibility to negotiate with the principal stakeholders of the company to develop a Chapter 11 plan of reorganization for the company, it is necessary at the outset for the attorney to develop a clear and objective understanding of the company s current situation, both from a business and financial perspective, and what factors have caused the company s current troubled circumstances. It will be important for the attorney to help assemble a team of advisors to work with the company in assessing its current situation, its future prospects, and a path to recovery or at least realization of maximum value for stakeholders. Attorneys can add value throughout this process by offering sound legal advice based upon years of experience in representing troubled companies. There is no substitute for experience. This is not a time for onthe-job training. The company s management and employees most typically have not experienced the difficult challenges of a troubled company facing a potential bankruptcy filing, so it is critical that they receive calm and steady professional leadership throughout the process. Upon being brought into the case, counsel needs to evaluate the strengths and weaknesses of the company s personnel and advisors. Further, counsel needs to assess what is causing the company s problems, whether they are purely financial or more deep-seated structural problems, whether the problems are temporary or recurring in nature, and whether there is a clear fix to the problems that can be implemented if the company is given some breathing room. Often among the most significant problems is credibility that is the credibility of the company and its management to the financial community, to particular creditors or groups of creditors, and to government or industry regulators. One of the key ingredients that the company s counsel and outside professional advisors can add is credibility. This is one reason why bringing in new counsel and new outside professional advisors for a troubled company may be very important. The alternative may be that if a Chapter 11 case is filed, efforts by one or more creditors, other parties in interest, the 2
United States Trustee or other regulators will result in a Chapter 11 trustee being appointed or the case being converted to a Chapter 7 liquidation. Another very important initial task for the attorney for the troubled company is working with the company s board of directors. An essential part of counsel s service will be providing guidance to the company s directors so that they can be made aware of their fiduciary duties and act accordingly. This has become an even more heightened issue in the post-enron era. The Sarbanes-Oxley Amendments have dramatically underscored and brought new attention to corporate governance issues and the need for professional legal advice for management and boards of directors of all public companies, but particularly so for troubled ones. Boards of directors of troubled companies face an additional challenge with respect to their fiduciary duties as the company approaches and enters what is often called the zone of insolvency. It is generally thought that at some point in an insolvency situation, fiduciary duties of directors shift from being owed exclusively to shareholders to include a duty to the creditors of the company. This rule will vary depending upon applicable corporate law and the facts applicable to each particular company. Experienced counsel is critical in the troubled company scenario. Working with the board through this maze of fiduciary duties becomes a very important part of the process for the lawyer assisting a company through troubled times. What it Means to Choose Chapter 11 Every company is different thus the circumstances surrounding every Chapter 11 are unique. One constant that attorneys and clients can count on is that bankruptcy is very expensive. Not only do companies in Chapter 11 need to pay their lawyers, accountants, financial advisors and other professionals, but they also have to pay the professionals employed by the Creditors Committee as well. This is one of the harsh realities of the economics of Chapter 11. Although the goal of a Chapter 11 is to confirm a viable Chapter 11 plan of reorganization, many Chapter 11 cases result in an orderly liquidation of the company. Indeed, this can be a successful use of Chapter 11 because it allows a troubled company to have adequate time to market its assets, including its business operations, and sell them as a going concern in order to maximize value. Using Chapter 11 rather than Chapter 7 allows the company to remain in control of the sale process rather than having a trustee take over the process. Another clear advantage to buying assets of a troubled company through a bankruptcy sale process is that the buyer can obtain good title to the assets, having the comfort of a court order confirming that the assets are being acquired free and clear of claims of creditors and other 3
interest holders. Buying and selling of businesses and assets in Chapter 11 has become a big business. Sales of businesses in Chapter 11 can be accomplished as part of the confirmation of a Chapter 11 plan or, if the need for speed to implement such a sale is a factor, through what is called a 363 sale of assets, prior to the confirmation of a plan. In either case, there will be an order of the Bankruptcy Court approving the sale free and clear of liens, encumbrances and other interests, or subject to such liabilities as the buyer agrees to assume as part of the transaction. Thus, in what is not an unusual Chapter 11 scenario, the basic core assets of the company are sold during the course of the Chapter 11 case for fair value and that money is then used to pay back creditors in their appropriate order of priority. This process may in fact result in a reorganization of the company with its business continuing, but in the hands of new owners. In addition, there are circumstances, particularly with privately held companies, where the buyer in a bankruptcy sale might be a former owner, or a new group which includes the former owner, all with full disclosure and an opportunity having been given to other interested parties to also bid for the assets being acquired. Thus, a successful Chapter 11 case can take many different shapes, depending upon whose perspective one is viewing the result obtained. Planning for the Chapter 11 Case Dealing with Chaos and Crisis A company facing a Chapter 11 filing needs to consider many factors, but unfortunately, by the time the client approaches its attorney, often it is deep in crisis and does not have a lot of time for planning. Traditionally, seeking the advice of a bankruptcy attorney was the last thing that a client wanted to do. It was tantamount to admitting failure. In more recent times, Chapter 11 has become a more acceptable business reorganization and restructuring tool. From the Chapter 11 attorney s perspective, it is always better to be consulted by a prospective client earlier in the process rather than later. The earlier in the process that a lawyer is consulted, the more time counsel and the company will have to put together a plan. In the ideal situation, there will be sufficient time to consider alternatives to Chapter 11. There may be other ways to solve the immediate problems and achieve the desired result for the company, depending upon what the crisis is and what challenges the company is facing. Developing an appropriate strategy in part demands listening closely to the management team, but as noted above, it also requires assembling a team of other professionals to work with the company. Counsel is only one key player on the team. Depending upon the size of the company and the nature of its business, other professionals might include financial advisors, a 4
turnaround manager, an independent accounting firm and other special counsel to address specific issues requiring separate expertise. Another important member of the professional team might be, in certain cases, a public relations firm experienced in troubled company situations to present the company s turnaround message to the public, the press, and other interested parties including key stakeholders, suppliers and customers of the business. Another important early step in planning for a Chapter 11 filing is to put together what are known as first day motions and orders. There are a number of issues that need to be addressed by the Bankruptcy Court on the first day of filing (or shortly thereafter). The company needs to be prepared to file these pleadings when it files its case. One of the goals in planning for Chapter 11 is to make the filing as seamless as possible from an operational point of view, and in order to achieve this, the company needs to have certain first day orders ready so the judge can consider them at the beginning of the case. Doing so will allow maximum continuity for the business, which is absolutely necessary to maintaining confidence in the face of a Chapter 11 filing. With appropriate planning a company can convey the message that it is filing to protect itself and its value from certain aggressive creditors (or whoever is to be portrayed as the outside evil cause of the filing) and to obtain some needed breathing room in order to achieve a successful restructuring of the company. The goal is to convey the message that the company has a fundamentally sound business, but just needs some time to right the ship. Once the filing occurs, the first goal is to try to stabilize any precipitating crisis that led to the company s seeking Chapter 11 relief. One of the principal protections in bankruptcy is the so-called automatic stay, which stops aggressive creditors from exercising their creditor remedies against the company and its assets. The automatic stay is a fundamental protection that the Chapter 11 debtor-in-possession has to help stabilize the company and obtain breathing room from aggressive creditor actions. The company also needs to stabilize itself operationally upon filing, so once the case is filed, company management, together with its financial advisors, need to have developed and be ready to implement an interim operating plan for the company in Chapter 11. Upon filing, there is immediate relief from payment of most prepetition, unsecured obligations. Certain other payments may be postponed for certain specified periods of time. A Chapter 11 operating budget will be essential. The key, both before filing Chapter 11 and during Chapter 11, is conserving cash. Cash management will be critical to the company s success or not in Chapter 11. One goal of the company s pre-petition planning is to 5
keep the business running as seamlessly as possible so that confidence can be upheld or restored and the company s customer base can be maintained. For attorneys dealing with corporate restructuring and bankruptcy, it is important to remember that it is not enough just to understand how the bankruptcy law works; they also need to know how each client s business works. Attorneys need to spend the time required to be familiar with the key strengths and weaknesses of their client s business so that they can better assist and advise the client in formulating a successful Chapter 11 strategy. This understanding is critical to the development of an interim operating plan for use during the Chapter 11 case and also fundamental to building a successful exit plan for the company. Counsel and the company s management and other advisors need to come up with a plan that will rightsize the company structurally and operationally and also meet the various tests required under the Bankruptcy Code. One of the first questions an attorney needs to ask the client is what they think will make their company successful. The partnership of client and professional advisors needs to identify the company s strengths and develop a plan that will maximize them and realize value for the company s stakeholders. The Chapter 11 Case Has Been Filed Steps to Stabilization Much of restructuring focuses on financial needs and changes which must be made operationally and structurally in order to save a business. Thus, the bankruptcy legal advice and fiduciary duty advice provided by counsel must be integrated with the analysis and recommendations of the company s business management and other professional advisors, particularly the key financial people, when a company undertakes the process of formulating its plan for stabilization and ultimately restructuring. Executing a stabilization and restructuring strategy, such as a work force reduction or closing business locations, can be very expensive, and companies need to realize that they will incur additional costs during their Chapter 11 case. The additional costs incurred in implementing the stabilization and restructuring plan during the Chapter 11 case must be justified by financial projections for the reorganized company showing that such steps will work during the Chapter 11 case and ultimately produce a healthy, more valuable company. There are various constituencies with whom the troubled company and its advisors must work through the Chapter 11 process. Few, if any, of them will be pleased with the bankruptcy filing, but it is important that the filing be presented in its most positive light a successful restructuring is an opportunity for the mutual benefit of all. In some cases such as single asset 6
real estate cases, there are not many unsecured creditors involved and the main constituency is a large secured lender. In larger operating businesses, there are typically groups of creditors who divide themselves into lenders, bondholders, and other financial creditors, and then trade creditors, the entities who have supplied goods and services to the business. An interesting dynamic often occurs at the outset of the case, during the time of formation of the Creditors Committee, when the unsecured financial creditors vie with the trade creditors for representation on and control of the committee. In rare cases there may be multiple committees, and in a case where there is a solvent or potentially solvent debtor, there may also be an equity security holders committee. The success of the Chapter 11 restructuring process is highly dependent upon developing and maintaining good working relations with the company s major secured creditors and its Creditors Committee. Depending upon the circumstances surrounding the filing of the case and the competing interests of these constituencies, this goal is sometimes difficult to achieve. Indeed, in some cases, counsel s skill may be measured by playing off one constituency against another at various times or concerning different issues during the course of the Chapter 11 case. In addition, the company needs to be attentive to the key players in its business, particularly its customers and suppliers. In order to operate successfully during Chapter 11, the company, with the assistance of its professional advisors, must identify what the problems were that led to its bankruptcy and communicate how those problems have been addressed and will be addressed in the future so that they will not be repeated. The confidence of and support from as many key constituencies as possible is a critical component to successfully operating in Chapter 11. The Chapter 11 Plan The goal of a successful Chapter 11 case is confirmation of a Chapter 11 plan of reorganization. Confirmation of a plan is usually a two step process. The first step involves preparation and approval by the Bankruptcy Court of a proposed disclosure statement to accompany the plan when it is sent out to creditors and other stakeholders, if any, entitled to vote on the plan. A disclosure statement must contain adequate information to enable those entitled to vote to make an informed judgment about the plan. See 11 U.S.C. 1125. After the proposed disclosure statement is approved by the court, the second step in the process is voting on the plan followed by a confirmation hearing, at which the Bankruptcy Court decides whether the plan has received the necessary votes and otherwise meets the tests required for 7
confirmation set forth in the Bankruptcy Code. See 11 U.S.C. 1126, 1129. Among the issues to be considered by the Bankruptcy Court at the confirmation hearing, is the issue of cramdown that is, whether the plan meets the requisite tests set forth in 1129 of the Bankruptcy Code for confirmation notwithstanding the lack of acceptance or rejection of the plan by one or more classes of creditors or interest holders. This is another important area of Chapter 11 practice requiring skillful Chapter 11 counsel for the troubled company. Another key part of the duties and responsibilities of the Chapter 11 attorney for the debtor-in-possession is crafting the proposed plan of reorganization. Section 1123 of the Bankruptcy Code entitled Contents of Plan sets forth a number of the mandatory and optional provisions for the plan. Many of the provisions of a Chapter 11 plan are reasonably standard, but there is clearly an art to crafting certain specific provisions to meet the challenges of each specific case. The plan of reorganization must be carefully drafted and, if possible, be the product of negotiations with the key constituencies in the case. Success of the confirmation process is generally the product of skillful negotiations with the significant players in the bankruptcy case and careful drafting of the plan itself. One of counsel s goals should be to obtain the support of the major constituencies in the case for the company s plan in advance of or during the disclosure statement and plan approval process. Having the support of the company s secured creditors and/or the Creditors Committee may be keys to the success of the confirmation process. Including a recommendation of support from the Creditors Committee for the debtorin-possession s proposed plan will dramatically increase the chances of receiving the requisite votes to accept the plan when it goes out for voting by the unsecured creditors class. One size does not fit all in Chapter 11 practice. This could not be more true than at the confirmation phase of a Chapter 11 case. In some cases, the troubled company has the support of its secured lenders; in other cases, the debtor-in-possession has the support of its unsecured creditors (or certain identifiable classes of unsecured creditors). Building the support and consensus of major stakeholders in the case is one of the clear measures of success of counsel for the troubled company in Chapter 11. The role of counsel is thus very important at the plan and confirmation phases of the Chapter 11 case. This process combines and showcases the two facets of the skilled bankruptcy lawyer, drafting, negotiating and deal making on the one hand, and litigating whatever issues remain unresolved at the confirmation hearing. 8
The Role of Litigation in Preserving, Realizing and Recovering Value An additional important tool available in bankruptcy cases for preserving, realizing and recovering value is the use of litigation. Because the bankruptcy case itself is a court proceeding, there is a forum available for resolving disputes. A Chapter 11 reorganization is commenced by the filing of a bankruptcy case in the appropriate U.S. Bankruptcy Court. Litigation in bankruptcy cases may take the form of motions (contested matters) and separate lawsuits within the bankruptcy case (adversary proceedings). Litigation is a very important strategic and tactical part of bankruptcy practice. It may be commenced by the debtor-in-possession, a trustee (if there is a trustee appointed in a particular case) or by creditors or other parties in interest. It typically begins at the outset of the case, with the various first-day motions and cash collateral and/or debtor-in-possession financing motions, and continues throughout the case, through plan confirmation and beyond. When and how to use litigation is a critical component of the bankruptcy attorney s job. Although designed to obtain specific relief from the court, litigation is often used as a means to facilitate a negotiated resolution of disputes. It is likely to shape the course of the case and define whether success is achieved. Some bankruptcy cases are all about litigation; other cases are characterized by out-of-court resolution of disputed issues. The one certainty is that litigation is expensive. The judicious use of litigation is most important. Sometimes a Chapter 11 debtor s attorney has no choice but to resort to litigation to advance the client s case. Again, experience and planning are critical, as is having the necessary resources and personnel to support and handle the litigation. With respect to realizing and recovering value for stakeholders, the various avoidance and recovery powers available under the Bankruptcy Code, for example, the recovery of preferences and fraudulent transfers, may be an important part of the case. Similarly, distributions to creditors may be shaped by the objection to claims process. The success of many bankruptcy cases turns on the outcome of highstakes litigation. Having bankruptcy counsel who has experience in such litigation may be critical to a successful resolution of a troubled company s case. Counsel to the Chapter 11 company has to be prepared to litigate, know when and how to do so, and be perceived by potential opposing parties as a 9
worthy adversary. Out of the threat or actual filing of litigation, some of the most successful negotiated resolutions of disputes in highly contentious bankruptcy cases have been achieved. Preserving, realizing and recovering value for stakeholders in bankruptcy cases has multiple facets; litigation is clearly one of them. Conclusion The passage in 1978 and then the effective date in October 1979 of the Bankruptcy Reform Act of 1978 was truly a watershed event in the practice of bankruptcy law. The Bankruptcy Code replaced the Bankruptcy Act, making sweeping changes to bankruptcy law in both procedure and substance. The last 25 years of practice under the Bankruptcy Code have been exciting and challenging times. Prior to the inception of the Bankruptcy Code, most large law firms in the United States did not have significant bankruptcy practices or bankruptcy practices at all. It was a specialized area of the law. The Bankruptcy Code brought with it a new court structure, elevating the Bankruptcy Court within the federal court system. Although there have been slips along the way (see Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982)), practice under the Bankruptcy Code in the last 25 years has brought in many more capable and skilled practitioners and judges, and inspired most large law firms to develop substantial bankruptcy practices. Chapter 11 work is a major practice area, providing sophisticated and challenging legal work. Bankruptcy itself has become much more of a corporate reorganization tool, providing a framework for complex restructurings of companies both within and outside Chapter 11. There is less of a stigma associated with Chapter 11 in the corporate world, particularly because many well-known businesses have gone through the process and achieved successful restructurings. As noted above, it has proven to be an excellent vehicle for buying and selling businesses and assets, and it has often been used to maximize recovery of value for stakeholders following major corporate reversals or fraudulent activity. Examiners have joined trustees as significant players in bankruptcy cases where wrongdoing is alleged or the significant players in the case believe that a neutral party should be brought in to investigate an issue or issues in the case. Another more recent change in the field has been the growth of the international aspects to restructurings. As business has gone global, so too has insolvency and restructuring practice. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), with its effective date of October 17, 2005 for most of its provisions, is another significant new set of changes to the Bankruptcy Code. Although highly publicized for its changes in the area of consumer 10
bankruptcy practice, the 2005 Amendments also made a number of very important changes applicable to business cases. Particularly noteworthy are the shortening of the exclusivity period that a Chapter 11 debtor-inpossession has to propose and confirm its plan of reorganization (see 1121(d) of the Bankruptcy Code), the time within which a debtor/lessee has to assume or reject a nonresidential real estate lease (see 365(d)(4) of the Bankruptcy Code), and the new provisions regarding the access to information made available to Creditors Committees (see 1102(b)(3) of the Bankruptcy Code). What effect these provisions, and numerous other ones contained in the 2005 Amendments, will have on Chapter 11 cases is currently unknown. As with previous changes to the Code, no doubt Chapter 11 will survive. Counsel and the courts will adapt to the changes. New best practices and not so best practices will evolve. One of the additional new changes added by the 2005 Amendments was the addition of new Chapter 15 to the Bankruptcy Code (11 U.S.C. 1501, et seq.), dealing with Ancillary and Other Cross-Border Cases. This new Chapter replaces 304 of the Bankruptcy Code, which had previously dealt with cases ancillary to foreign proceedings, and brings the Bankruptcy Code more in line with other international insolvency and restructuring laws. There is no doubt that the future will see many more multinational insolvency and restructuring proceedings. Indeed, that is likely to be the legacy of the 21 st Century, with many future changes still to be made to applicable laws in this country and throughout the world during the course of this Century. Years of experience have confirmed that the law is an exciting and dynamic profession. Business restructuring, reorganization and insolvency law, including Chapter 11 practice, continue to be challenging and rewarding parts of that profession. 2006 Richard L. Wasserman All Rights Reserved 11