Chapter 11 Reorganization

Chapter 11 is a pay out style bankruptcy case that is available to individuals but almost always used by business entities like corporations. Chapter 11 cases involve restructuring the debts and other obligations of companies that need help. The general idea, as with Chapter 13, is that a debtor will repay a portion of its debts over time from its future operations. The plan must pay its priority claims in full, allowed secured claims in full, and some plans pay a distribution to unsecured creditors.

The plan approval process is different in a Chapter 11 case than it is in a chapter 13 case. In a Chapter 11, the debtor solicits votes from classes of creditors, for what it hopes will turn out to be a consensual Chapter 11 payout plan. Creditors are placed in classes for the purpose of plan voting. If all classes of creditors vote to go along with the plan, then the court generally approves the plan. If there are holdouts who are not in favor of the plan, the court can sometimes force creditors to accept the plan, assuming that various tests are met by the plan and the debtor.

Operations

Instead of a trustee, the person in charge of the Chapter 11 reorganization case is the debtor in possession, which generally consists of a company’s management. The debtor in possession has, under the Code, all of the duties and powers of a trustee. The debtor in possession in a fiduciary and is charged with creating the best possible distributions for creditors. The debtor in possession, then, has many conflicting duties, to shareholders, to management, to creditors, and to employees. However, the primary duty should be to creditors. Usually a trustee is not appointed, but general notions of fraud and misbehavior by the debtor in possession would prompt the creditors to ask for a trustee to be appointed. The debtor in possession can use regular cash in the ordinary course of business without notifying creditors or giving them the opportunity to object. On the other hand, use of cash collateral (cash subject to a lien) is limited or restricted. A secured creditor with an interest in cash collateral has a right to adequate protection of the collateral.

Creditor Treatment

All creditors (oversecured, undersecured and unsecured) are entitled to pre-petition interest if their contracts and state law provide for. Secured creditors must at least receive the value of their collateral, or the amount of their loan (whichever is less) over the life of the plan, with present value interest from the time the plan becomes effective. Oversecured creditors must be paid in full and are entitled to accrue interest. Undersecured claims will be bifurcated. The claim will be secured to the extent of the value of its collateral, and any remaining debt over and above the value of its collateral will be placed in the general unsecured creditor class. Undersecured claims are not entitled to interest in the post petition period. Priority claims must be paid in full shortly after the plan is confirmed, (1) unless the creditor has agreed to be paid over time, or (2) unless the claim is for priority taxes, which can be paid over 6 years from the date of assessment. Unsecured creditors are not entitled to any particular distribution in Chapter 11. Their distribution is typically negotiated based on what the debtor can afford to pay creditors while still staying in business. Chapter 11 requires that the debtor in possession place creditor claims into classes according to their legal rights for the purpose of plan voting.

Postpetition Financing

The Code creates incentives for people to lend money to troubled companies by providing high priority to the money lent post-petition, and by providing special rights to those who procure new collateral post petition. Bankruptcy filings do not produce cash, thus a reorganizing debtor will usually have to find new lenders. They may attempt to infuse new capital by going to current lenders, distress lenders, or finding new equity owners. The Codes sets up incentives for lenders to deal with bankrupt companies by offering them superpriority claims even higher than those of administrative creditors. Many suppliers will be willing to continue supplying a debtor post-petition. A supplier who does so will be entitled to a 1st position administrative priority claim for goods and services provided to the debtor on credit post-petition. This hierarchy of favoritism can often put a lender at ease when dealing with a financially troubled company.

Avoiding Powers

Avoiding powers give the trustee or debtor in possession the power to recover assets by undoing certain pre-bankruptcy transfers, usually cash transfers, asset transfers, or transfers of security interests. The economic effect of the bankruptcy estate of recovering cash and/or assets that were transferred prior to bankruptcy is obvious. That cash and/or those assets become available to pay creditors or to use in the reorganization. The avoiding powers usually relate to preferential transfers or fraudulent transfers.

Preferential Transfers

For a preferential transfer to be undone, six key elements must be met. Was the transfer:

Of an interest of the debtor in property?

To or for the benefit of a creditor?

For or on account of an antecedent debt?

Made while debtor was insolvent?

On or within 90 days of the bankruptcy filing?

The improvement in position test requires the calculation of a hypothetical Chapter 7 liquidation. A comparison is then made between the total payment a creditor would receive if the transfer is left intact and the total payment that the creditor would receive if the case were in Chapter 7, the transfer had not been made and the creditor received payment in Chapter 7.

There are exceptions to the avoidance of preferential transfers. The ordinary course of business exception protects those transactions that are routine and linked to everyday course of business. The underlying reason for the ordinary course exception is clear. It is these very routine transactions that a debtor really needs to maintain during financial crisis. Bankruptcy law doesn’t want to discourage creditors from providing services and transactions that would help a struggling debtor.

Fraudulent Transfers

Fraudulent transfers may also be avoided. The law in this area voids any transfer of interest of debtor in property or any obligation incurred by the debtor with actual fraud (actual intent to commit fraud), or constructive fraud (a transfer for which the debtor received less than reasonable value). The basic policy of this avoiding power is creditor protection. A transfer made with the actual intent to commit fraud or for less than reasonable value while debtor is insolvent harms creditors. This is an equity based theory. If the transfers or obligations occur shortly before bankruptcy, the trustee or debtor in possession should be able to recover them for the benefit of creditors. One interesting problem is that the equitable purposes of fraudulent transfer law that require courts to strike down transactions where there is a significant disparity between the value received and the obligation assumed by the debtor might clash with the need to accommodate contemporary financing practices under which it might not be possible to determine with specificity the exact amount of value received.

The Strong Arm Clause

Unperfected security interests can be avoided by trustee/debtor in possession under a section of the Code (often called strong arm clause). When this happens, the previously secured creditor is turned into a general unsecured creditor. The security interest is in essence returned to the estate, and the property is now unencumbered and its value can be distributed to unsecured creditors

Executory Contracts & Unexpired Leases

The bankruptcy estate can act like a debtor not in bankruptcy. If debtors outside of bankruptcy can reject bad contracts, debtors in bankruptcy can reject bad contracts or accept good ones. The key difference is that outside of bankruptcy, the aggrieved party is put in the same position as it would have been with full performance. In bankruptcy however, the trustee or debtor in possession pays little or no restitution towards putting the party in performance position. The bankrupt debtor has 3 options when it comes to executory contracts (contracts where performance remains due on both sides): (1) Reject; (2) Assume; or (3) Assume and Assign. The Code provides that an interest becomes property of the estate notwithstanding any provision in an agreement (a) that restricts or conditions transfer of such interest by the debtor; or (b) that is conditioned on the insolvency of the debtor on the appointment or taking possession of the trustee and that effects an option to effect a termination of the debtor’s interest in property. Therefore, the contract or lease becomes property of the estate notwithstanding a provision in the contract that it terminates upon the filing of bankruptcy. If there has been a default in an executory contract, the trustee or debtor in possession may not assume the contract unless he cures or provides adequate assurance that it will promptly cure the default, compensate pecuniary loss and provide adequate assurance of future performance under such contract or lease.

Confirmation Plans

Confirmation is the process by which debtor in possession gets a Chapter 11 plan approved by the court. The plan must comply with basic priority and secured creditor treatment, the good faith test, the best interests test, and the feasibility test. The debtor will need to place all creditors into classes of claims. The classes will later be used to gather and count votes on the plan. The debtor will need 2/3 in amount and ½ in number in each class in order for the class to be an accepting class.

Three crucial aspects of confirmation that receive the most attention are: (1) best interest; (2) feasibility; and (3) good faith.

The Best Interests Test requires a finding that each creditor will receive as much under the plan as the creditor would receive in Chapter 7 liquidation. It is more accurate to say that the best interests test requires that the total amount to be paid on a claim under the plan has a present value of at least equal to what the creditor would have received had the estate been liquidated under Chapter 7. This requires the court to do a liquidation analysis and to estimate the amount that could be obtained by selling each asset and calculating the resulting dividend that would be paid to the non-accepting creditor. Notice that this standard applies to each creditor individually unless that creditor has individually voted in favor of the plan. In some cases, the issue of the liquidation value of certain assets might be highly controversial, but also could be crucial to a determination under the state statute.

The Feasibility Test must be met even if all the creditors agree to the plan. It addresses the issue of how likely it is that a plan will succeed. This test is highly fact sensitive and must be decided on a case-by-case basis. It reflects the best business judgment of the bankruptcy judge.

The Good Faith Test requires the debtor to prove that he proposed the plan in good faith and not by any means forbidden by law.