Bankruptcy 101: When Is Bankruptcy Right for Your Corporate Client? - ABA YLD 101 Practice Series

By Jason L. Boland and Johnathan C. Bolton

The right to file for bankruptcy protection is one of the rights found in Article I, section 8 of the United States Constitution. Bankruptcy protection allows a corporate entity to receive a discharge of its indebtedness so that it can start over again in business or orderly liquidate its assets.

There are a multitude of reasons why companies seek bankruptcy protection. For example, a company may find itself in significant litigation with a creditor (whether it be a lender, trade creditor, tort claimant or a governmental entity) or the company may have already suffered an adverse jury verdict or judgment which, if enforced, would put the company out of business. Alternatively, a creditor may be seeking to foreclose on the company's most valuable assets by virtue of a judgment or because of a default under security documents. In addition, there are many business factors that may lead a company to file for bankruptcy protection including a lack of liquidity, an inability to secure new capital, an inability to collect accounts receivable, increased raw material prices, increased competition, poor location, or the loss of key personnel. Finally, sometimes companies file for bankruptcy protection because of certain disasters which may have crippled their businesses - i.e., September 11th, hurricane Katrina, etc.

This article examines some of the benefits of bankruptcy protection for your corporate client and also discusses why bankruptcy may not be the answer.

  1. A Company Must Choose Between Chapter 7 and Chapter 11
    When a company chooses to file a voluntary petition for bankruptcy protection, it must choose between two chapters, Chapter 11 and Chapter 7. Chapter 11 allows current management to remain in control of the company (this is called a "debtor-in-possession") in order to attempt to reorganize the business, restructure the company's debt and emerge from bankruptcy pursuant to a plan of reorganization. Chapter 7 is a liquidation proceeding in which an independent trustee is appointed to replace the board of directors and orderly liquidate the company's assets.

    Chapter 11 is available to individuals, partnerships, limited liability companies as well as public and private corporations and railroads. The goal of Chapter 11 is for a company to reorganize its business, restructure its debt and emerge from bankruptcy as a going concern. Some preliminary considerations in the decision to file for Chapter 11 protection, as opposed to a Chapter 7 liquidation, include: (1) whether the company has sufficient funds to pay the costs of a Chapter 11 proceeding, (2) whether there is a realistic projection of future income for the company; (3) whether additional financing is needed or has been obtained; (4) whether the company will be able to pay at least some of its debts; and (5) whether current shareholders will receive any distributions in the bankruptcy.

    Under the Bankruptcy Code, debts against the company are organized according to the "absolute priority" rule, which generally means that secured claims get paid in full (in cash, notes or stock) before any unsecured claims receive any distribution; unsecured claims get paid in full (in cash, notes or stock) before shareholders receive any distribution; and preferred shareholders get paid in full (in cash, notes or stock) before common shareholders receive any distribution.

    If a company decides to file for Chapter 11 protection, state law generally requires authorization by the board of directors at a board meeting that has been properly called and held. Individual board members or officers cannot file for a corporation on their own. 1
  2. Benefits of Filing
    1. The Automatic Stay - 11 U.S.C. § 362
      One of the biggest benefits, and perhaps biggest reason companies choose to file for bankruptcy relief, is the "automatic stay" that is imposed under 11 U.S.C. § 362. The stay is an "automatic" injunction that is effective immediately upon the filing of a voluntary bankruptcy petition under any chapter of the Bankruptcy Code. The stay generally prohibits creditors from taking any act to collect their debts from the company, whether or not the creditor has notice of the stay. The automatic stay is designed to give debtors a "breathing spell" so that they can evaluate their financial condition and attempt to reorganize their businesses. The automatic stay is very broad in scope and provides for a worldwide stay of litigation, lien enforcement and other actions, judicial or otherwise, that are attempts to enforce or collect pre-petition claims, attempts to interfere with property of the estate, property of the debtor or property in the custody of the estate. 2
    2. The Debtor Receives a Fresh Start
      Generally, the automatic stay remains in effect until (1) the judge "lifts" the stay at the request of a creditor, (2) the debtor gets a discharge, (3) the case is dismissed, or (4) the asset at issue is no longer property of the estate. Section 362(d) of the Bankruptcy Code sets forth the standards by which, after notice and a hearing, a party in interest is entitled to relief from the automatic stay by "terminating, annulling, modifying, or conditioning such stay." Most notably, the stay can be lifted "for cause" 3 (which includes the lack of adequate protection), or when the creditor can show that the debtor has no equity in the specific property that is subject to the stay and that the property is not necessary to an effective reorganization.

      In order for a company to successfully restructure its business in Chapter 11, the company must raise cash (by secured borrowing, equity financing or through a sale of assets), reduce debt (by cutting costs, selling assets and rejecting above-market leases and contracts), and formulate a feasible business plan that realistically projects positive future cash flow that will enable the company to pay its debts as they come due in the future.

      In a Chapter 11 case, a "plan of reorganization" is the mechanism by which this is achieved. The debtor is given the initial opportunity to propose a plan that will be voted on by creditors who are impaired by the plan. If the debtor does not propose a feasible plan within its "exclusivity period", or if the debtor's exclusivity period has expired or been terminated by the court, any creditor or party-in-interest may propose a plan.

      A strategic plan of reorganization will either pay down or restructure existing debt. If the company is fortunate, it can implement its plan through consensual negotiations with its major creditors or creditor constituencies. It may be necessary, however, to force implementation of a plan in the bankruptcy proceeding through a "cram down" if a class of creditors votes against the plan. The intended culmination of Chapter 11 is to give the debtor a "fresh start" through the binding effect of the order confirming the plan of reorganization which allows the company to emerge from bankruptcy.
  3. Bankruptcy May Not Always Be the Best Answer
    1. An Out of Court "Workout" May be More Beneficial to A Company
      The time and expense of a bankruptcy proceeding can sometimes be avoided through an out-of-court "workout" process. Through this workout process, a debtor and its restructuring professionals can attempt to negotiate with major creditors in an attempt to reach an agreement about the restructure of its debt outside the bankruptcy process. Such a process can be very attractive to both parties as it will be significantly cheaper and less onerous than a bankruptcy case. However, for an out-of-court "workout" to be successful, all parties must be in agreement.
    2. Bankruptcy Requires Full Disclosure
      If the "workout" process is unsuccessful and negotiations have broken down, the company may be left with no alternative other than filing for bankruptcy relief. However, companies must keep in mind that there are numerous disclosure requirements that force a debtor to reveal a lot about its business. For example, debtors must provide an initial debtor report, detailed schedules of assets and liabilities, a statement of financial affairs (including information about transactions with insiders) and monthly operating reports. Debtors may also be required to make additional reporting to secured creditors. In addition, debtors must ultimately propose a disclosure statement which is filed in connection with the confirmation of a plan and contains all of the information about the company that would entitle a creditor to make an informed decision about voting on the plan.

      Creditors have the opportunity to review all of the information disclosed by the debtor and can also seek the examination of the debtor under Federal Rule of Bankruptcy Procedure 2004 which is a federally-created "fishing expedition." Additionally, the information disclosed by the debtor may indicate possible fraud or gross mismanagement which, if true, may justify the appointment of a Chapter 11 trustee to take the place of current management. 4
      1. The Initial Debtor Report
        In Chapter 11 cases, the Office of the United States Trustee (which is a part of the United States Department of Justice that supervises bankruptcy cases) (the "US Trustee"), requires the debtor to complete an initial debtor report. 5 These initial debtor reports require the debtor to provide an organizational overview, balance sheets, tax returns, financial statements, and proof of insurance on the debtor's assets. Some US Trustees also require that the debtor be interviewed to discuss the initial report.
      2. Schedules of Assets and Liabilities and Statement Of Financial Affairs
        All debtors, regardless of whether they file for bankruptcy under Chapter 7 or Chapter 11, are also required to file Schedules of Assets and Liabilities ("Schedules") and a Statement of Financial Affairs ("SOFA"). 6 These Schedules and SOFA, which can be quite lengthy in larger Chapter 11 cases, are filed under penalty of perjury and describe all of the debtor's assets, liabilities, obligations, and financial affairs as of the date of the filing.

        Among other things, in the Schedules the debtor must disclose all of its real property (including an estimated current value of the property), personal property (including an estimated current value of the property), intangible property, all creditors holding secured claims (including an indication of whether such claims are contingent, unliquidated or disputed), all creditors holding unsecured priority claims, all creditors holding unsecured non-priority claims, all executory contracts, all unexpired leases and any co-debtors. These documents must be supplemented and amended as necessary throughout the entire bankruptcy case.
      3. Monthly Operating Reports
        The Office of the US Trustee also requires that Chapter 11 debtors complete monthly operating reports ("MORs"). These MORs detail the debtor's financial condition while in Chapter 11. For a public company, the task of completing the MORs can be significant and expensive. The MORs, as with the Schedules and SOFA, must be signed under penalty of perjury by the debtor's representative and filed with the bankruptcy court. Once filed, these MORs are available to the public for review.

        As evident from the sheer amount of information that must be provided (and continually supplemented) in the MORs, employees in the financial department of Chapter 11 debtors often find themselves consumed with such tasks. In such cases, the employees may become overworked and leave the already struggling company because, in some cases, they will find that their workload has effectively doubled. Other times, a debtor may choose to hire an outside financial restructuring firm to assist or take over such tasks. Outside assistance of course means more fees and expenses will be incurred.

        The MORs, along with the Schedules, SOFA and all other major pleadings, will be closely scrutinized by the court and all parties-in-interest.
    3. Bankruptcy Will Not Fix a Broken Business Model
      Most importantly, although the bankruptcy process can be beneficial to a company in numerous ways, it is not magic. A company must carefully assess its business and determine what its problems are, why it is in the position it currently is in, and how those problems can be fixed. Such careful consideration is integral in making any determination of whether to proceed with the filing of a bankruptcy case, as the mere filing of a bankruptcy case, in most situations, will not fix poor management, will not bring in new customers and will not cause lenders, creditors or vendors to loosen their credit terms. To the contrary, the stigma and negative connotations that are often associated with a bankruptcy filing may scare off existing customers and may cause employees to leave due to the fear of job stability. Replacements employees may not be easy to find as most individuals are not often eager to go to work for a bankrupt company. Similarly, vendors may tighten up credit terms, request security deposits or letters of credit, or may stop doing business with the company due to the fear, whether justified or not, of non-payment.
    4. Business Bankruptcy Cases Can be Very Expensive
      Before filing, companies must also consider the cost of filing for bankruptcy, especially under Chapter 11, since legal fees alone in a relatively simple Chapter 11 business case could easily cost in excess of $100,000. In addition to paying its own counsel's legal fees, the debtor may also have to hire financial advisors and other professionals to help guide it through the bankruptcy process. In addition, the debtor's estate may also be required to pay the fees of other parties including any official committee, 7 trustee, 8 examiner, 9 health care ombudsman, 10 and/or future claims representatives, 11 just to name a few. The combination of these fees can reach well in the millions (if not hundreds of millions) of dollars if enough people are involved and if the case is highly contested. 12
  4. Conclusion
    In this Bankruptcy 101 article, we have discussed the basics of why a company might file for bankruptcy protection, some of the benefits to filing and why bankruptcy may not be the answer to all of a company's problems. To the contrary, there are several problems, such as a poor business model, which bankruptcy alone cannot fix on its own. While the bankruptcy process may provide certain tools to facilitate such solutions, a company must strategically analyze all of its options, especially any non-bankruptcy options, and consult with an appropriate bankruptcy professional prior to filing for bankruptcy.

1 In re Arkco Props., Inc., 207 B.R. 624 (Bankr. E.D. Ark. 1997); In re Stavola/Manson Electric Co., 94 B.R. 21 (Bankr. D. Conn. 1988); In re Autumn Press, Inc., 20 B.R. 60 (Bankr. D. Mass. 1982); In re Al-Wyn Food Distributors, Inc., 8 B.R. 42 (Bankr. M.D. Fla. 1980); In re American Int'l Ind., Inc., 10 B.R. 695 (Bankr. S.D. Fla. 1981).
2 11 U.S.C. § 362(a).
3 "Cause" is not defined anywhere in the Bankruptcy Code.
4 Under 11 U.S.C. § 1104(a) a "party in interest" may seek appointment of a trustee, among other things, "for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management."
5 See 28 U.S.C. § 586.
6 See FED. R. BANKR. P. 1007.
7 Section 1102 of the Bankruptcy Code provides that, as soon as practicable after the entry of an order for relief under chapter 11, the US Trustee shall appoint a committee of creditors holding unsecured claims and may appoint additional committees of creditors or equity security holders. 11 U.S.C. § 1102(a)(1).
8 If the facts of the case warrant trustee appointment, then the debtor-in-possession is ousted, and the trustee takes over operation of the business. See 11 U.S.C. § 1104. Likewise, at any time before confirmation of a plan, the court may also terminate the trustee's appointment and restore the debtor to possession and management of the property of the estate and of the operation of the debtor's business. 11 U.S.C. § 1105.
9 If the bankruptcy court finds it necessary to have third-party oversight, but prefers to keep administrative costs minimal, the court can choose to appoint an examiner instead of a trustee (of course, some cases may warrant both). See Fuller, Chapter 11 Examiner: When, Why, What And How, Parts I and II, AM. BANKR. INST. L.J. (March & April 2005); Zaretsky, Trustees and Examiners In Chapter 11, 44 S.C. L. REV. 907 (1993); Gumport, The Bankruptcy Examiner, 20 CAL BANKR. J. 71 (1992); see also 11 U.S.C. §§ 1104, 1106 (discussing the appointment and duties of an examiner).
10 A major addition to the Bankruptcy Code under BAPCPA is a new Section 333, entitled "Appointment of patient care ombudsman." Under Section 333, an ombudsman may be appointed to monitor the quality of patient care and represent the interests of the patients.
11 A future claims representative is a court-appointed official or agent charged with the representation of the as-yet-unknown future claimants who have been injured by pre-petition conduct of the debtor.
12 For example, law firms and other consultants working on the massive Pacific Gas & Electric Co. bankruptcy case accrued approximately $450 million to $475 million over three years. See Jeff Chorney, "Calif. Bankruptcy Judge OKs About $450 Million in PG&E Fees," The Recorder (Sept. 16, 2004) available at http://www.law.com/jsp/article.jsp?id=1095207107316 (last visited Oct. 12, 2006).

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About the Author

Mr. Boland and Mr. Bolton are associates in the Bankruptcy, Reorganization and Creditors' Rights Practice Group of Fulbright & Jaworski L.L.P. in Houston, Texas. Mr. Bolton is Board Certified in Business Bankruptcy Law by the Texas Board of Legal Specialization and is the Chair of the Bankruptcy Section of the Young Lawyer's Division of the American Bar Association.

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