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Basic Chapter 11 Concepts

Dealing with Corporate Distress 06: Four Basic Chapter 11 Concepts to Know Before We Go any Further

The ABCs of ABCs, Business Bankruptcy, & Corporate Restructuring/Insolvency

In the last two installments of this series, we introduced you to things a company should consider before deciding whether to file chapter 11, and a timeline for understanding how a “typical” chapter 11 case proceeds. In this quick little ditty, we want to make sure you understand four concepts that permeate every chapter 11 case except, perhaps, a prepack.

1. The Automatic Stay

When a bankruptcy case is filed, an “automatic stay,” is triggered under Bankruptcy Code § 362. The automatic stay operates as an injunction against certain actions affecting the debtor or its property. The structure of the section is straightforward:

  • Subsection (a) lists specific acts that are halted by the stay.
  • Subsection (b) lists specific acts that are not halted by the stay.
  • Subsection (c) covers how long the stay remains in effect (assuming a party has not obtained stay relief).
  • Subsections (d), (e), (f), (g), and (m) set forth the rules by which a party may try to obtain stay relief.
  • Subsection (h) deals with reaffirmation agreements in the context of an individual’s bankruptcy case.
  • Subsections (i) and (n) deal with issues that exist in the case of a serial debtor (i.e., a party that files bankruptcy more than once).
  • Subsection (j) just allows a party to get a formal order to make clear that the stay was terminated when that happens under subsection (c).
  • Subsection (k) is the provision that allows for damages against parties who violate the stay.
  • Subsection (l) is simply a potential basis to avoid the effect of subsection (b)(22) (which deals with residential lease evictions).

Pulling the camera back from the trees of the Bankruptcy Code, these provisions work together to set up this basic framework:

  1. Company files bankruptcy.
  2. Automatic stay arises automatically, which prevents most actions to collect any debts that accrued prepetition (this is § 362(a)).
  3. There are exceptions, some of which relate to debts owed to the government (this is § 362(b)).
  4. Creditors may seek relief from the automatic stay (this is § 362 (d), (e), (f), (g), and (m))
  5. If a creditor dares try to collect prepetition debts without first getting relief, it can get in trouble (this is § 362(k)).
  6. The automatic stay is arguably “too strong” in the sense that it not only prevents creditors from seeking to collect on prepetition debt without getting stay relief first, it also prevents the debtor from paying any prepetition debt without getting stay relief (but when it’s the debtor seeking such relief, nobody refers to it as stay relief).

Re-read point #6 above please. What we are referring to is a good part of the need for first day motions, which debtors routinely file on (or in the immediate days following) the petition date. We discuss first day motions at length in installment 8. For now, though, having the general understanding that first day motions are filed to seek relief from the restrictions of the Bankruptcy Code that otherwise inhibit a debtor’s ability to operate in the ordinary course of business while it is in chapter 11. The relief they seek cannot be effective until the bankruptcy court enters orders (“first day orders”) granting them, which is why they are filed on the first days of a case, and usually heard on an emergency basis.

2. Using, Selling, or Leasing Property of the Bankruptcy Estate

Chapter 11 debtors can use, sell, or lease their property in the ordinary course of business without authorization from the bankruptcy court. That said, if a debtor wants to use, sell, or lease property outside of the ordinary course of business, it must request court approval to do so.

What constitutes a debtor’s “ordinary course of business” is a function of both what is ordinary for the debtor and what is ordinary for other, similar businesses. For example, a debtor operating a manufacturing business can sell inventory to its customers without court approval. But if the debtor wants to sell its plant, or lease a new warehouse location, it must seek the bankruptcy court’s blessing before doing so. These types of transactions are governed by Bankruptcy Code § 363 and cases interpreting it.

3. Postpetition Financing

The phrase “Cash is King,” rings particularly true for chapter 11 debtors. In many chapter 11 cases, a debtor will have a major lender that holds a security interest in all or substantially all of the debtor’s assets, including its cash. In some cases, the debtor will have enough “unencumbered” cash to operate after filing without seeking new infusions of cash. In most cases, however, the debtor must usually rely, at least, on cash that is subject to its lender’s security interest. We call this cash “cash collateral.” We say “at least” because for many companies, its cash just isn’t enough to pay necessary operating costs and the chapter 11 administrative expenses without borrowing.

The use of cash collateral is governed by Bankruptcy Code § 363, whereas the borrowing of more money is governed by § 364. Remember, though, as you learned in Installment 1, while the Bankruptcy Code is the foundation of bankruptcy law in the United States, that’s not to say it’s the only thing that counts. Quite to the contrary. Case law interpreting the Bankruptcy Code, other titles of the United States Code, and various state statutes and case law all come into play to create what is commonly thought of as “bankruptcy law.”

Let’s discuss cash collateral a bit more: a debtor who wants to use cash collateral can do so in one of two ways: with the consent of its lender, or by obtaining bankruptcy court approval. When a debtor elects the latter route, it must provide its lender “adequate protection.” Adequate protection, in turn, may exist or can be satisfied in various ways. For example, adequate protection can be provided by granting the lender replacement liens, or by showing that the cash collateral will be used to generate accounts receivable that also constitute the secured party’s collateral. If you have a Westlaw Account, read the relevant section of Commercial Bankruptcy Litigation.

Many debtors, as noted above, are not in the enviable position of being able to survive on a post-petition basis by just using cash collateral. In these cases, a debtor may require a line of credit or other postpetition financing, referred to as “debtor-in-possession loans,” or simply “DIP” loans.

Section 364 governs DIP financing and provides four different routes for a debtor to obtain postpetition financing.

1. The first is for a debtor to obtain a loan in the “ordinary course of business.” This kind of financing is often extended by one of the debtor’s main vendors and provides the lender with a first-priority administrative claim. Naturally, the issue most often litigated in this context is whether the loan was truly within the ordinary course of the debtor’s business. Really, when speaking about “DIP financing,” this is not what restructuring professionals generally mean to refer to.

2. Section 364(b) provides a second method for a debtor to seek approval of its DIP financing. Here, the secured party is given a first-priority administrative claim for the additional funds extended to the debtor. Section 364(b), however, is reserved for unsecured loans made outside the ordinary course of the debtor’s business. This type of financing, in practice, is rare because few lenders are willing to help fund a debtor’s reorganization with an unsecured loan.

3. Third, a debtor may obtain a secured loan under section 364(c). The lender’s security interest under section 364(c) is limited to a lien on unencumbered property or to a subordinate lien on already encumbered property. Although the provision related to the creditor’s ability to obtain a superpriority claim is worded in the disjunctive, frequently courts will approve a debtor’s postpetition financing package that permits a lender to have both a priority claim and a lien on unencumbered property.

Section 364(c) permits the court, after notice and hearing, to authorize the debtor-in-possession to obtain credit that (1) has priority over all administrative expenses allowable under section 503(b)(1) and over any claim for inadequate protection allowable under section 507(b) and (2) is secured by a lien on unencumbered property or a junior lien on encumbered property of the estate.

Secured borrowing requires court approval in all cases, even if such borrowing would be an ordinary course of business transaction for the debtor. Before the court will authorize a loan under section 364(c), however, the debtor must be able to demonstrate that it was unable to obtain a loan under either section 364(a) or (b).

4. Finally, a debtor may attempt to obtain postpetition financing by a fourth method set forth in section 364(d) by providing the lender with a priming lien on property that is already encumbered. Before the court will approve such a loan, the debtor must establish that its prepetition lenders, whose liens would be primed by its postpetition lender, are adequately protected.

[Editor’s Note: these four bullet points are reprinted with permission from the 2021 edition of Commercial Bankruptcy Litigation, available as a softbound and on Westlaw.]

4. Executory Contracts & Leases

Before filing for bankruptcy, a business debtor will likely be party to a number of contracts or lease agreements that have unperformed obligations outstanding on either side of the contract or lease. These may take the form of ongoing supply contracts, or leases for office or warehouse space that have not run their course at the time the bankruptcy case is filed. These agreements are generally referred to as “executory contracts,” or “unexpired leases,” in bankruptcy jargon. Unfortunately, the Bankruptcy Code does not contain an exact definition of an “executory contract.” But generally speaking, an executory contract is one in which performance remains due to some extent on both sides.

Bankruptcy Code § 365 provides debtors with flexibility regarding these types of ongoing agreements. They can generally be “assumed” by the debtor, and either performed by the debtor going forward; assigned to a third party; or rejected. And while a debtor can generally assume or reject any contract, it cannot unilaterally modify one.

The decision to assume, assume and assign to a third party, or reject a contract requires court approval, but courts typically defer to the debtor’s “business judgment.” There are exceptions to this rule that limit a debtor’s options with respect to certain types of executory contracts, which we discuss in greater depth in Installment 16 of the series.

[Authors’ Note: Most of these concepts are general bankruptcy concepts, and not limited to chapter 11. By having a foundational understanding of these bankruptcy concepts, set against the timeline of a chapter 11, we can begin digging into more advanced concepts and strategies for and against companies in distress.

Editors’ Note: This article, while written to be read and understood on a standalone basis, is part of a series. To read Installment 1, which includes a table of contents and links to every article in the series, click here.

The authors are corporate restructuring and insolvency attorneys. Read more about three of them at the end of Installment 1.

Understanding all this stuff in the context of bankruptcy is important, but not every distressed company winds up in bankruptcy. So, you also need to understand how it works outside of bankruptcy. Read Installment 7 to read the rest of the story.

To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

©2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.

About Jonathan Friedland

Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer” by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…

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Jonathan Friedland

About Jack O'Connor

Jack is a corporate and restructuring partner in the Chicago office of Sugar Felsenthal Grais & Helsinger LLP. Jack’s practice covers a range of healthy and distressed business engagements. He is widely recognized for his excellent work as a restructuring attorney including recognition by various organizations for his strategic thinking and tactical expertise, including SuperLawyers…

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Jack O'Connor

About Hajar Jouglaf

Hajar is an associate with Much Shelist in both its Business Transactions Group and its Restructuring & Insolvency Group.

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Hajar Jouglaf