Dealing With Distress For Fun & Profit – Installment #5 – A Peek Into Some Basic Chapter 11 Concepts

A written tour of business bankruptcy and its alternatives

Subsequent installments in this series will cover the concepts touched upon here in more detail.  We think it prudent, if not necessary, to at least throw some basic chapter 11 concepts on the table now, however, since they are so fundamental to any Chapter 11 case- regardless of which side of the table you sit on.

The Automatic Stay

Commencing a bankruptcy case triggers an “automatic stay,” which, with certain exceptions (carved out by §362(b)), operates as an injunction against actions affecting the debtor or its property. The automatic stay provides a respite for the debtor and also protects its creditors as a whole, by stopping individual creditors from satisfying their claims using non-bankruptcy law.

The automatic stay usually does not protect parties who are not in bankruptcy themselves, such as guarantors or co-obligors. On occasion, a court will extend the automatic stay to a non-debtor in a chapter 11 case, but when that happens it is not automatic; the debtor needs to seek it by motion.

A creditor may seek relief from the automatic stay, if it meets the standards set forth in §362(d).

Use, Sale or Lease of Property of the Estate

A debtor may use, sell, or lease its property in the ordinary course of its business without authorization from the bankruptcy court. However, actions outside of the ordinary course of business require court approval.

What constitutes ordinary course of business is a function of both what is ordinary for the debtor and what is ordinary for businesses like the debtor. For example, a retail debtor can sell its inventory to retail customers without court approval, but if it wants to sell whole stores or enter into major new leases, it will require court approval. Bankruptcy Code §363 and cases interpreting it govern this aspect of bankruptcy.

Financing

Some debtors have enough unencumbered cash to enable them to operate in chapter 11 without new cash infusions. Such debtors, however, must usually rely on cash that is subject to a lender’s security interest.  Such cash is referred to as “cash collateral.”

In order to use cash collateral, a debtor must obtain agreement of the secured party or court approval. To obtain court approval in the absence of the secured creditor’s consent a debtor must provide “adequate protection” to the lender.  What this essentially means is that the debtor must either compensate the secured creditor in some way for the use of its cash collateral or show that the collateral’s value will not diminish to an unacceptably low level through the proposed use. All of this is laid out in a relatively straightforward manner in §363.

Many debtors, however, cannot survive with just the use of cash collateral. Instead, a debtor may require a line of credit or other post-petition financing, which are referred to as debtor-in-possession loans or simply “DIP loans.”  Bankruptcy Code §364 permits a debtor to borrow funds and to offer protections to induce lenders to make these loans if certain showings can be satisfied.  In extreme cases where a debtor cannot get financing on any other terms, the court may even authorize a lien that is equal to, or even senior to, other liens on estate assets.

Executory Contracts and Leases

The Bankruptcy Code contains no precise definition of an “executory contract.” Generally, an executory contract is one in which performance remains due to some extent on both sides (for instance, ongoing leases or supply agreements).

Bankruptcy Code §365 provides the debtor with flexibility regarding these types of ongoing agreements. They can generally be assumed and performed by the debtor, assigned to a third party, or rejected.

When assuming a contract, the debtor binds itself and all other contracting parties to perform the contract fully in accordance with its original terms. Rejection of a contract, in contrast, constitutes a breach of the contract in most jurisdictions and entitles the non-debtor party to a claim against the estate.

Although the debtor can generally assume or reject any contract, it can not unilaterally modify one. The decision to assume, assume and assign, or reject a contract requires court approval, but courts typically defer to the debtor’s business judgment, subject especially to balancing the rights of the counterparty to having certain rights to object to the assignment to a third party.  There are also exceptions that limit a debtor’s options with respect to certain types of executory contracts (e.g. leases of commercial real estate, aircraft leases and financing agreements, timeshare contracts, and intellectual property licenses).

Generally, a debtor is not obligated to make the decision to assume, assign, or reject until a plan is confirmed. A party bound under a contract or lease with a debtor may, however, successfully move for an earlier deadline, if it can show that the delayed decision would prejudice it in some significant way. However, in a commercial real estate case, the debtor gets no more than 210 days.  Additionally, until a contract is assumed or rejected, both the debtor and the non-debtor party are generally obligated to perform under it.

To read other installments in this series, click here.

For a great discussion on insolvency, we recommend this webinar and this webinar. You can also learn about federal equity receiverships here, and get advice on what to do when your business is struggling here.