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Dealing With Distress For Fun & Profit – Installment #6 – The Mundane Middle of A Bankruptcy Case

Dealing with Distress for Fun and Profit

A written tour of business bankruptcy and its alternatives

In case you are hopping on board the bus in the middle of our tour, you may want to know that this installment looks at some of the more mundane stuff that happens after a Chapter 11 case is filed but before the end of the case.  We will discuss that in later installments.

Before we let you out of the bus to look around at this stop, let’s review what we’ve already seen (and what you may want to go back and look at if you missed it):

  • In Installment #1 we explained who would benefit most from this column:  we wrote it for PE and hedge funds managers and for C-level executives of businesses that may be dealing with financially distressed third parties (customers, suppliers, etc.) or who themselves may be at the helm of a troubled company, and for companies thinking about trying to buy (or invest in) troubled companies.
  • We took the time in Installment #2 to identify the various players who typically sit around the proverbial table when a distressed company and its various constituents talk.
  • In Installment #3 we described the scenery of the Bankruptcy Code.  That is, we provided a broad overview of the Bankruptcy Code (not section by section- that would have been overwhelming- but by Chapter, to give the reader a sense of how the Code is set up).
  • We got down to business in Installment #4, giving a broad overview of what the life cycle of a typical Chapter 11 debtor looks like  (though there is really no such thing as a typical Chapter 11 debtor).
  • And in Installment #5 we wrote about some of the key concepts that apply in any bankruptcy case (the automatic stay; the use, sale, or lease of property of the estate; financing; and executory contracts and leases).

Fear not, business bankruptcy is a big subject and we still have plenty to discuss. For now, though, let’s look at what we call the middle of a bankruptcy case …

The “Middle” of the Case

Business operations tend to normalize, and the debtor is, in many ways, able to conduct “business as usual” after the first few weeks following a chapter 11 filing.

In addition to running its business, however, a debtor must comply with the various obligations bankruptcy law imposes and must remain cognizant of deadlines imposed by the Bankruptcy Code and Rules. There will be disclosure obligations, less confidentiality, and more public scrutiny than before bankruptcy. Various constituencies will comment on the debtor’s actions or inactions and attempt to second-guess decisions that outside of bankruptcy would be within the sole purview of management. The debtor will have to obtain court approval for some acts that it previously could undertake in its discretion.

Early in the “middle” of the case, the debtor must attend a “first meeting of creditors” (also referred to as a “341 meeting” because that is the Code section that imposes this obligation). At this meeting, a representative of the debtor (typically, the owner, CEO, or CFO) must answer questions posed by the United States Trustee (“UST”), and sometimes by creditors, under oath.

Other administrative obligations of the debtor include the filing of monthly operating reports and the payment of quarterly fees to the UST. Of course, the debtor must ordinarily comply with its non-bankruptcy obligations as well, such as filing tax returns and SEC filings, if applicable.

The “middle” of the case also affords the debtor a chance to evaluate its business and legal strategies, such as whether to sell or shut down stores or plants or particular business lines, whether its workforce is of optimal size, ways to reduce expenses and improve profitability, and so forth. Legal strategy will include ways to use the special powers of a debtor in bankruptcy to enhance the estate.  These powers include assumption and rejection of contracts and actions to avoid and recover pre-petition payments.

Finally, the middle of the case may involve a lot of negotiating with players in the case, including committees, the UST, secured creditors, landlords, labor unions, government agencies, suppliers, and others. Some of this negotiation will relate to exit from bankruptcy, but much of it will relate to various interim issues that arise.

Often interspersed with this negotiation is litigation over various matters, such as creditors who seek relief from the automatic stay, landlords who want the debtor to assume or reject leases, disputes over the extension of various time periods, arguments over whether creditors are receiving adequate protection, and many other issues that can arise.

Taking a Step Back and Looking Forward: What Comes Next

Broadly stated, there are two ways chapter 11 helps a debtor deal with its problems:

  • First, it provides the debtor with a host of powers that can help it to remedy operational problems. The ability to reject executory contracts and unexpired leases is one well-known example. A lot of this is the focus of the middle of a case.
  • Second, chapter 11 enables a debtor to restructure its balance sheet to better reflect the actual—and usually diminished—ability of the business to service debt. This is accomplished through the formulation and approval—the “confirmation”—of a chapter 11 reorganization plan.

A Few More Words About Pre-Plan Powers

Plenty of times a debtor and its creditors can simply make and carry out deals without court intervention, and when this is allowable an out-of-court workout may be possible, thus obviating the need for Chapter 11.

But chapter 11 does enable a debtor to accomplish some purposes that cannot be achieved outside bankruptcy.   The automatic stay is another example of a power unique to bankruptcy.  And, if there is a need to sell an insolvent company, doing so in bankruptcy gives a buyer far more comfort that the transaction will not be challenged (as a fraudulent transfer, or otherwise). (For a great discussion on insolvency, we recommend this webinar and this webinar.)

A Few More Words About Plans

Let’s re-read the prior sentence:

And, if there is a need to sell an insolvent company, doing so in bankruptcy gives a buyer far more comfort that the transaction will not be challenged (as a fraudulent transfer, or otherwise).

Some debtors do not use chapter 11 to reorganize, but as a forum for an orderly liquidation.  We will write much more about such sales- “363 Sales”- in later installments.

Even in those cases involving a sale of substantially all of the debtor’s assets, the Chapter 11 plan is still typically very important, as it is the document that defines the creditors’ rights to receive the proceeds of the sale.

A Chapter 11 plan can be confirmed if the proponent of the plan gets the right number of votes, and a confirmed plan governs the rights of all creditors, even those who voted against the plan.   We will write much more about Chapter 11 plans in later installments.

Why This Chapter Should Not Be Read Too Literally

It is impossible to generalize what activities and events will occur in any particular chapter 11 case because each case is so different; however, the typical chapter 11 case does involve certain interrelated groups of activities or processes, such as claims administration, avoidance, and confirmation.

There is no rule that prescribes the order in which such tasks must be completed. Rather, when, or even if, these activities will take place in any given case will depend on a multitude of factors, including whether the case involves a “free fall,” “pre-arranged,” or “pre-packaged bankruptcy;” whether the case involves a reorganization, liquidation, or sale of all assets to a third party; and the level of creditor cooperation. It will also depend on what issues are of most pressing concern in the particular case.

The manner in which one of these tasks is performed may impact the others. For instance, the claims-administration process is sometimes a critical part of the plan-confirmation process.

A plan cannot be confirmed unless the bankruptcy court makes a number of specific findings, i.e. that the debtor will be able to pay most §503 and §507 “administrative” and “priority” claims—those claims that Congress has determined should enjoy priority over other unsecured claims—on the “effective date” of the plan.

Thus, thinking ahead to confirmation, debtors sometimes spend great resources on claims administration, addressing not only the validity and amount of claims, but also their priority levels. Successful chapter 11 debtors, however, often (perhaps even typically) defer claims administration and litigation to the post-confirmation period. We will write much more about the claims reconciliation process in later installments.

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.

About George Kuney

Prior to joining the faculty in 2000, Professor Kuney was a partner in the San Diego office of Allen Matkins Leck Gamble & Mallory LLP where he concentrated his practice on insolvency and reorganization matters nationwide.  Before that he received his legal training with the Howard, Rice and Morrison & Foerster firms in his hometown…

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George Kuney

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