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An Overview of the Chapter 11
Reorganization Process
THE SECOND FORUM FOR ASIAN
INSOLVENCY REFORM (FAIR)
Bangkok, Thailand
December 16 & 17, 2002
Presented by George Kelakos,
Co-Chair of the International Committee of the
American Bankruptcy Institute
Heller Ehrman White & McAuliffe LLP
Introduction

Economic Premises of Chapter 11 (Reorganization)

Players

Strategic Objectives of Players

Valuation Issues
Heller Ehrman White & McAuliffe LLP
Phases Of A Chapter 11 Case

Prepetition

Initial Phase

Middle Phase

Final Phase
Heller Ehrman White & McAuliffe LLP
Economic Premises of Chapter 11
(Reorganization)

A business, even though not currently able to meet its
obligations, can sometimes be restructured so that
creditors receive more from future profits (or a sale of
company) than the “auction value” of the assets;
excess of “going-concern value” of assets over
“auction value” (“going-concern premium”) is usually
divided between creditors and stockholders so that in
a successful reorganization, both groups do better
than they would under Chapter 7.
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Economic Premises of Chapter 11
(Reorganization)

Chapter 11 case commenced when bankruptcy
petition is filed with bankruptcy court

Voluntary petition can be filed by Debtor

Creditors (with certain requirements) and a foreign
representative of a debtor’s estate in a foreign
proceeding can file an involuntary petition
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Who May Be A Debtor?

Bankruptcy remedies are available to all business
entities in the U.S. (corporations, limited liability
companies, sole proprietorships, and partnerships
are all eligible for liquidation under chapter 7 or
reorganization under chapter 11)

Chapters 7 and 11 are also available to individuals
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Who May Be A Debtor?

Other chapters include chapter 9 (reorganization of
municipalities and other subdivisions of state
government), chapter 12 (reorganization of family
farms), and chapter 13 (a simplified reorganization
available to individuals with regular income and
limited debts)

Railroad reorganizations have specific requirements
under chapter 11

Stock and commodity brokers cannot file chapter 11,
only chapter 7
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Cast of Principal Characters

Debtor-in-possession (“DIP”) - debtor remains in
control (fiduciary, no trustee appointed), and has
possession of assets

DIP has rights, powers, and duties of a trustee

Bankruptcy judge (independent court /“unit” of U.S.
District court given decision-making power over
bankruptcy cases)-- primary role is to adjudicate
disputes

U.S. Trustee - officer of department of justice
administers cases and performs a number of
statutory duties
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Cast of Principal Characters


Committees “watch dog” for their constituents (may
be multiple committees) (fiduciary role), and can file
plan

Bank(s)

Trade creditors (“single shot”/“long-term”)

Machinery and equipment lender(s)

Landlord(s)
Equity security holders
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Cast of Principal Characters:
Professionals

Legal advisors (Debtor/committee/bank/other
creditors)

Financial advisors (Debtor/committee)

Accountants

Turnaround management/business advisors

Investment banker

Valuation/liquidation experts

Brokers
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Strategic Objectives of Players
What are their goals?

The debtor keeps business alive (for benefit of equity
holders)

Banks and M&E lenders maximize return on
disposition of collateral

Landlord:

Rising real estate market: oppose reorganization
efforts

Falling real estate market: may support
reorganization efforts
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Strategic Objectives of Players
What are their goals?


Unsecured creditors:

“Single shot” no interest in long-term, oppose
debtor

“Long run” retain debtor as a customer, support
debtor
Equity holders: keep business alive
Heller Ehrman White & McAuliffe LLP
Valuation Issues

“Retail”-value (fair market value?) at which collateral
can be sold to ultimate user

“Wholesale”- value at which collateral can be sold to
dealer

“Forced Sale”- “quick and dirty” value(necessary with
perishables)

“Going Concern” or “Enterprise” value”--essential
operating assets are sold as an entity (calculate
value by applying a multiple to projected profit)
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Valuation Issues

“Reorganization value” - “going concern” value plus
the “upside” (future expectation)

Combination of two or more of the foregoing
Source: Queenan, James F., “Standards for Valuation of Security
Interests in Chapter 11,” 92 Commercial Law Journal at 19, et. seq.
Heller Ehrman White & McAuliffe LLP
Phases Of A
U.S. Reorganization Case

Prepetition

Strategic considerations

Debtor

Lenders

Trade creditors
Heller Ehrman White & McAuliffe LLP
Phases Of A
U.S. Reorganization Case

Initial phase

Petition/automatic stay

Cash collateral

Postpetition borrowing

Relief from the automatic stay
Heller Ehrman White & McAuliffe LLP
Phases Of A
U.S. Reorganization Case

Middle phase

Executory contracts and unexpired leases

Assets sales (public/private)

Avoidance actions

Development of business plan (exclusivity
extensions/bar date motion)
Heller Ehrman White & McAuliffe LLP
Phases Of A
U.S. Reorganization Case

Final phase

Plan confirmation process

Elements of a plan of reorganization

Disclosure statement

Confirmation standards
Heller Ehrman White & McAuliffe LLP
Prepetition
Strategic Considerations

Open lines of communication with parties may result
in debtor filing case with support of bank and major
creditors

Parties gain time to prepare voluminous
paperwork required for a reorganization case
(prenegotiated or prepackaged)
Heller Ehrman White & McAuliffe LLP
Prepetition
Strategic Considerations

When events cause an emergency filing of a petition
or where the major players (bank/key trade creditors)
are not consulted, a number of issues may arise:

Immediate cash crunch

Increased tensions/lost debtor
credibility/diminished creditor confidence
Heller Ehrman White & McAuliffe LLP
Prepetition
Strategic Considerations

When events cause an emergency filing of a petition
or where the major players (bank/key trade creditors)
are not consulted, a number of issues may arise:

Creditors may take precipitous action (file an
involuntary petition)

Emergency may be harmful to debtor’s
business/operations
Heller Ehrman White & McAuliffe LLP
Prepetition Debtor

Does debtor have cash reserves? If so, what is the “burn
rate”

How will case be funded? (cash collateral
stipulation/motion/borrowing motion)

Are there sufficient funds to cover initial payroll? Can
petition be timed to minimize unpaid prepetition wages?
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Prepetition Debtor

Is an open line of communication maintained with key
lender(s) and trade creditors?

Have the debtor and its reorganization team begun to
prepare the documents and motions necessary for a
bankruptcy filing?

Does the debtor have an exit strategy?
Heller Ehrman White & McAuliffe LLP
Prepetition Lender

Is lender receiving sufficient information from the
debtor (is there an open line of communication)?

Does lender “want out” of the credit?

If so, lender may take aggressive action forcing
debtor to file

Does lender want to continue financing a DIP?

If so, lender will seek to negotiate key terms of
cash collateral/postpetition borrowing stipulation
Heller Ehrman White & McAuliffe LLP
Prepetition Trade Creditors

Strategy may depend on “which side of the fence” the
creditor falls

“Single shot” creditors may not have an interest in
pursuing a long term relationship with the debtor
will aggressively pursue collection efforts

“Long-term” creditors may wish to maintain debtor
as a future customer (make up losses through
future sales) will cooperate with debtor and
actively support reorganization (extend
postpetition credit)?
Heller Ehrman White & McAuliffe LLP
Initial Phase

Petition/automatic stay

Cash collateral

Postpetition borrowing

Relief from automatic stay

Summary of strategic consideration

Valuation issues
Heller Ehrman White & McAuliffe LLP
Initial Phase
Petition / Automatic Stay

Debtors (or creditors) run to court (castle) to seek
relief (sanctuary/time/control of asset disposition)

Once debtor enters castle gate (bankruptcy petition
filed/order of relief is entered), the gate is closed
(automatic stay (moratorium) is imposed)

Automatic stay stops actions against debtor or
property of the estate
Heller Ehrman White & McAuliffe LLP
Initial Phase
Petition / Automatic Stay

Automatic stay (moratorium) freezes position of
creditors and makes bankruptcy court the sole forum
for dispute resolution

Relief from automatic stay is granted only upon leave
of court
Heller Ehrman White & McAuliffe LLP
Initial Phase
Cash Collateral

The problem:

Debtors usually face a “cash deficit” at outset of
case

Cash or cash equivalents are often a secured
creditor’s “cash collateral.” They are collections of
accounts subject to security interests or proceeds
from the sale of pledged inventory or equipment.
Heller Ehrman White & McAuliffe LLP
Initial Phase
Cash Collateral

The problem:

Unless there is an agreement with creditor to use
“cash collateral,” debtor must seek emergency
relief to use “cash collateral”

Without court relief, there is no hope of a
successful reorganization
Heller Ehrman White & McAuliffe LLP
Initial Phase
Cash Collateral

The solution:

Under U.S. Law, a prepetition security interest
does not apply to postpetition property (exception:
proceeds)

Debtor is allowed to use non-cash collateral (real
estate, M&E, inventory) in the “ordinary course of
business”

Secured creditor is entitled to ask court for
“adequate protection” of its interest in the property
Heller Ehrman White & McAuliffe LLP
Initial Phase
Postpetition Borrowing

Debtors often cannot operate (or reorganize) without
new funding (even use of cash collateral may not be
enough to keep business afloat)

In U.S., solution is for debtor to obtain a new loan
(with court approval) from either the existing lender or
a new lender (super priority loan)
Heller Ehrman White & McAuliffe LLP
Initial Phase
Postpetition Borrowing

Postpetition Lenders in U.S. Often attempt to attach
“onerous” terms to the new loan:

Higher interest rates

Cross-collateralize prepetition debt with
postpetition collateral

“Sign off” by all parties on validity/perfection
issues/release of claims

Assignment of proceeds of avoidance actions

Bind future and successor trustees
Heller Ehrman White & McAuliffe LLP
Initial Phase
Postpetition Borrowing

Courts in U.S. will often allow economic terms but will
strike onerous terms from loan agreement (“level the
playing field”)
Heller Ehrman White & McAuliffe LLP
Initial Phase
Relief From Automatic Stay

For “cause,” including lack of “adequate protection”

Where debtor has no equity in property and property
is not “necessary to an effective reorganization”
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Initial Phase
Relief From Automatic Stay

What is “adequate protection”?

Protection vs. decline in “value”

Common forms of adequate protection: periodic
cash payments; replacement lien on postpetition
assets
Heller Ehrman White & McAuliffe LLP
Initial Phase
Summary of Strategic Considerations

For all - avoid “crying wolf” (your credibility is at
stake). Seek and expect only the minimum relief
necessary

For all - pick your fights carefully (attempt to resolve
disputes out of court)

Bank - is lender satisfied with debtor’s projection?
Does lender intend to continue funding debtor
postpetition? Get budget from debtor
Heller Ehrman White & McAuliffe LLP
Initial Phase
Summary of Strategic Considerations

Debtor - has the debtor team provided the necessary
projections and budget information to lender and to
parties in interest (cash collateral)? Has the debtor’s
team prepared the necessary backup information for
motion to pay prepetition wages and other first day
motions (procedural motions / professional
retention)?

Creditors - preserve creditors’ rights (Court may grant
minimum relief -- to preserve balance in negotiating
positions) / may want to file proof of claim
Heller Ehrman White & McAuliffe LLP
Initial Phase
Valuation Issues

Automatic stay

Does debtor have “equity” in collateral above the
lien?

Has collateral experienced a “loss or diminution of
value”?

Is proposed “adequate protection” sufficient?
Heller Ehrman White & McAuliffe LLP
Initial Phase
Valuation Issues

Use of cash collateral:

Has collateral experienced a “loss or diminution of
value”?

Is proposed “adequate protection” sufficient?
Heller Ehrman White & McAuliffe LLP
Initial Phase
Valuation Issues

Postpetition borrowing

Valuation of “new” collateral for new loan (risk
assessment)
Heller Ehrman White & McAuliffe LLP
Middle Phase

Executory contracts and Unexpired leases

Asset sales

Examination/pursuit of avoidance actions

Development of business plan

Valuation issues
Heller Ehrman White & McAuliffe LLP
Middle Phase
Executory Contracts and
Unexpired Leases

“Executory” contracts or leases - are contracts or
leases where performance, to some extent, remains
due on both sides

If executory, debtor may assume or reject

Examples of executory contracts:

Franchise or distributor agreements
Heller Ehrman White & McAuliffe LLP
Middle Phase
Executory Contracts and
Unexpired Leases

Examples of non-executory contracts:


Personal service contracts/contracts to make a
loan or extend financing
Debtor may assume an executory contract or an
unexpired lease under the following conditions:

Debtor must cure defaults or provide adequate
assurances that it will promptly cure defaults, and
provide adequate assurances of future
performance under the contract/lease
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Middle Phase
Executory Contracts and
Unexpired Leases

Once debtor assumes executory contract or
unexpired lease, debtor may assign such
contract/lease to a third party if such third party
provides adequate assurances of future performance

Special rules for non-residential leases and other
types of contracts
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Middle Phase
Asset Sales

Purpose:

Dispose of non-essential assets in a manner
generating highest possible return for debtor’s
estate
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Middle Phase
Asset Sales

Sales of assets (public or private) outside of a plan of
reorganization must be authorized by the court and
may be permitted under following circumstances:

Assets are rapidly deteriorating (boatload of fish)

Notice and opportunity for hearing must be
provided

Courts require that sale motions provide sufficient
background / disclosure to justify sale outside of a
plan

Courts will test “commercial reasonableness” of
proposed sale (method of sale, marketing and
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advertising)
Middle Phase
Asset Sales

How will assets be sold (public vs. Private sale)?


Professionals (broker/liquidation/valuation
expert/auctioneer) will often be employed to
maximize return to debtor’s estate
How will parties (and court) know that method of
sale/proposed sale will generate highest possible
return?

Parties will seek advice of professional valuation
expert to obtain fair market value, liquidation
value appraisals to demonstrate that price/method
of sale is commercially reasonable and is in best
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interest of debtor’s estate
Middle Phase
Asset Sales

Benefits of Asset Sales:

Finality (protection for good faith purchases, no
unwinding of sale on appeal)

Speed

Costs/expenses are usually less than alternatives

Generally, “clean” title (sale free and clear of liens,
encumbrances and attachments) (particularly in
real estate transactions) is transferred
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Middle Phase
Avoidance Actions

U.S. law favors fair and equal treatment of similarlysituated creditors in proportion to their claims (as
opposed to first come, first served)

Prepetition transactions may be “avoided” (set aside)
for actual fraud, inadequate consideration
(“fraudulent transfers”), or preference of one creditor
over others
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Middle Phase
Avoidance Actions

Sometimes assets are transferred within the
applicable “avoidance period” for less than fair value
$ equivalent of assets may be recovered for benefit
of debtor’s estate

DIP or trustee can bring avoidance actions
Heller Ehrman White & McAuliffe LLP
Middle Phase
Development of Business Plan

The key to a successful consensual business
reorganization case is a credible, viable business
plan

Identify, evaluate:

Assets and earning power of business

Secured and unsecured liabilities

Priority liabilities, including costs of proceeding
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Middle Phase
Development of Business Plan

Determine if business is viable

Consider structural approaches; stand alone, sale or
merger

Design business plan which business can perform
and which addresses key economic requirements

Develop financial projections for plan model

Develop liquidation analysis (needed for plan of
reorganization)
Heller Ehrman White & McAuliffe LLP
Middle Phase
Valuation Issues

Asset sales:


Fair market value and liquidation analyses will be
required to support sale of assets outside of a
plan
Avoidance actions:

Parties may seek expert testimony concerning
value of assets transferred within applicable
avoidance period
Heller Ehrman White & McAuliffe LLP
Middle Phase
Valuation Issues

Development of business plan:

Plan proponent(s) will require professional
assistance in order to generate a liquidation
analysis for the plan of reorganization
Heller Ehrman White & McAuliffe LLP
Final Phase

Plan confirmation process

Disclosure statement

Elements of a plan of reorganization

Confirmation standards
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Final Phase
Plan Confirmation Process

The process:

Plan proponent files disclosure statement and
plan of reorganization

Court conducts hearing on disclosure statement

Plan proponent(s) disseminate(s) plan (and
disclosure statement) to creditors and parties in
interest along with: (i) notice of confirmation
hearing (deadline to object to plan); And (ii)
voting ballot
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Final Phase
Plan Confirmation Process

The process:

Court conducts hearing on confirmation of plan

Confirmation of plan discharges debtor from any
debt that arose before confirmation (some
exceptions)

Confirmed plan creates new contractual rights,
replacing or superceding pre-bankruptcy contracts
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Final Phase
Disclosure Statement

The disclosure statement is a “prospectus” -- a
document intended to provide “adequate information”
(the debtor’s history, assets and liabilities, operations
in the case, description of the business plan, the plan
funding, pre and post-confirmation management,
avoidance actions, tax issues, risk factors and
alternatives to the plan) to creditors/parties in interest
to assist them in determining whether to vote for or
against the plan
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Final Phase
Disclosure Statement

In contrast to the (often) complex, technical plan of
reorganization, a good disclosure statement will
describe in “plain language” the business plan
embodied in the plan of reorganization along with the
risk factors and alternatives to the plan (detailed
liquidation analysis)
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Final Phase
Elements of a Plan of Reorganization

Plan of reorganization must be drafted to embody key
economic terms/requirements of the business plan

The plan of reorganization must provide for:

Payment of priority claims (includes administrative
costs of case)

Classification of claims
Heller Ehrman White & McAuliffe LLP
Final Phase
Elements of a Plan of Reorganization

Plan of reorganization must be drafted to embody key
economic terms/requirements of the business plan

The plan of reorganization must provide for:

Satisfy “best interests/liquidation equivalent”
requirement on unsecured claims

Treatment of equity security holders

Economic components (sale, capital infusions,
debt modification, designation of plan
administrator, prospective management)
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Final Phase
Confirmation Standards

Proposed in good faith

Plan and proponent in compliance with code

“Best interest of creditors” test plan provides
creditors/interest holders with liquidation (Chapter 7)
value or greater (valuation issues)

“Feasibility” test

Acceptance of plan by all classes
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Final Phase
Confirmation Standards

“Cramdown”

Requires acceptance by at least one impaired
class (majority in number of allowed claims in
class, 2/3 in $ amount for which ballots are cast)

Plan proponent must show plan treats nonaccepting class “fairly and equitably” and does not
“unfairly discriminate” vs. non-accepting class
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Final Phase
Confirmation Standards

“Cramdown”

Secured creditors must receive full value of their
collateral either in immediate cash or in NPV of
payments/time

“Absolute value” rule, no junior class will receive
or retain property on account of its interest (new
value exception?)
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Final Phase
Confirmation Standards

Plan not likely to be followed by liquidation or need
for further financial reorganization
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Concluding Observations

In an ideal reorganization case, parties will use the
time afforded by the filing of the petition and the court
(sanctuary) to arrive at a consensual plan so that the
enterprise can be rehabilitated and emerge from the
bankruptcy proceedings

Use time wisely (slow reorganization may result in a
quick death)
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Concluding Observations

Keep lines of communication open between
constituent groups to arrive at a consensual plan of
reorganization

Credibility - once lost, it’s almost impossible to regain

Pick your fights carefully
Heller Ehrman White & McAuliffe LLP
Concluding Observations

Only when there are points of contention which
cannot be resolved through negotiation, should
parties resort to the court for assistance

Bankruptcy forum affords a central place for the
resolution of disputes but resources of the judge
should be used wisely (use the judge as a facilitator)

Committees can play a very important role in the
case, alternating between siding with the debtor or
opposing the debtor to negotiate the best economic
terms for their constituency (threat of a competing
plan)
Heller Ehrman White & McAuliffe LLP
A
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Presented by George M. Kelakos
Heller Ehrman
601 S. Figueroa St.
Los Angeles, California 90017
(213) 689-7652
[email protected]
Heller Ehrman White & McAuliffe LLP