Business Bankruptcy Executive Summary


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Business Bankruptcy Executive Summary

  1. 1. bankruptcylawa legal update from Shumaker, Loop & Kendrick November 2008Business Bankruptcy: First Day MotionsExecutive Summary • In almost every Chapter 11 proceeding, the debtor will file a number of “first day” motions which are usually scheduled for hearing a day or two afterNeed to Know Bankruptcy Concepts the bankruptcy filing. Most of the “first day” motions are procedural and administrative, but there are alsoThe following is an executive summary substantive motions. Perhaps the mostof the “need to know” bankruptcy substantive first day motion is theconcepts as they impact creditors in debtor’s motion to approve debtor inbusiness insolvencies. possession or “DIP” financing. Chapter 11 has been increasingly used as a • The Bankruptcy Code provides thatChapter 11 vs. Chapter 7 pre-petition liens on collateral do not tool to liquidate business• Chapter 11 is technically used for extend to property acquired by the assets as a “going debtor post-petition. In addition, thebankruptcy reorganizations, whileChapter 7 applies to liquidations. concern” hence the , Bankruptcy Code provides that theChapter 11 and Chapter 7 can apply to frequent “liquidating 11”. debtor may not use as working capitaleither business or individual the lender’s “cash collateral”, which isbankruptcies. the cash generated by inventory sales and accounts receivable collections,• Chapter 11 has been increasingly used unless the lender consents or theas a tool to liquidate business assets as Bankruptcy Court permits the debtor to use cash collateral over the lender’sa “going concern”, hence the frequent Automatic Stay objection.“liquidating 11”. By contrast, in aChapter 7 liquidation, the appointed • To promote the bankruptcy concepttrustee is not permitted to operate the • For these reasons, it is common for of providing “breathing room” to a debtor and its lender to reach abusiness, except in rare circumstances. debtors, the Bankruptcy Code enjoinsAccordingly, any going concern value consensual post-petition financing any action to collect pre-petition debts arrangement, called DIP financing.can be achieved only through a owed to creditors. This would include“liquidating” Chapter 11. commencing or continuing a lawsuit, • Very often the lender has superior entering or enforcing a judgment, negotiating position and thus the DIP• Many lenders, who assert liens on terminating contracts or taking any othersubstantially all of a debtor’s assets, financing agreement appears one-sided. action to enforce payment. Bankruptcy Courts almost alwaysoften prefer a “liquidating” Chapter 11because of the Bankruptcy Code’s approve DIP financing as necessary to • There are limited occasions where the allow a debtor to continue operating,unique provisions allowing debtors to Bankruptcy Code permits a creditor tosell assets free and clear of liens (with although creditor objections can modify obtain “relief from stay” to proceed. or eliminate objectionable provisionsliens attaching to proceeds), whichenable a debtor to deliver “clear” title of the DIP financing. • Stay violations can result in claimto prospective buyers. Many buyers elimination, penalties and sanctionsinsist that their purchase of assets be including attorneys’ fees for the debtor’sconducted through a Section 363 sale a liquidating Chapter C H A R L O T T E T O L E D O T A M P A C O L U M B U S 1
  2. 2. November 2008• Clearly there are substantive rights of Doing Business With a • The practical solution to this problemother creditor’s constituents that can be has been for vendors to require the pre-compromised as a result of a DIP Chapter 11 Debtor petition purchase orders to be re-issuedfinancing, and creditors’ committees post-petition.often file objections to DIP financing •Upon the filing of a Chapter 11 by aproposals. customer, vendors must determine • Many debtors, particularly in larger whether to sell to the debtor post- cases, file a “first day” motion seeking• In light of the global credit crisis, petition. an order from the Bankruptcy Courtlenders’ willingness and perhaps ability granting administrative claim priorityto make DIP loans will undoubtedly be • To avoid the inherent risk of a for post-petition shipments on pre-materially reduced. Chapter 11, vendors often sell on a cash petition orders, to avoid the re-issuance before delivery or “CBD” basis. of purchase orders.• As an alternative source of cash,Debtors unable to obtain DIP financing • To remain competitive, vendors are • In the case of a pre-petition supplymay seek Bankruptcy Court permission sometimes compelled to extend credit contract which provides for credit terms,to use the lender’s “cash collateral” over terms to Chapter 11 customers. In this debtors may assert that such contractsthe lender’s objections. event, creditors should carefully impose an obligation on the vendor to evaluate the risk of non-payment in extend credit. While Bankruptcy Courts• At one time, critical vendor motions Chapter 11. usually compel a vendor who is a partywere also included in the “first day” to a supply contract to ship goods,motions. However, the current trend • The Bankruptcy Code treats credit Bankruptcy Courts have rarely forced ais for courts to delay consideration of extended to a Chapter 11 debtor in the vendor to extend credit to a Chapter 11any critical vendor motion until various ordinary course of business as an debtor.parties, including the unsecured administrative expense priority claim.creditors’ committee, have been given As indicated below regarding claim • Since a Chapter 11 filing effectivelyan opportunity to evaluate the motion. priorities, administrative expense relieves the debtor of pre-petition debt, claims enjoy a “high priority” and are the debtor’s post-petition cash flow may generally paid, absent an actually be healthier than it was pre- “administrative insolvency”. petition. However, creditors should independently evaluate the risks of • By contrast, extensions of credit that extending credit to a Chapter 11 debtor. To remain competitive, are not in the ordinary course of A key component of this evaluation vendors are sometimes business must first be approved by the should be the debtor’s DIP financing and Bankruptcy Court, or they are not its impact on the debtor’s working capital compelled to extend entitled to administrative expense requirements. credit terms to Chapter priority treatment. 11 customers. • At the time of the Chapter 11 filing, it is common for vendors to have open purchase orders from debtors that arose prior to the Chapter 11 filing, that provide for post-petition shipment by the vendor. • In a recent Bankruptcy Court ruling, the Court denied the vendor administrative expense priority status for post-petition shipments on pre- petition purchase orders since the shipment arose from a pre-petition C H A R L O T T E T O L E D O T A M P A C O L U M B U S 2
  3. 3. November 2008Schedules of Assets and – Employee wage claims of not more • Absent an administrative insolvency, than $10,950 for 2008. administrative claims are generally paidLiabilities and Statement in full, as the Bankruptcy Code requiresof Financial Affairs – Certain employee benefit contribution that such claims be paid in full as a claims as defined by the Bankruptcy condition precedent to confirmation of• The Bankruptcy Code imposes a Code. any plan of reorganization.requirement on every debtor to filedetailed Schedules of Assets and – Deposit claims of not more than • Moreover, while not a specificLiabilities as well as a Statement of $2,425 for 2008 for deposits made by requirement of the Bankruptcy Code, aFinancial Affairs. The Schedules of individuals for the purchase of goods debtor is generally obligated to “pay asAssets and Liabilities list the debtors or services for family or household use. it goes” while in Chapter 11, meaning itassets and values and detail the names must be able to pay its ongoingof secured and unsecured creditors, the – Certain government tax claims as administrative claims in the ordinaryamount of the indebtedness and defined by the Bankruptcy Code. course of business. A material build upwhether or not the indebtedness is in unpaid administrative claims indicatesdisputed. The Schedules also contain – Allowed unsecured claims of a a potential inability to obtain plana list of equity holders and contracts to Federal Depository Institution confirmation, and thus, provides thewhich the debtor is a party. The regarding capital requirements of an grounds for a conversion of the ChapterStatement of Financial Affairs includes insured depository institution. 11 proceeding to a liquidation proceedingthe disclosure of the location of books under Chapter 7.and records, and transfers made to – General unsecured claims.insiders and non-insiders prior to thebankruptcy filing. – Equity interests. Creditor Remedies • Secured, administrative and priority claims are generally paid in full while • 20 Day Administrative ClaimClaim Priorities unsecured claims are rarely paid in full and in fact rarely receive any material – The 2005 Bankruptcy Code• The Bankruptcy Code sets forth clear dividend. Equity interests are almost Amendments added Section 503(b)(9) topriorities of payment or entitlement to always canceled at no value. the Bankruptcy Code which providespayment by types of creditors or claims that sellers of goods are entitled to anas follows: • There are many exceptions to the administrative priority claim for the general rules. In the case of an value of goods delivered to a debtor– Secured creditors, as a result of pre- “administrative insolvency”, the value within 20 days prior to the bankruptcypetition consensual liens on assets and of the debtor’s assets are insufficient filing.proceeds of assets. to pay the lender’s claims and also the administrative claims. With increasing – The case law addressing Section– Administrative claims, which are the frequency, and as a result of very high 509(b)(a) provides some predictabilitycosts associated with the administration loan to collateral value ratios, assets on how this remedy will benefit vendors.of the post-petition bankruptcy estate. are insufficient to pay lenders in fullThese would include purchases of much less claims “below the line”. – There are two essential components togoods and services post-petition as well Often lenders will find it necessary to the 20 day administrative claim: 1)as professional fees associated with the pay professional fees associated with getting the claim allowed as anadministration of the bankruptcy estate. negotiating and closing a sale of its administrative claim in the first instance; collateral in connection with a and 2) getting the claim paid by the– Claims arising during the “gap” Bankruptcy Code Section 363 sale. bankruptcy estate. Upon a motion byperiod, which is the time period Lenders often resist paying other the creditor, most courts have allowedbetween the filing of an involuntary administrative claims, creating lack of vendors an administrative claim for thepetition by three or more creditors and equality in treatment of similarly value of goods delivered within 20 daysthe date on which an order for relief is situated claims. prior to the filing. As a result of theentered by the Bankruptcy Court. general rule that unsecured C H A R L O T T E T O L E D O T A M P A C O L U M B U S 3
  4. 4. November 2008receive little or no distribution and – Prior to the 2005 Bankruptcy Code – Only a debtor can make theadministrative claims are generally paid Amendments, the Bankruptcy Code determination that a particular vendorin full, converting any portion of an recognized the state law remedy of is critical and seek court approval ofunsecured claim to an administrative reclamation but also recognized that same. A creditor cannot independentlyclaim is a material achievement. permitting vendors to reclaim goods impose its critical vendor status on a would be disruptive to a debtor’s debtor.– Courts have been less willing to order attempted reorganization. Accord-immediate payment of 20 day ingly, the Bankruptcy Code allowed a – Critical vendor payments have becomeadministrative claims, instead allowing bankruptcy judge to grant a lien or increasingly controversial and certainthem to be paid in connection with plan administrative claim to the seller in court rulings, including the Kmartconfirmation or in connection with the lieu of the actual return of goods. decision, have limited the critical vendorsale of substantially all of the debtor’s remedy. Some jurisdictions refuse toassets. As with any other administrative – The 2005 Bankruptcy Code Amend- entertain a critical vendor motion.claim, if the Chapter 11 proceeding is ments eliminated the provision allow- However, Delaware and New Yorkadministratively solvent, payment of ing a bankruptcy judge to grant a lien continue to be jurisdictions where criticalthe 20 day administrative claim is or administrative priority in lieu of the vendor payments can be approved inprobable. In cases where the debtor’s actual return of goods. Accordingly, it appropriate circumstances. As recentlyChapter 11 proceeding is “insolvent”, is unclear what value the current as September, 2008, the Delawarethe likelihood of payment is reclamation claim will have. Bankruptcy Court in the Hines Nurserycompromised. However, payment on case approved $2 million of criticalsuch claims nevertheless exceeds what – Sellers of goods should nevertheless vendor payments.would be paid absent the 20 day continue the practice of sending aadministrative claim. reclamation demand which must be – Vendors who are truly critical to a sent within 20 days after the Chapter debtor-customer should continue to seek 11 filing and can cover invoices for critical vendor status as a means of goods delivered within 45 days prior getting paid. In doing so, vendors should to the bankruptcy filing. be careful to not violate the automatic For more information on stay by conditioning future business on For more information on payment of pre-petition debt. Moreover, 20 Day Administrative vendors should be aware that getting Reclamation: Claims click here and click here paid as a critical vendor will likely be click here. conditioned on providing normal lines of credit, pricing and terms, or other • Critical Vendor “customary trade procedures.” – Critical vendor is a creditor remedy For more information on based on a theory that a particular Critical Vendor: vendor is so essential to a debtor’s click here• Reclamation ability to continue operating that with- and out the uninterrupted flow of the click here– Historically, reclamation has been the seller’s goods, the debtor cannot con-standard bearer of a vendor’s remedies. tinue to operate and thus has noReclamation is a state law remedy realistic chance of a successful re-arising from the Uniform Commercial organization. In these instances, aCode’s provisions on sales of goods. In bankruptcy court has broad authorityparticular, most states allow a vendor to order relief that facilitates ato reclaim goods delivered to a customer successful reorganization.(or stop goods in transit), if the sellerlearns of the customer’s insolvency. C H A R L O T T E T O L E D O T A M P A C O L U M B U S 4
  5. 5. November 2008• Set-off and Recoupment to the vendor or is limited to amounts – Unlike a voluntary petition where an directly related to the goods in its order for relief is entered essentially– An often overlooked remedy, setoff possession. simultaneously with the filing of thearises from the settlement of mutual petition, in an involuntary case, upondebts or accounts owed between a • Disclosure the filing of the involuntary petition bydebtor and a creditor. Simply, if A owes creditors, a debtor has 30 days to file anB $100 and B owes A $50, then the debts – The Bankruptcy Code provides all answer to the petition. If the debtorcan be resolved as follows: $100 - $50 creditors substantial rights to learn contests the bankruptcy, the Bankruptcy= $50, so A pays B $50 and the accounts details about the debtor’s financial Court will schedule and conduct a trialare settled. The Bankruptcy Code condition, historical transactions and on whether the creditors’ petition meetscodifies this common law remedy and prospects for reorganization. Although the requirements of Section 303 of thein fact provides that the creditor has a creditors have the right to appear at Bankruptcy Code.secured claim to the extent of the value and attend the Section 341 “firstof its setoff claim. meeting of creditors”, this is rarely – During the “gap” period (time period productive. Modern practice has been between the date of the involuntary– The debts owing must be owed to that the Office of the United States petition and the date a Bankruptcy Courtand from precisely the same legal Trustee conducts the 341 meeting and enters an order for relief) note theentities and the debts must arise either covers primarily administrative issues following:both pre-petition or both post-petition. with limited opportunity for creditorsThe debts do not, however, have to arise to examine the debtor’s representatives. 1. The automatic stay is in effectout of the same transaction. upon the filing of the involuntary – Rule 2004 of the Bankruptcy Rules petition;– The exercise of a setoff remedy permits creditors broad rights torequires relief from the automatic stay examine the debtor under oath and 2. Claims arising during the “gap”from the Bankruptcy Court. Moreover, penalty of perjury about its financial period, including extensions ofthere are somewhat complicated rules affairs, historical transactions and unsecured credit, are second-tierregarding exercise of setoff during the prospects for reorganization, and to priority claims, which are90 days prior to the bankruptcy filing, obtain relevant documents. subordinate to claims arising afterwhich if not followed, could result in the order for relief is entered;preference exposure. – These tools allow a creditor to obtain details about the debtor’s financial 3. If an order for relief is entered,For more information on Set-off: condition necessary to evaluate the risk payments on pre-petition debtsclick here and probability of payment. made during the “gap” period can be voided as avoidable post-petition– Recoupment is similar to setoff, except • Involuntary Petition transactions if no value wasthat the mutual debts must arise from provided in the “gap” period.the same transaction. – Normally a bankruptcy proceeding is commenced by the filing of a – Creditors may seek the immediate• Statutory Liens voluntary petition for relief by the appointment of an interim trustee if there debtor. However, Section 303 of the is a concern that the debtor may be– Vendors in possession of goods Bankruptcy Code permits three or dissipating assets.belonging to a debtor may be able to more creditors to file an involuntaryassert a valid possessory lien under petition against a debtor, in either – Debtors have the absolute right tostate law. The Bankruptcy Code Chapter 7 or Chapter 11, if certain convert an involuntary Chapter 7 caserecognizes these liens, and treats the requirements are met. The to a Chapter 11 proceeding or vice versa.vendor as a secured claimant to the requirements are that the aggregateextent of the value of the goods in the debt owed to the three or more – A creditor considering an involuntaryvendor’s possession. States’ laws differ creditors is at least $13,475 for 2008, petition should always analyze paymentson the extent and priority of the lien such debts are not contingent as to received in the prior 90 days, as theand whether it covers all amounts owed liability or subject to a bona fide involuntary filing will establish the 90 dispute, and the debtor is not generally day preference period. paying its debts as they come C H A R L O T T E T O L E D O T A M P A C O L U M B U S 5
  6. 6. November 2008• Motion to Convert to Chapter 7 – A conversion to Chapter 7 will end – Claim purchasers will only purchase Chapter 11 administrative expenses; claims that are not disputed or– A party in interest including a creditor however, the Chapter 7 trustee and its contingent as to liability. Claimor creditors’ committee may file a counsel will incur administrative purchasers will usually agree to buymotion seeking to convert a Chapter 11 expenses that will have priority over claims based on the debtor’s schedulescase to a Chapter 7 liquidation case if the Chapter 11 administrative of assets and liabilities. However,the creditor can establish “cause” and expenses. Moreover, the Bankruptcy purchasers will not buy claims based onthat a conversion is in the best interest Code allows the trustee to be paid a a creditors’ proof of claim if it isof creditors. “Cause” includes: percentage of funds distributed to materially greater than the claim listed creditors, which can be as high as 3%. on the debtor’s schedules, at least until 1. Substantial losses and no the claim is resolved in the claims reasonable likelihood of • Motion to Appoint a reconciliation process. reorganization. Trustee or Examiner Executory Contracts 2. Gross mismanagement of the – A party in interest including a creditor estate. or creditors’ committee can also file a • Executory Contract is the Bankruptcy motion seeking the appointment of a Code term given to essentially any 3. Failure to maintain insurance. trustee or an examiner. A Chapter 11 contract between a debtor and a non- trustee would supplant management debtor party where both parties owe 4. Unauthorized use of cash and take control of the debtor’s performance to the other. A promissory collateral. bankruptcy estate and assets. An note would NOT be an executory examiner does not supplant contract since the holder of the note has 5. Failure to pay taxes. management or take control of the no performance obligation. However, a debtor’s estate; rather, an examiner supply contract or other sales agreement 6. Failure to file or confirm a plan investigates discrete issues, usually would almost always meet the of reorganization within the relating to questionable transactions, requirements of an executory contract applicable time period. and reports findings to the Court and under the Bankruptcy Code. Real estate creditors. leases are also treated as executory– Assuming a creditor has the contracts. The Bankruptcy Code Rulesappropriate grounds for conversion, – A creditor may seek the appointment for rejecting executory contracts andthe creditor should nevertheless of a trustee or an examiner for cause leases are debtor-friendly which isconsider several issues. including fraud, dishonesty, precisely why retailers who want to close incompetence or gross mismanage- stores often choose Chapter 11 as the– Since a Chapter 7 trustee cannot ment, if such appointment is in the vehicle to accomplish such goal.operate the business, a conversion will best interest of creditors or if groundslikely result in a closure of the business to convert to Chapter 7 exists. • The Bankruptcy Code provides debtorsoperation and a quicker liquidation or the unfettered right to assume or rejectauction of the assets, or an aban- • Claims Sale executory contracts and leases. If adonment of the assets to the secured debtor rejects an executory contract, thelender. – At least up until the 2008 economic non-debtor party receives a general crisis, there has been a vigorous market unsecured claim for damages arising– The Chapter 7 trustee will take control for the purchase of bankruptcy debt, from the debtor’s “breach” of contract.of the debtor and its assets and any particularly in larger bankruptcy cases. Thus, a debtor escapes the contract withcreditors’ committee or individual The purchasers are usually Wall Street little cost. On the other hand, the debtorcreditors will have less influence in the funds that are in essence seeking to also has the right to assume or assign abankruptcy process. For example, a purchase claims at a discount in hopes contract. In this instance, the BankruptcyChapter 7 trustee may have more that the ultimate dividend, whether in Code requires that the debtor “cure” theincentive to aggressively pursue the form of cash payments or stock in contract by paying existing defaults.avoidance actions such as preferences the reorganized entity, will provide a Presumably, debtors would assumeagainst creditors. return on such investment. contracts that they deem to be C H A R L O T T E T O L E D O T A M P A C O L U M B U S 6
  7. 7. November 2008 Proof of Claim Section 363 Sale • A proof of claim is the document by • Section 363 of the Bankruptcy Code The potential costs and which a creditor registers its claim with allows a debtor to sell substantially all the debtor’s bankruptcy estate, of its assets free and clear of liens with vagaries of a jury trial indicating the type of claim (secured, liens attaching to proceeds of sale. This might provide leverage administrative, priority or unsecured), provision allows for the quick and to a preference the amount of the claim and the basis efficient liquidation of a debtor’s assets for the claim. without having to first resolve the extent, defendant. validity and priority of liens on assets. • Bankruptcy courts almost always set This allows assets to be sold relatively a bar date for filing proofs of claim quickly and avoids further erosion of several months after the bankruptcy value due to operating losses. petition is filed. To be considered, all claims must be filed within this bar • Buyers of assets often favor acquiring date. assets in a Section 363 sale (thus requiringeither because they insure an a Chapter 11 filing) since sales to gooduninterrupted supply of goods or • If the debtor’s Schedules of Assets faith purchasers are not subject to latercontain favorable pricing or terms. For and Liabilities lists a particular challenge.a creditor who is a party to an executory creditor’s claim correctly, and does notcontract, the assumption of such list it as unliquidated, contingent or • Generally a Section 363 sale is teed upcontract can be an effective vehicle to disputed, and the creditor otherwise as an auction with a stalking horse saleobtain payment of pre-petition debt. agrees with the debtor’s Schedules, as the initial bid. After appropriate there is no need for the filing of a proof advertising and marketing, an auction• Debtors in Chapter 11 must assume of claim. is conducted where interested buyersan executory contract before or in are permitted to overbid the stalkingconjunction with the confirmation of • In order to assure participation in horse bid and thus allow the estate tothe Chapter 11 Plan. The non-debtor any distribution to creditors or vote on obtain the greatest possible value for itsparty to the contract can ask the court a Chapter 11 plan, creditors often file assets. There is usually a requiredto set a shorter time if it will be harmed a proof of claim, rather than rely on percentage bidding increment and theby the delay in the debtor’s decision. the debtor’s Schedules of Assets and stalking horse bidder often has bid Liabilities. protection in the form of a break-up fee• The Bankruptcy Code requires that and expense reimbursement.the non-debtor party to an executory • Creditors who file a proof of claimcontract must continue to perform its waive the right to demand a jury trial • Secured creditors are generally entitledobligations under the contract pending in, for instance, a preference action. to “credit bid” their secured debt,the debtor’s decision to assume or reject The potential costs and vagaries of a provided the secured claim is notsuch contract, and provided that the jury trial might provide leverage to a disputed.debtor is in fact performing its preference defendant.obligations of the contract post-petition.• A supply agreement impacts acreditor’s rights as a critical vendorsince the leverage of not shipping isarguably eliminated in the context ofan executory C H A R L O T T E T O L E D O T A M P A C O L U M B U S 7
  8. 8. November 2008• Although a Section 363 sale can be a Plan of Reorganization – The so called “absolute priority rule”valuable tool for maximizing the requires that a junior class of creditorsliquidation value of a debtor’s assets, • A Plan of Reorganization is cannot receive value on its claims unlesssuch sales can also create an inherent essentially the debtor’s contract senior classes are paid in full or vote totension between the secured creditor detailing how the debtor will satisfy accept the plan. Thus, unless unsecuredwho asserts liens on the assets being pre-petition claims. This can be in the creditors are paid in full, equity holderssold and other creditors of the estate. form of cash distributions, an allocation are not permitted to retain their equityThe secured creditor’s goal is payment of future profits, and/or redistribution interest absent a capital contributionof its secured debt and nothing more, of the debtor’s equity. commensurate to the value of thewhile other creditors seek to achieve a reorganized debtor’s in excess of secured debt to • For a Plan of Reorganization togenerate proceeds for other creditors. become effective, it must be confirmed – To be confirmed, a Plan must also beThe quickest sale does not necessarily by the Bankruptcy Court. feasible. A key element of feasibility isproduce the best sale, however, usually whether or not a debtor hasprolonged sales processes have the – For purposes of Plan confirmation, committed exit financing. The currentdisadvantage of higher administrative similarly situated creditors are placed credit crisis may undermine the abilitycosts. in classes of creditors, usually roughly of Debtors to obtain exit financing, and corresponding to the claim priorities thus exit Chapter 11.• With increasing frequency, and due set forth above. If a class of creditorsto the recent trend of high loan to value is unimpaired, meaning their claimsratios, many Section 363 sales have are satisfied, that class is deemed toproduced sales proceeds less than the have accepted the Plan. For creditoramount owed to secured creditors. classes that are impaired, the class must The current credit crisisThese “short sales” create an either consent to the Plan or beadministrative insolvency where only “crammed down”. For a class to may undermine thesecured creditors benefit from the sale. consent to a Plan, of the class members ability of Debtors toMany courts have required the secured who vote, there must be more than 1/2creditor to pay administrative claims obtain exit financing, in number and 2/3 in dollar amountassociated with the Chapter 11 of creditors accepting the Plan. and thus exit Chapter 11.proceeding to obtain the benefit of theChapter 11 process and protections. – A debtor can “cram down” its planThis has been euphemistically referred on non-consenting classes if the Planto as the “pay to play” rule. In addition, is “fair and equitable,” does notcreditors often assert that the Chapter “discriminate unfairly” within classes,11 process contemplates a benefit to all and is in the “best interests ofcreditor classes and thus unsecured creditors,” primarily that creditors willcreditors should receive a “carve-out” receive more in the Plan than in aof the sale proceeds to fund a dividend Chapter 7 unsecured creditors.• In the recent Clear Channel case, theNinth Circuit (includes California)Bankruptcy Appellate Panel (BAP)ruled that in the case of a “short sale”,the Section 363 sale was NOT “free andclear”, and the buyer acquired the assetsSUBJECT TO the junior liens. WhetherClear Channel is an aberration or thebeginning of a trend remains to be C H A R L O T T E T O L E D O T A M P A C O L U M B U S 8
  9. 9. November 2008Avoidance Actions - Contemporaneous exchange for Non-Bankruptcy value is where the parties intended• Preferences. the payment to be substantially Alternatives contemporaneous with the creditor– Bankruptcy Code Section 547 allows providing new value. The classic • The two most common non-the debtor to recover pre-petition example of contemporaneous bankruptcy alternatives are the out ofpayments to third parties that were exchange for value is where a debtor court workout, which may involve amade within 90 days prior to filing as desperate for goods promises to composition agreement, or anto non-insiders and within one (1) year send a check if the creditor will assignment for the benefit of creditorsprior to filing with respect to insiders. release goods. Documentation of under state law.The requirements to assert a preference the parties’ intent of payment inare that the payment in question be exchange for specific value is critical • A non-bankruptcy workoutmade within the appropriate time to this defense. generally involves a forbearanceperiod, made while the debtor is agreement with secured lender(s) and ainsolvent, the payment is on account forbearance or composition agreementof antecedent debt and the payment with unsecured creditors. Suchallows the creditor to receive more than composition agreement may involve ait would in a Chapter 7 liquidation. For more information on moratorium or delay in payment of debtsDebtors or trustees pursuing preference Preferences click here owed and/or a compromise of theclaims rarely have difficulty establishing amount owed. Immediate cash and click here. payments for creditors usually requirethese basic requirements. a discount, a longer term payout may– The statute of limitations on result in payment in full.preference actions is two years fromthe petition date. • Fraudulent Transfers • Assignments for the benefit of creditors are governed by each states’ laws, which– Creditors who have received – Fraudulent transfers is a partial differ materially from state to state.allegedly preferential payments have misnomer because fraud is not There is little uniformity among states’several defenses, the most common required. The debtor can recover laws on assignments with some statesthree being that the payment was made payments made to non-insiders for having highly developed statutes andin the ordinary course of business, that transfers occurring within one (1) year procedures and other states havingthe creditor provided subsequent new prior to bankruptcy and for two (2) virtually nothing.value after the payment at issue, or that years with respect to insiders. Thethe payment constituted a debtor can recover transfers that were • Conceptually, an assignment involvescontemporaneous exchange for value. made in an attempt to defraud creditors a transfer of all of the debtor’s assets to but also when the transfer was simply a third party assignee, whose duties and - The ordinary course of business for “less than reasonably equivalent responsibilities are similar to a Chapter defense is based on the notion that value”. 7 trustee. Assignees can operate a the payment in question was business enterprise, but assignments consistent with the ordinary course – A statute of limitations on asserting generally involve the ultimate sale of the of business between the debtor and fraudulent transfer claims is two (2) assets. the particular creditor or consistent years from the petition date. with industry standards generally. • Assignments for the benefit of creditors – Debtors and trustees in bankruptcy are usually limited to smaller business - Subsequent new value is simply are also entitled to assert claims under enterprises whose assets are located that creditors provided additional state law fraudulent transfer statutes within one state since the assignment value in the form of goods or which are similar to the Bankruptcy laws in one jurisdiction cannot be services after receipt of the payment Code fraudulent transfer statute but imposed on assets in another jurisdiction. that in essence replenished the often have a longer statute of estate’s assets. The defense exists limitations, and the reach back period to the extent of such new value. may be C H A R L O T T E T O L E D O T A M P A C O L U M B U S 9
  10. 10. November 2008Cross-Border Insolvency – ALI NAFTA Transnational Insolvency – In the recent Bear Stearns case, two Project Bear Stearns hedge funds, registered• When a multi-national business faces under the laws of the Cayman Islands,insolvency, assets in more than one • COMI (or Center of Main Interests) and with their primary operations incountry likely require administration is a key concept in Chapter 15, the New York, filed “winding up”and protection. It is sometimes not UNCITRAL Model Law and the proceedings in the Cayman Islands.clear what country’s law will apply, European Union Insolvency However, in response to investorand which jurisdiction will control the Regulation, all of which presume lawsuits arising from sub-primeinsolvency process. This can be COMI is where an entity has its investments, the Hedge Funds neededdeterminative of outcome since corporate registration. protection in the United States. Thecountries’ laws and approach to Hedge Funds’ administrators thus filedbusiness insolvencies can differ – COMI impacts where the main Chapter 15 petitions in New York seekingmaterially. proceeding should occur, based on recognition of the Cayman Islands where a business has its “center of proceedings as “foreign main”• Typically, a multi-national business main interests”, which is analogous to proceedings or in the alternative aslocated outside the United States with the principal place of business. Thus, “foreign non-main” proceedings.assets in the United States would seek if COMI exists in a foreign country, ainsolvency protection under the laws U.S. Bankruptcy judge should – Even though no party objected to theof its country, but will also file an recognize a foreign insolvency Chapter 15 petitions, the U.S. Bankruptcy“ancillary” proceeding in the United proceeding as the “foreign main” Court refused to recognize the CaymanStates. proceeding and the U.S. Chapter 15 Islands proceedings as either “foreign proceeding as an “ancillary” main” or “foreign non-main”• There are many laws, treaties and proceeding. If a debtor does not have proceedings since the Court found thatregulations that address these issues, COMI in the country where it files its the Cayman Islands was neither the placeincluding: insolvency proceeding, but has an of COMI nor of an “establishment”. “establishment” in such country, the Rather, the Court concluded that the– Chapter 15 of the Bankruptcy Code U.S. Bankruptcy Court should Hedge Funds were in New York. Theon Ancillary Cases recognize the foreign proceeding as a effect of this ruling is that to obtain the “foreign non-main” proceeding. protections of the U.S. Bankruptcy Code, 1. Mostly follows the United Nations’ the Hedge Funds would be required to Model Law on Cross-Border – If the foreign insolvency proceeding file Chapter 11 proceedings in New York. Insolvency is recognized as a “foreign main” The Court also suggested that involun- proceeding, the approval of the tary proceedings might be filed against 2. Chapter 15 passed as part of the Chapter 15 proceeding will invoke the the Hedge Funds in New York. 2005 Bankruptcy Code Amendments automatic stay. If the foreign insolvency proceeding is recognized – The Bear Stearns opinion has been– UNCITRAL (United Nations as a “foreign non-main” proceeding, sharply criticized internationally as aCommission on International Trade the Chapter 15 proceeding will not U.S. attempt to control internationalLaw) Model Law on Cross-Border invoke the automatic stay protections. insolvencies through Chapter 11. AmongInsolvency other things, critics argue that it is disingenuous for a U.S. BankruptcyGoal: to “modernize and harmonize Court to find Chapter 11 jurisdiction, inthe rules on international business and Delaware for example, based solely onto enhance predictability in cross-border the place of incorporation, whilecommercial transactions”. applying a different, more stringent standard to foreign insolvency– European Union Regulation on proceedings.Insolvency C H A R L O T T E T O L E D O T A M P A C O L U M B U S 10
  11. 11. November 2008• Many countries have also recently In many respects, these laws tend to The contents of this update are offeredenacted new insolvency laws including make insolvency laws more similar in as general information only and arethe following: different jurisdictions, and many are not intended for legal advice on in fact based on the UNCITRAL Model specific matters.– Brazil (2005) Law (above).– China – Enterprise Bankruptcy Law • A key difference between the U.S. of the People’s Republic of China Bankruptcy Code and most foreign (2007) bankruptcy laws is the concept of– Columbia (2006) “Debtor in Possession”. In U.S. bankruptcy cases, it is extraordinary– France (2006) for a trustee or examiner to be imposed,– Italy – 2005/2006 reforms and 2008 while most foreign insolvency laws Corrective Decree require the appointment of a third party administrator or liquidator with– Japan – (2000) varying degrees of responsibility and– Mexico – Ley de Concursos involvement regarding the business. Mercantiles (2000)– Spain (2003)– United Kingdom (2005)© David H. ConawayShumaker, Loop & Kendrick, LLPdconaway@slk-law.comNovember, 2008For more on the authorclick hereFor more on Shumaker’s Bankruptcy, Insolvency and Creditors’ Rights Practiceclick hereFor more on Shumaker’s Practice Areasclick here First Citizens Bank Plaza 128 South Tryon Street Suite 1800 Charlotte, North Carolina 28202-5013 C H A R L O T T E T O L E D O T A M P A C O L U M B U S 11