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

bankruptcylawa legal update from Shumaker, Loop & Kendrick November 2008

The following is an executive summaryof the “need to know” bankruptcyconcepts as they impact creditors inbusiness insolvencies.

Chapter 11 vs. Chapter 7

• Chapter 11 is technically used forbankruptcy reorganizations, whileChapter 7 applies to liquidations.Chapter 11 and Chapter 7 can apply toeither business or individualbankruptcies.

• Chapter 11 has been increasingly usedas a tool to liquidate business assets asa “going concern”, hence the frequent“liquidating 11”. By contrast, in aChapter 7 liquidation, the appointedtrustee is not permitted to operate thebusiness, except in rare circumstances.Accordingly, any going concern valuecan be achieved only through a“liquidating” Chapter 11.

• Many lenders, who assert liens onsubstantially all of a debtor’s assets,often prefer a “liquidating” Chapter 11because of the Bankruptcy Code’sunique provisions allowing debtors tosell assets free and clear of liens (withliens attaching to proceeds), whichenable a debtor to deliver “clear” titleto prospective buyers. Many buyersinsist that their purchase of assets beconducted through a Section 363 salein a liquidating Chapter 11.

Automatic Stay

• To promote the bankruptcy conceptof providing “breathing room” todebtors, the Bankruptcy Code enjoinsany action to collect pre-petition debtsowed to creditors. This would includecommencing or continuing a lawsuit,entering or enforcing a judgment,terminating contracts or taking any otheraction to enforce payment.

• There are limited occasions where theBankruptcy Code permits a creditor toobtain “relief from stay” to proceed.

• Stay violations can result in claimelimination, penalties and sanctionsincluding attorneys’ fees for the debtor’scounsel.

First Day Motions

• In almost every Chapter 11proceeding, the debtor will file a numberof “first day” motions which are usuallyscheduled for hearing a day or two afterthe bankruptcy filing. Most of the “firstday” motions are procedural andadministrative, but there are alsosubstantive motions. Perhaps the mostsubstantive first day motion is thedebtor’s motion to approve debtor inpossession or “DIP” financing.

• The Bankruptcy Code provides thatpre-petition liens on collateral do notextend to property acquired by thedebtor post-petition. In addition, theBankruptcy Code provides that thedebtor may not use as working capitalthe lender’s “cash collateral”, which isthe cash generated by inventory salesand accounts receivable collections,unless the lender consents or theBankruptcy Court permits the debtorto use cash collateral over the lender’sobjection.

• For these reasons, it is common fora debtor and its lender to reach aconsensual post-petition financingarrangement, called DIP financing.

• Very often the lender has superiornegotiating position and thus the DIPfinancing agreement appears one-sided.Bankruptcy Courts almost alwaysapprove DIP financing as necessary toallow a debtor to continue operating,although creditor objections can modifyor eliminate objectionable provisionsof the DIP financing.

Business Bankruptcy:Executive SummaryNeed to Know Bankruptcy Concepts

Chapter 11 has beenincreasingly used as atool to liquidate businessassets as a “goingconcern”, hence thefrequent “liquidating 11”.

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Doing Business With aChapter 11 Debtor

•Upon the filing of a Chapter 11 by acustomer, vendors must determinewhether to sell to the debtor post-petition.

• To avoid the inherent risk of aChapter 11, vendors often sell on a cashbefore delivery or “CBD” basis.

• To remain competitive, vendors aresometimes compelled to extend creditterms to Chapter 11 customers. In thisevent, creditors should carefullyevaluate the risk of non-payment inChapter 11.

• The Bankruptcy Code treats creditextended to a Chapter 11 debtor in theordinary course of business as anadministrative expense priority claim.As indicated below regarding claimpriorities, administrative expenseclaims enjoy a “high priority” and aregenerally paid, absent an“administrative insolvency”.

• By contrast, extensions of credit thatare not in the ordinary course ofbusiness must first be approved by theBankruptcy Court, or they are notentitled to administrative expensepriority treatment.

• At the time of the Chapter 11 filing,it is common for vendors to have openpurchase orders from debtors thatarose prior to the Chapter 11 filing,that provide for post-petition shipmentby the vendor.

• In a recent Bankruptcy Court ruling,the Court denied the vendoradministrative expense priority statusfor post-petition shipments on pre-petition purchase orders since theshipment arose from a pre-petitioncontract.

• The practical solution to this problemhas been for vendors to require the pre-petition purchase orders to be re-issuedpost-petition.

• Many debtors, particularly in largercases, file a “first day” motion seekingan order from the Bankruptcy Courtgranting administrative claim priorityfor post-petition shipments on pre-petition orders, to avoid the re-issuanceof purchase orders.

• In the case of a pre-petition supplycontract which provides for credit terms,debtors may assert that such contractsimpose an obligation on the vendor toextend credit. While Bankruptcy Courtsusually compel a vendor who is a partyto a supply contract to ship goods,Bankruptcy Courts have rarely forced avendor to extend credit to a Chapter 11debtor.

• Since a Chapter 11 filing effectivelyrelieves the debtor of pre-petition debt,the debtor’s post-petition cash flow mayactually be healthier than it was pre-petition. However, creditors shouldindependently evaluate the risks ofextending credit to a Chapter 11 debtor.A key component of this evaluationshould be the debtor’s DIP financing andits impact on the debtor’s working capitalrequirements.

• Clearly there are substantive rights ofother creditor’s constituents that can becompromised as a result of a DIPfinancing, and creditors’ committeesoften file objections to DIP financingproposals.

• In light of the global credit crisis,lenders’ willingness and perhaps abilityto make DIP loans will undoubtedly bematerially reduced.

• As an alternative source of cash,Debtors unable to obtain DIP financingmay seek Bankruptcy Court permissionto use the lender’s “cash collateral” overthe lender’s objections.

• At one time, critical vendor motionswere also included in the “first day”motions. However, the current trendis for courts to delay consideration ofany critical vendor motion until variousparties, including the unsecuredcreditors’ committee, have been givenan opportunity to evaluate the motion.

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To remain competitive,vendors are sometimescompelled to extendcredit terms to Chapter11 customers.

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Schedules of Assets andLiabilities and Statementof Financial Affairs

• The Bankruptcy Code imposes arequirement on every debtor to filedetailed Schedules of Assets andLiabilities as well as a Statement ofFinancial Affairs. The Schedules ofAssets and Liabilities list the debtorsassets and values and detail the namesof secured and unsecured creditors, theamount of the indebtedness andwhether or not the indebtedness isdisputed. The Schedules also containa list of equity holders and contracts towhich the debtor is a party. TheStatement of Financial Affairs includesthe disclosure of the location of booksand records, and transfers made toinsiders and non-insiders prior to thebankruptcy filing.

Claim Priorities

• The Bankruptcy Code sets forth clearpriorities of payment or entitlement topayment by types of creditors or claimsas follows:

– Secured creditors, as a result of pre-petition consensual liens on assets andproceeds of assets.

– Administrative claims, which are thecosts associated with the administrationof the post-petition bankruptcy estate.These would include purchases ofgoods and services post-petition as wellas professional fees associated with theadministration of the bankruptcy estate.

– Claims arising during the “gap”period, which is the time periodbetween the filing of an involuntarypetition by three or more creditors andthe date on which an order for relief isentered by the Bankruptcy Court.

– Employee wage claims of not morethan $10,950 for 2008.

– Certain employee benefit contributionclaims as defined by the BankruptcyCode.

– Deposit claims of not more than$2,425 for 2008 for deposits made byindividuals for the purchase of goodsor services for family or household use.

– Certain government tax claims asdefined by the Bankruptcy Code.

– Allowed unsecured claims of aFederal Depository Institutionregarding capital requirements of aninsured depository institution.

– General unsecured claims.

– Equity interests.

• Secured, administrative and priorityclaims are generally paid in full whileunsecured claims are rarely paid in fulland in fact rarely receive any materialdividend. Equity interests are almostalways canceled at no value.

• There are many exceptions to thegeneral rules. In the case of an“administrative insolvency”, the valueof the debtor’s assets are insufficientto pay the lender’s claims and also theadministrative claims. With increasingfrequency, and as a result of very highloan to collateral value ratios, assetsare insufficient to pay lenders in fullmuch less claims “below the line”.Often lenders will find it necessary topay professional fees associated withnegotiating and closing a sale of itscollateral in connection with aBankruptcy Code Section 363 sale.Lenders often resist paying otheradministrative claims, creating lack ofequality in treatment of similarlysituated claims.

• Absent an administrative insolvency,administrative claims are generally paidin full, as the Bankruptcy Code requiresthat such claims be paid in full as acondition precedent to confirmation ofany plan of reorganization.

• Moreover, while not a specificrequirement of the Bankruptcy Code, adebtor is generally obligated to “pay asit goes” while in Chapter 11, meaning itmust be able to pay its ongoingadministrative claims in the ordinarycourse of business. A material build upin unpaid administrative claims indicatesa potential inability to obtain planconfirmation, and thus, provides thegrounds for a conversion of the Chapter11 proceeding to a liquidation proceedingunder Chapter 7.

Creditor Remedies

• 20 Day Administrative Claim

– The 2005 Bankruptcy CodeAmendments added Section 503(b)(9) tothe Bankruptcy Code which providesthat sellers of goods are entitled to anadministrative priority claim for thevalue of goods delivered to a debtorwithin 20 days prior to the bankruptcyfiling.

– The case law addressing Section509(b)(a) provides some predictabilityon how this remedy will benefit vendors.

– There are two essential components tothe 20 day administrative claim: 1)getting the claim allowed as anadministrative claim in the first instance;and 2) getting the claim paid by thebankruptcy estate. Upon a motion bythe creditor, most courts have allowedvendors an administrative claim for thevalue of goods delivered within 20 daysprior to the filing. As a result of thegeneral rule that unsecured claims

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receive little or no distribution andadministrative claims are generally paidin full, converting any portion of anunsecured claim to an administrativeclaim is a material achievement.

– Courts have been less willing to orderimmediate payment of 20 dayadministrative claims, instead allowingthem to be paid in connection with planconfirmation or in connection with thesale of substantially all of the debtor’sassets. As with any other administrativeclaim, if the Chapter 11 proceeding isadministratively solvent, payment ofthe 20 day administrative claim isprobable. In cases where the debtor’sChapter 11 proceeding is “insolvent”,the likelihood of payment iscompromised. However, payment onsuch claims nevertheless exceeds whatwould be paid absent the 20 dayadministrative claim.

• Reclamation

– Historically, reclamation has been thestandard bearer of a vendor’s remedies.Reclamation is a state law remedyarising from the Uniform CommercialCode’s provisions on sales of goods. Inparticular, most states allow a vendorto reclaim goods delivered to a customer(or stop goods in transit), if the sellerlearns of the customer’s insolvency.

– Prior to the 2005 Bankruptcy CodeAmendments, the Bankruptcy Coderecognized the state law remedy ofreclamation but also recognized thatpermitting vendors to reclaim goodswould be disruptive to a debtor’sattempted reorganization. Accord-ingly, the Bankruptcy Code allowed abankruptcy judge to grant a lien oradministrative claim to the seller inlieu of the actual return of goods.

– The 2005 Bankruptcy Code Amend-ments eliminated the provision allow-ing a bankruptcy judge to grant a lienor administrative priority in lieu of theactual return of goods. Accordingly, itis unclear what value the currentreclamation claim will have.

– Sellers of goods should neverthelesscontinue the practice of sending areclamation demand which must besent within 20 days after the Chapter11 filing and can cover invoices forgoods delivered within 45 days priorto the bankruptcy filing.

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• Critical Vendor

– Critical vendor is a creditor remedybased on a theory that a particularvendor is so essential to a debtor’sability to continue operating that with-out the uninterrupted flow of theseller’s goods, the debtor cannot con-tinue to operate and thus has norealistic chance of a successful re-organization. In these instances, abankruptcy court has broad authorityto order relief that facilitates asuccessful reorganization.

– Only a debtor can make thedetermination that a particular vendoris critical and seek court approval ofsame. A creditor cannot independentlyimpose its critical vendor status on adebtor.

– Critical vendor payments have becomeincreasingly controversial and certaincourt rulings, including the Kmartdecision, have limited the critical vendorremedy. Some jurisdictions refuse toentertain a critical vendor motion.However, Delaware and New Yorkcontinue to be jurisdictions where criticalvendor payments can be approved inappropriate circumstances. As recentlyas September, 2008, the DelawareBankruptcy Court in the Hines Nurserycase approved $2 million of criticalvendor payments.

– Vendors who are truly critical to adebtor-customer should continue to seekcritical vendor status as a means ofgetting paid. In doing so, vendors shouldbe careful to not violate the automaticstay by conditioning future business onpayment of pre-petition debt. Moreover,vendors should be aware that gettingpaid as a critical vendor will likely beconditioned on providing normal linesof credit, pricing and terms, or other“customary trade procedures.”

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• Set-off and Recoupment

– An often overlooked remedy, setoffarises from the settlement of mutualdebts or accounts owed between adebtor and a creditor. Simply, if A owesB $100 and B owes A $50, then the debtscan be resolved as follows: $100 - $50= $50, so A pays B $50 and the accountsare settled. The Bankruptcy Codecodifies this common law remedy andin fact provides that the creditor has asecured claim to the extent of the valueof its setoff claim.

– The debts owing must be owed toand from precisely the same legalentities and the debts must arise eitherboth pre-petition or both post-petition.The debts do not, however, have to ariseout of the same transaction.

– The exercise of a setoff remedyrequires relief from the automatic stayfrom the Bankruptcy Court. Moreover,there are somewhat complicated rulesregarding exercise of setoff during the90 days prior to the bankruptcy filing,which if not followed, could result inpreference exposure.

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– Recoupment is similar to setoff, exceptthat the mutual debts must arise fromthe same transaction.

• Statutory Liens

– Vendors in possession of goodsbelonging to a debtor may be able toassert a valid possessory lien understate law. The Bankruptcy Coderecognizes these liens, and treats thevendor as a secured claimant to theextent of the value of the goods in thevendor’s possession. States’ laws differon the extent and priority of the lienand whether it covers all amounts owed

to the vendor or is limited to amountsdirectly related to the goods in itspossession.

• Disclosure

– The Bankruptcy Code provides allcreditors substantial rights to learndetails about the debtor’s financialcondition, historical transactions andprospects for reorganization. Althoughcreditors have the right to appear atand attend the Section 341 “firstmeeting of creditors”, this is rarelyproductive. Modern practice has beenthat the Office of the United StatesTrustee conducts the 341 meeting andcovers primarily administrative issueswith limited opportunity for creditorsto examine the debtor’s representatives.

– Rule 2004 of the Bankruptcy Rulespermits creditors broad rights toexamine the debtor under oath andpenalty of perjury about its financialaffairs, historical transactions andprospects for reorganization, and toobtain relevant documents.

– These tools allow a creditor to obtaindetails about the debtor’s financialcondition necessary to evaluate the riskand probability of payment.

• Involuntary Petition

– Normally a bankruptcy proceedingis commenced by the filing of avoluntary petition for relief by thedebtor. However, Section 303 of theBankruptcy Code permits three ormore creditors to file an involuntarypetition against a debtor, in eitherChapter 7 or Chapter 11, if certainrequirements are met. Therequirements are that the aggregatedebt owed to the three or morecreditors is at least $13,475 for 2008,such debts are not contingent as toliability or subject to a bona fidedispute, and the debtor is not generallypaying its debts as they come due.

– Unlike a voluntary petition where anorder for relief is entered essentiallysimultaneously with the filing of thepetition, in an involuntary case, uponthe filing of the involuntary petition bycreditors, a debtor has 30 days to file ananswer to the petition. If the debtorcontests the bankruptcy, the BankruptcyCourt will schedule and conduct a trialon whether the creditors’ petition meetsthe requirements of Section 303 of theBankruptcy Code.

– During the “gap” period (time periodbetween the date of the involuntarypetition and the date a Bankruptcy Courtenters an order for relief) note thefollowing:

1. The automatic stay is in effect upon the filing of the involuntary petition;

2. Claims arising during the “gap” period, including extensions of unsecured credit, are second-tier priority claims, which are subordinate to claims arising after the order for relief is entered;

3. If an order for relief is entered, payments on pre-petition debts made during the “gap” period can be voided as avoidable post-petitiontransactions if no value was provided in the “gap” period.

– Creditors may seek the immediateappointment of an interim trustee if thereis a concern that the debtor may bedissipating assets.

– Debtors have the absolute right toconvert an involuntary Chapter 7 caseto a Chapter 11 proceeding or vice versa.

– A creditor considering an involuntarypetition should always analyze paymentsreceived in the prior 90 days, as theinvoluntary filing will establish the 90day preference period.

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• Motion to Convert to Chapter 7

– A party in interest including a creditoror creditors’ committee may file amotion seeking to convert a Chapter 11case to a Chapter 7 liquidation case ifthe creditor can establish “cause” andthat a conversion is in the best interestof creditors. “Cause” includes:

1. Substantial losses and no reasonable likelihood of reorganization.

2. Gross mismanagement of the estate.

3. Failure to maintain insurance.

4. Unauthorized use of cash collateral.

5. Failure to pay taxes.

6. Failure to file or confirm a planof reorganization within the applicable time period.

– Assuming a creditor has theappropriate grounds for conversion,the creditor should neverthelessconsider several issues.

– Since a Chapter 7 trustee cannotoperate the business, a conversion willlikely result in a closure of the businessoperation and a quicker liquidation orauction of the assets, or an aban-donment of the assets to the securedlender.

– The Chapter 7 trustee will take controlof the debtor and its assets and anycreditors’ committee or individualcreditors will have less influence in thebankruptcy process. For example, aChapter 7 trustee may have moreincentive to aggressively pursueavoidance actions such as preferencesagainst creditors.

– A conversion to Chapter 7 will endChapter 11 administrative expenses;however, the Chapter 7 trustee and itscounsel will incur administrativeexpenses that will have priority overthe Chapter 11 administrativeexpenses. Moreover, the BankruptcyCode allows the trustee to be paid apercentage of funds distributed tocreditors, which can be as high as 3%.

• Motion to Appoint aTrustee or Examiner

– A party in interest including a creditoror creditors’ committee can also file amotion seeking the appointment of atrustee or an examiner. A Chapter 11trustee would supplant managementand take control of the debtor’sbankruptcy estate and assets. Anexaminer does not supplantmanagement or take control of thedebtor’s estate; rather, an examinerinvestigates discrete issues, usuallyrelating to questionable transactions,and reports findings to the Court andcreditors.

– A creditor may seek the appointmentof a trustee or an examiner for causeincluding fraud, dishonesty,incompetence or gross mismanage-ment, if such appointment is in thebest interest of creditors or if groundsto convert to Chapter 7 exists.

• Claims Sale

– At least up until the 2008 economiccrisis, there has been a vigorous marketfor the purchase of bankruptcy debt,particularly in larger bankruptcy cases.The purchasers are usually Wall Streetfunds that are in essence seeking topurchase claims at a discount in hopesthat the ultimate dividend, whether inthe form of cash payments or stock inthe reorganized entity, will provide areturn on such investment.

– Claim purchasers will only purchaseclaims that are not disputed orcontingent as to liability. Claimpurchasers will usually agree to buyclaims based on the debtor’s schedulesof assets and liabilities. However,purchasers will not buy claims based ona creditors’ proof of claim if it ismaterially greater than the claim listedon the debtor’s schedules, at least untilthe claim is resolved in the claimsreconciliation process.

Executory Contracts

• Executory Contract is the BankruptcyCode term given to essentially anycontract between a debtor and a non-debtor party where both parties oweperformance to the other. A promissorynote would NOT be an executorycontract since the holder of the note hasno performance obligation. However, asupply contract or other sales agreementwould almost always meet therequirements of an executory contractunder the Bankruptcy Code. Real estateleases are also treated as executorycontracts. The Bankruptcy Code Rulesfor rejecting executory contracts andleases are debtor-friendly which isprecisely why retailers who want to closestores often choose Chapter 11 as thevehicle to accomplish such goal.

• The Bankruptcy Code provides debtorsthe unfettered right to assume or rejectexecutory contracts and leases. If adebtor rejects an executory contract, thenon-debtor party receives a generalunsecured claim for damages arisingfrom the debtor’s “breach” of contract.Thus, a debtor escapes the contract withlittle cost. On the other hand, the debtoralso has the right to assume or assign acontract. In this instance, the BankruptcyCode requires that the debtor “cure” thecontract by paying existing defaults.Presumably, debtors would assumecontracts that they deem to be valuable

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either because they insure anuninterrupted supply of goods orcontain favorable pricing or terms. Fora creditor who is a party to an executorycontract, the assumption of suchcontract can be an effective vehicle toobtain payment of pre-petition debt.

• Debtors in Chapter 11 must assumean executory contract before or inconjunction with the confirmation ofthe Chapter 11 Plan. The non-debtorparty to the contract can ask the courtto set a shorter time if it will be harmedby the delay in the debtor’s decision.

• The Bankruptcy Code requires thatthe non-debtor party to an executorycontract must continue to perform itsobligations under the contract pendingthe debtor’s decision to assume or rejectsuch contract, and provided that thedebtor is in fact performing itsobligations 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 contract.

Proof of Claim

• A proof of claim is the document bywhich a creditor registers its claim withthe debtor’s bankruptcy estate,indicating the type of claim (secured,administrative, priority or unsecured),the amount of the claim and the basisfor the claim.

• Bankruptcy courts almost always seta bar date for filing proofs of claimseveral months after the bankruptcypetition is filed. To be considered, allclaims must be filed within this bardate.

• If the debtor’s Schedules of Assetsand Liabilities lists a particularcreditor’s claim correctly, and does notlist it as unliquidated, contingent ordisputed, and the creditor otherwiseagrees with the debtor’s Schedules,there is no need for the filing of a proofof claim.

• In order to assure participation inany distribution to creditors or vote ona Chapter 11 plan, creditors often filea proof of claim, rather than rely onthe debtor’s Schedules of Assets andLiabilities.

• Creditors who file a proof of claimwaive the right to demand a jury trialin, for instance, a preference action.The potential costs and vagaries of ajury trial might provide leverage to apreference defendant.

Section 363 Sale

• Section 363 of the Bankruptcy Codeallows a debtor to sell substantially allof its assets free and clear of liens withliens attaching to proceeds of sale. Thisprovision allows for the quick andefficient liquidation of a debtor’s assetswithout having to first resolve the extent,validity and priority of liens on assets.This allows assets to be sold relativelyquickly and avoids further erosion ofvalue due to operating losses.

• Buyers of assets often favor acquiringassets in a Section 363 sale (thus requiringa Chapter 11 filing) since sales to goodfaith purchasers are not subject to laterchallenge.

• Generally a Section 363 sale is teed upas an auction with a stalking horse saleas the initial bid. After appropriateadvertising and marketing, an auctionis conducted where interested buyersare permitted to overbid the stalkinghorse bid and thus allow the estate toobtain the greatest possible value for itsassets. There is usually a requiredpercentage bidding increment and thestalking horse bidder often has bidprotection in the form of a break-up feeand expense reimbursement.

• Secured creditors are generally entitledto “credit bid” their secured debt,provided the secured claim is notdisputed.

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The potential costs andvagaries of a jury trialmight provide leverageto a preferencedefendant.

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• Although a Section 363 sale can be avaluable tool for maximizing theliquidation value of a debtor’s assets,such sales can also create an inherenttension between the secured creditorwho asserts liens on the assets beingsold and other creditors of the estate.The secured creditor’s goal is paymentof its secured debt and nothing more,while other creditors seek to achieve asale in excess of secured debt togenerate proceeds for other creditors.The quickest sale does not necessarilyproduce the best sale, however,prolonged sales processes have thedisadvantage of higher administrativecosts.

• With increasing frequency, and dueto the recent trend of high loan to valueratios, many Section 363 sales haveproduced sales proceeds less than theamount owed to secured creditors.These “short sales” create anadministrative insolvency where onlysecured creditors benefit from the sale.Many courts have required the securedcreditor to pay administrative claimsassociated with the Chapter 11proceeding to obtain the benefit of theChapter 11 process and protections.This has been euphemistically referredto as the “pay to play” rule. In addition,creditors often assert that the Chapter11 process contemplates a benefit to allcreditor classes and thus unsecuredcreditors should receive a “carve-out”of the sale proceeds to fund a dividendto 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 seen.

Plan of Reorganization

• A Plan of Reorganization isessentially the debtor’s contractdetailing how the debtor will satisfypre-petition claims. This can be in theform of cash distributions, an allocationof future profits, and/or redistributionof the debtor’s equity.

• For a Plan of Reorganization tobecome effective, it must be confirmedby the Bankruptcy Court.

– For purposes of Plan confirmation,similarly situated creditors are placedin classes of creditors, usually roughlycorresponding to the claim prioritiesset forth above. If a class of creditorsis unimpaired, meaning their claimsare satisfied, that class is deemed tohave accepted the Plan. For creditorclasses that are impaired, the class musteither consent to the Plan or be“crammed down”. For a class toconsent to a Plan, of the class memberswho vote, there must be more than 1/2in number and 2/3 in dollar amountof creditors accepting the Plan.

– A debtor can “cram down” its planon non-consenting classes if the Planis “fair and equitable,” does not“discriminate unfairly” within classes,and is in the “best interests ofcreditors,” primarily that creditors willreceive more in the Plan than in aChapter 7 liquidation.

– The so called “absolute priority rule”requires that a junior class of creditorscannot receive value on its claims unlesssenior classes are paid in full or vote toaccept the plan. Thus, unless unsecuredcreditors are paid in full, equity holdersare not permitted to retain their equityinterest absent a capital contributioncommensurate to the value of thereorganized debtor’s stock.

– To be confirmed, a Plan must also befeasible. A key element of feasibility isusually whether or not a debtor hascommitted exit financing. The currentcredit crisis may undermine the abilityof Debtors to obtain exit financing, andthus exit Chapter 11.

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The current credit crisismay undermine theability of Debtors toobtain exit financing,and thus exit Chapter 11.

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Avoidance Actions

• Preferences.

– Bankruptcy Code Section 547 allowsthe debtor to recover pre-petitionpayments to third parties that weremade within 90 days prior to filing asto non-insiders and within one (1) yearprior to filing with respect to insiders.The requirements to assert a preferenceare that the payment in question bemade within the appropriate timeperiod, made while the debtor isinsolvent, the payment is on accountof antecedent debt and the paymentallows the creditor to receive more thanit would in a Chapter 7 liquidation.Debtors or trustees pursuing preferenceclaims rarely have difficulty establishingthese basic requirements.

– The statute of limitations onpreference actions is two years fromthe petition date.

– Creditors who have receivedallegedly preferential payments haveseveral defenses, the most commonthree being that the payment was madein the ordinary course of business, thatthe creditor provided subsequent newvalue after the payment at issue, or thatthe payment constituted acontemporaneous exchange for value.

- The ordinary course of businessdefense is based on the notion thatthe payment in question wasconsistent with the ordinary courseof business between the debtor andthe particular creditor or consistentwith industry standards generally.

- Subsequent new value is simplythat creditors provided additionalvalue in the form of goods orservices after receipt of the paymentthat in essence replenished theestate’s assets. The defense existsto the extent of such new value.

- Contemporaneous exchange forvalue is where the parties intendedthe payment to be substantiallycontemporaneous with the creditorproviding new value. The classicexample of contemporaneousexchange for value is where a debtordesperate for goods promises tosend a check if the creditor willrelease goods. Documentation ofthe parties’ intent of payment inexchange for specific value is criticalto this defense.

• Fraudulent Transfers

– Fraudulent transfers is a partialmisnomer because fraud is notrequired. The debtor can recoverpayments made to non-insiders fortransfers occurring within one (1) yearprior to bankruptcy and for two (2)years with respect to insiders. Thedebtor can recover transfers that weremade in an attempt to defraud creditorsbut also when the transfer was simplyfor “less than reasonably equivalentvalue”.

– A statute of limitations on assertingfraudulent transfer claims is two (2)years from the petition date.

– Debtors and trustees in bankruptcyare also entitled to assert claims understate law fraudulent transfer statuteswhich are similar to the BankruptcyCode fraudulent transfer statute butoften have a longer statute oflimitations, and the reach back periodmay be longer.

Non-BankruptcyAlternatives

• The two most common non-bankruptcy alternatives are the out ofcourt workout, which may involve acomposition agreement, or anassignment for the benefit of creditorsunder state law.

• A non-bankruptcy workoutgenerally involves a forbearanceagreement with secured lender(s) and aforbearance or composition agreementwith unsecured creditors. Suchcomposition agreement may involve amoratorium or delay in payment of debtsowed and/or a compromise of theamount owed. Immediate cashpayments for creditors usually requirea discount, a longer term payout mayresult in payment in full.

• Assignments for the benefit of creditorsare governed by each states’ laws, whichdiffer materially from state to state.There is little uniformity among states’laws on assignments with some stateshaving highly developed statutes andprocedures and other states havingvirtually nothing.

• Conceptually, an assignment involvesa transfer of all of the debtor’s assets toa third party assignee, whose duties andresponsibilities are similar to a Chapter7 trustee. Assignees can operate abusiness enterprise, but assignmentsgenerally involve the ultimate sale of theassets.

• Assignments for the benefit of creditorsare usually limited to smaller businessenterprises whose assets are locatedwithin one state since the assignmentlaws in one jurisdiction cannot beimposed on assets in another jurisdiction.

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Cross-Border Insolvency

• When a multi-national business facesinsolvency, assets in more than onecountry likely require administrationand protection. It is sometimes notclear what country’s law will apply,and which jurisdiction will control theinsolvency process. This can bedeterminative of outcome sincecountries’ laws and approach tobusiness insolvencies can differmaterially.

• Typically, a multi-national businesslocated outside the United States withassets in the United States would seekinsolvency protection under the lawsof its country, but will also file an“ancillary” proceeding in the UnitedStates.

• There are many laws, treaties andregulations that address these issues,including:

– Chapter 15 of the Bankruptcy Codeon Ancillary Cases

1. Mostly follows the United Nations’Model Law on Cross-BorderInsolvency

2. Chapter 15 passed as part of the2005 Bankruptcy Code Amendments

– UNCITRAL (United NationsCommission on International TradeLaw) Model Law on Cross-BorderInsolvency

Goal: to “modernize and harmonizethe rules on international business andto enhance predictability in cross-bordercommercial transactions”.

– European Union Regulation onInsolvency Proceedings

– ALI NAFTA Transnational InsolvencyProject

• COMI (or Center of Main Interests)is a key concept in Chapter 15, theUNCITRAL Model Law and theEuropean Union InsolvencyRegulation, all of which presumeCOMI is where an entity has itscorporate registration.

– COMI impacts where the mainproceeding should occur, based onwhere a business has its “center ofmain interests”, which is analogous tothe principal place of business. Thus,if COMI exists in a foreign country, aU.S. Bankruptcy judge shouldrecognize a foreign insolvencyproceeding as the “foreign main”proceeding and the U.S. Chapter 15proceeding as an “ancillary”proceeding. If a debtor does not haveCOMI in the country where it files itsinsolvency proceeding, but has an“establishment” in such country, theU.S. Bankruptcy Court shouldrecognize the foreign proceeding as a“foreign non-main” proceeding.

– If the foreign insolvency proceedingis recognized as a “foreign main”proceeding, the approval of theChapter 15 proceeding will invoke theautomatic stay. If the foreigninsolvency proceeding is recognizedas a “foreign non-main” proceeding,the Chapter 15 proceeding will notinvoke the automatic stay protections.

– In the recent Bear Stearns case, twoBear Stearns hedge funds, registeredunder the laws of the Cayman Islands,and with their primary operations inNew York, filed “winding up”proceedings in the Cayman Islands.However, in response to investorlawsuits arising from sub-primeinvestments, the Hedge Funds neededprotection in the United States. TheHedge Funds’ administrators thus filedChapter 15 petitions in New York seekingrecognition of the Cayman Islandsproceedings as “foreign main”proceedings or in the alternative as“foreign non-main” proceedings.

– Even though no party objected to theChapter 15 petitions, the U.S. BankruptcyCourt refused to recognize the CaymanIslands proceedings as either “foreignmain” or “foreign non-main”proceedings since the Court found thatthe Cayman Islands was neither the placeof COMI nor of an “establishment”.Rather, the Court concluded that theHedge Funds were in New York. Theeffect of this ruling is that to obtain theprotections of the U.S. Bankruptcy Code,the Hedge Funds would be required tofile Chapter 11 proceedings in New York.The Court also suggested that involun-tary proceedings might be filed againstthe Hedge Funds in New York.

– The Bear Stearns opinion has beensharply criticized internationally as aU.S. attempt to control internationalinsolvencies through Chapter 11. Amongother things, critics argue that it isdisingenuous for a U.S. BankruptcyCourt to find Chapter 11 jurisdiction, inDelaware for example, based solely onthe place of incorporation, whileapplying a different, more stringentstandard to foreign insolvencyproceedings.

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• Many countries have also recentlyenacted new insolvency laws includingthe following:

– Brazil (2005)

– China – Enterprise Bankruptcy Law of the People’s Republic of China (2007)

– Columbia (2006)

– France (2006)

– Italy – 2005/2006 reforms and 2008 Corrective Decree

– Japan – (2000)

– Mexico – Ley de Concursos Mercantiles (2000)

– Spain (2003)

– United Kingdom (2005)

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In many respects, these laws tend tomake insolvency laws more similar indifferent jurisdictions, and many arein fact based on the UNCITRAL ModelLaw (above).

• A key difference between the U.S.Bankruptcy Code and most foreignbankruptcy laws is the concept of“Debtor in Possession”. In U.S.bankruptcy cases, it is extraordinaryfor a trustee or examiner to be imposed,while most foreign insolvency lawsrequire the appointment of a third partyadministrator or liquidator withvarying degrees of responsibility andinvolvement regarding the business.

The contents of this update are offeredas general information only and arenot intended for legal advice onspecific matters.

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© David H. ConawayShumaker, Loop & Kendrick, LLPdconaway@slk-law.comNovember, 2008