Heller Ehrman White & McAuliffe LLP An Overview of the Chapter 11 Reorganization Process THE SECOND FORUM FOR ASIAN INSOLVENCY REFORM (FAIR) Bangkok, Thailand

Heller Ehrman White & McAuliffe LLP

A T T O R N E Y S

An Overview of the Chapter 11 An Overview of the Chapter 11 Reorganization ProcessReorganization Process

THE SECOND FORUM FOR ASIAN INSOLVENCY REFORM (FAIR)

Bangkok, ThailandDecember 16 & 17, 2002

Presented by George Kelakos, Co-Chair of the International Committee of the American Bankruptcy Institute


IntroductionIntroduction

Economic Premises of Chapter 11 (Reorganization)

Players

Strategic Objectives of Players

Valuation Issues


Phases Of A Chapter 11 CasePhases Of A Chapter 11 Case

Prepetition

Initial Phase

Middle Phase

Final Phase


Economic Premises of Chapter 11 Economic Premises of Chapter 11 (Reorganization)(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.


Economic Premises of Chapter 11 Economic Premises of Chapter 11 (Reorganization)(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


Who May Be A Debtor?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


Who May Be A Debtor?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


Cast of Principal CharactersCast 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


Cast of Principal CharactersCast 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


Cast of Principal Characters: Cast of Principal Characters: ProfessionalsProfessionals

Legal advisors (Debtor/committee/bank/other creditors)

Financial advisors (Debtor/committee) Accountants Turnaround management/business advisors Investment banker Valuation/liquidation experts Brokers


Strategic Objectives of PlayersStrategic 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


Strategic Objectives of PlayersStrategic 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


Valuation IssuesValuation 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)


Valuation IssuesValuation 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 SecurityInterests in Chapter 11,” 92 Commercial Law Journal at 19, et. seq.


Phases Of A Phases Of A U.S. Reorganization CaseU.S. Reorganization Case

Prepetition

Strategic considerations

Debtor

Lenders

Trade creditors



Initial phase

Petition/automatic stay

Cash collateral

Postpetition borrowing

Relief from the automatic stay



Middle phase

Executory contracts and unexpired leases

Assets sales (public/private)

Avoidance actions

Development of business plan (exclusivity extensions/bar date motion)



Final phase

Plan confirmation process

Elements of a plan of reorganization

Disclosure statement

Confirmation standards


PrepetitionPrepetitionStrategic ConsiderationsStrategic 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)



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



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


Prepetition DebtorPrepetition 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?


Prepetition DebtorPrepetition 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?


Prepetition LenderPrepetition 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


Prepetition Trade CreditorsPrepetition 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)?


Initial PhaseInitial Phase

Petition/automatic stay

Cash collateral


Relief from automatic stay

Summary of strategic consideration

Valuation issues


Initial PhaseInitial PhasePetition / Automatic StayPetition / 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


Initial PhaseInitial PhasePetition / Automatic StayPetition / 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


Initial PhaseInitial PhaseCash CollateralCash 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.


Initial PhaseInitial PhaseCash CollateralCash 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


Initial PhaseInitial PhaseCash Collateral 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


Initial PhaseInitial PhasePostpetition BorrowingPostpetition 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)



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



Courts in U.S. will often allow economic terms but will strike onerous terms from loan agreement (“level the playing field”)


Initial PhaseInitial PhaseRelief From Automatic StayRelief 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”


Initial PhaseInitial PhaseRelief From Automatic StayRelief 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


Initial PhaseInitial PhaseSummary of Strategic ConsiderationsSummary 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


Initial PhaseInitial PhaseSummary of Strategic ConsiderationsSummary 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


Initial PhaseInitial PhaseValuation IssuesValuation 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?



Use of cash collateral:

Has collateral experienced a “loss or diminution of value”?

Is proposed “adequate protection” sufficient?




Valuation of “new” collateral for new loan (risk assessment)


Middle PhaseMiddle Phase

Executory contracts and Unexpired leases

Asset sales

Examination/pursuit of avoidance actions

Development of business plan

Valuation issues


Middle PhaseMiddle PhaseExecutory Contracts and Executory Contracts and

Unexpired LeasesUnexpired 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



Unexpired LeasesUnexpired 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



Unexpired LeasesUnexpired 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


Middle PhaseMiddle PhaseAsset SalesAsset Sales

Purpose:

Dispose of non-essential assets in a manner generating highest possible return for debtor’s estate



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 advertising)



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 ofsale/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 interest of debtor’s estate



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


Middle PhaseMiddle PhaseAvoidance ActionsAvoidance Actions

U.S. law favors fair and equal treatment of similarly-situated 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


Middle PhaseMiddle PhaseAvoidance ActionsAvoidance 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


Middle PhaseMiddle PhaseDevelopment of Business PlanDevelopment 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


Middle PhaseMiddle PhaseDevelopment of Business PlanDevelopment 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)


Middle PhaseMiddle PhaseValuation IssuesValuation 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


Middle PhaseMiddle PhaseValuation IssuesValuation Issues

Development of business plan:

Plan proponent(s) will require professional assistance in order to generate a liquidation analysis for the plan of reorganization


Final PhaseFinal Phase

Plan confirmation process

Disclosure statement

Elements of a plan of reorganization

Confirmation standards


Final PhaseFinal PhasePlan Confirmation ProcessPlan 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


Final PhaseFinal PhasePlan Confirmation ProcessPlan 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


Final PhaseFinal PhaseDisclosure StatementDisclosure 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


Final PhaseFinal PhaseDisclosure StatementDisclosure 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)


Final PhaseFinal PhaseElements of a Plan of ReorganizationElements 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


Final PhaseFinal PhaseElements of a Plan of ReorganizationElements 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)


Final PhaseFinal PhaseConfirmation StandardsConfirmation 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



“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 non-accepting class “fairly and equitably” and does not “unfairly discriminate” vs. non-accepting class



“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?)



Plan not likely to be followed by liquidation or need for further financial reorganization


Concluding ObservationsConcluding 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)


Concluding ObservationsConcluding 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


Concluding ObservationsConcluding 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)


A T T O R N E Y S

Presented by George M. KelakosPresented by George M. KelakosHeller EhrmanHeller Ehrman

601 S. Figueroa St.601 S. Figueroa St.Los Angeles, California 90017Los Angeles, California 90017

(213) 689-7652(213) [email protected]@hewm.com

Documents

Heller Ehrman White & McAuliffe LLP An Overview of the Chapter 11 Reorganization Process THE SECOND FORUM FOR ASIAN INSOLVENCY REFORM (FAIR) Bangkok, Thailand