Advanced Chapter 11 Practice: Strategies for Minimizing Losses and Maximizing Recoveries in a Customer Bankruptcy

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1 Advanced Chapter 11 Practice: Strategies for Minimizing Losses and Maximizing Recoveries in a Customer Bankruptcy Thomas R. Fawkes and Brian J. Jackiw Goldstein & McClintock LLLP

2 Agenda Chapter 11 Overview Priority of Claims Executory Contracts and Unexpired Leases Creditors Committees Sales of Assets in Bankruptcy Chapter 11 Plans Creditors Rights Strategies in Bankruptcy 2

3 Chapter 11 Overview: Reorganization (or Liquidation) The usual purpose of a Chapter 11 bankruptcy is to enable a business to continue its operations despite its inability to meet its obligations to creditors as they become due In recent years, Chapter 11 cases have often been used as strategic business devices to enable businesses to: Force a restructuring on its secured creditor Get rid of unwanted leases or other contracts Minimize/Eliminate trade debt Close business and orderly liquidate all of the assets 3

4 Priority of Claims What a creditor receives from the bankruptcy estate is based on the priority of its claim The Bankruptcy Code has the following fixed priority system (i.e., secured creditors paid first, common stock last): 1. Secured creditor, to the extent of its collateral 2. Post-bankruptcy Debtor in Possession ( DIP ) lender 3. Pre- and post-bankruptcy administrative expenses (503(b)(9) claims, postpetition trade, employees, bankruptcy professionals) 4. Certain pre-bankruptcy priority claims, including taxing authorities and employees up to $12,850 per employee 5. General unsecured, pre-bankruptcy creditors 6. Preferred Stock 7. Common Equity 4

5 Executory Contracts and Unexpired Leases One of the most significant powers afforded a debtor in chapter 11 is the ability to assume or reject executory contracts and unexpired leases Contracts are generally considered executory when there remain material unperformed obligations by both parties to the contract as of the petition date Debtors have the ability to reject contracts and leases that are either unnecessary to the reorganization/sale, or contain terms that are above market 5

6 Executory Contracts and Unexpired Leases Where the debtor desires to continue performing under a contract or lease, or wishes to assign that contract to a purchaser, it may assume the contract As a condition to assumption, all defaults under the contract must be cured In addition, a demonstration must be made by the assignee of adequate assurance of future performance (i.e., has the financial wherewithal to perform under the contract) Debtors must assume contracts in their entirety (cannot cherrypick favorable provisions and shed unfavorable ones) Anti-assignment clauses generally do not prevent a debtor from assigning your contract! 6

7 Executory Contracts and Unexpired Leases Assumption of a lease or executory contract will also result in the elimination of any preference liability that the counterparty may have had Debtors, however, may try to avoid this outcome by rejecting the lease/contract and then renegotiating a new agreement Where leverage exists, you should always demand that any renegotiations occur in the context of a lease assumption and amendment, rather than a rejection and renegotiation While debtors have a certain period of time under the Bankruptcy Code to decide whether to assume or reject a lease/contract (for leases 120 days with a 90 day extension for cause ; additional extensions must be approved by the landlord; and for executory contracts, prior to a plan confirmation), a counterparty can move to compel assumption or rejection for cause Such relief is difficult to obtain; courts often give debtors latitude to make decisions regarding leases and contracts 7

8 Executory Contracts and Unexpired Leases Importantly, a counterparty to an executory contract (such as a supply agreement) must continue to honor its obligations under the contract after the bankruptcy case has been filed In certain circumstances, the Bankruptcy Court may order your continued compliance with the contract even if the Debtor is not paying you! However, you will have an administrative expense claim for any goods or services you provide post-petition 8

9 Creditors Committees Creditors committees play a fundamental role in chapter 11 cases. Effective committees can significantly enhance value and creditor recoveries, as well as realize many other tangible and intangible benefits. Section 1103 of the Bankruptcy Code requires the Office of the United States Trustee to form a committee where sufficient interest exists from eligible creditors The committee generally consists of unsecured creditors who hold the largest unsecured claims against the debtor and are willing to serve Committees generally have an odd number of members to avoid deadlocks A creditors committee may, with the court s approval and at the estate s expense, hire an attorney, financial advisor or other professionals to assist in the performance of the committee s duties 9

10 Sales of Assets in Bankruptcy A debtor can sell its assets in bankruptcy through two separate mechanisms: (1) pursuant to a chapter 11 plan; or (2) by motion pursuant to section 363(b) of the Bankruptcy Code Section 363(b) of the Bankruptcy Code permits debtors to sell their assets outside of the ordinary course of business Bankruptcy sales are attractive to purchasers, in that they can often obtain assets for less than in a non-bankruptcy context, and take such assets free and clear of liens, claims and encumbrances Liens of secured creditors attach to the proceeds of the sale 10

11 Sales of Assets in Bankruptcy Asset sales in bankruptcy are generally conducted as follows: The debtor identifies a stalking horse bidder, and offers that bidder protections (including break-up fees and expense reimbursements) as an enticement to having that bid shopped out to competing bidders The debtor will seek approval of bidding procedures which govern the auction of the debtor s assets, and provide for dates, deadlines and procedures that competing bidders must follow If qualifying competing bids are received, an auction will be conducted The winning bid will be submitted to the Bankruptcy Court for approval 11

12 Chapter 11 Plans A chapter 11 plan is a contract that provides for the proposed treatment of various classes of creditors upon confirmation May be proposed in a restructuring or a sale case In sale cases, these plans take the form of liquidating plans where the debtor or a liquidating trust liquidates remaining assets, pursues causes of action for the benefit of creditors, and reconciles claims Debtors have, initially, the exclusive right to file and solicit a plan After the exclusivity period expires, other parties (including creditors committees) may file their own plan with the Bankruptcy Court 12

13 Chapter 11 Plans A chapter 11 plan is filed along with a disclosure statement, which sets forth, in plain English, the treatment proposed under the plan and gives creditors additional information intended to induce them to vote in favor of the plan Disclosure statements are governed by section 1125 of the Bankruptcy Code, and impose upon the filing party an obligation to provide adequate information that will allow creditors and other parties the ability to make an informed judgment about the plan A plan cannot be solicited to creditors for voting until a disclosure statement has been approved 13

14 Chapter 11 Plans While no two plans are the same, you should expect to see the following provisions in each plan you see: Definitions Provisions describing treatment of non-classified claims (such as administrative and priority tax claims), as well as classified claims and interests (such as secured and general unsecured claims) Provisions governing plan distributions Means for implementation of the plan Procedures related to disputed claims Provisions governing executory contracts and unexpired leases Conditions to confirmation and effectiveness of the plan Effect of confirmation Miscellaneous provisions 14

15 Evaluating a Chapter 11 Plan By taking stock of the key issues facing your company, you can easily narrow down the plan provisions that require your review. In most cases, you will be concerned with the following: What distribution will I receive, and when will I receive it? Is there a possibility of my claim being disputed? Do we have pending contracts or leases with the debtor, and if so, how will they be treated under the plan? Are we a potential subject of litigation with the debtor? What are the scope of releases being given to third parties? Each of the above questions can be answered without having to read the plan cover to cover you just need to know where to look 15

16 Plan Confirmation Requirements In order for a plan proponent to confirm a chapter 11 plan, it must satisfy the requirements of section 1129 of the Bankruptcy Code, which include: The plan must be proposed in good faith and not forbidden by law The plan must meet the best interest of creditors test (each creditor or interest holder will receive at least as much under the plan as it would in a chapter 7 liquidation) The plan must provide for the payment in full of certain priority claims (including administrative expense claims) The plan must be accepted by at least one impaired class, excluding insiders Numerosity requirement 2/3 in amount and 1/2 in number The plan must be feasible (i.e., not likely to be followed by a liquidation or further reorganization) 16

17 The One-Page Guide to Plan Analysis Distributions: Consideration: Refer to Plan, Classification and Treatment of Claims Amount of distribution: Refer to Disclosure Statement, near beginning of document Timing of distribution: Refer to Plan, Provisions Governing Distributions Disputed Claims: Schedules of Assets and Liabilities: if your claim is listed as contingent, disputed or unliquidated, assume objection will be filed Procedures for Disputing Claims: Refer to Plan, Procedures for Resolving Claims Contracts: Rejection and Assumption Procedures: Refer to Plan, Treatment of Executory Contracts If contract is rejected: Plan will provide for deadlines for filing rejection damages claims If contract is assumed: Plan, or separate notice of assumption, will provide proposed cure amount and objection procedure Plan Voting: If your class of creditors is impaired and entitled to vote, you will receive a ballot along with the plan Ballot will provide an option to vote to accept or reject the plan Litigation: Avoidance action procedures: Refer to Plan sections on prosecution of causes of action, or sections referring to creditor/liquidating trusts If you received payments in 90 days prior to bankruptcy, you should assume you will be a target unless avoidance claims have expressly been released Third-Party Releases: Refer to Plan sections on Settlements and Releases or Effect of Confirmation Release language will always be in bold type Voting to reject a plan will often result in the releases not being applicable to you 17

18 Liquidating Trusts Chapter 11 cases, with increasing frequency, are being used as a vehicle to conduct going concern sales of the debtor s business and assets (rather than a traditional restructuring) After the sale has been completed, a chapter 11 plan of liquidation may be confirmed, which places remaining assets (generally, chapter 5 causes of action and other estate litigation claims) in the hands of a liquidation trustee Liquidation trustee is usually appointed by the Creditors Committee 18

19 Creditors Rights Strategies in Bankruptcy Upon the filing of a bankruptcy case by a customer or vendor, a creditor should consider (and where appropriate, implement) the following strategies to maximize distributions: Filing of a proof of claim Seeking critical vendor status Making a reclamation demand Filing a section 503(b)(9) claim Enforcing credit protections 19

20 Proofs of Claim Within 14 days of a bankruptcy filing, a debtor is required to file its schedules of assets and liabilities ( Schedules ) and statement of financial affairs ( SOFA ) with the Bankruptcy Court The Schedules provide a detailed listing of all real and personal assets held by the debtor, as well as all secured, unsecured and priority claims it believes are held against it Claims can be scheduled as contingent, disputed or unliquidated The SOFA lists various information regarding the financial condition of the debtor as of the petition date, including income, pending litigation and transfers made prior to the bankruptcy filing Pay particular attention to Item 3(b) of the SOFA, which lists transfers that may be subject to preference actions 20

21 Proofs of Claim The debtor will be required to file a notice of claims bar date, setting forth deadlines by which creditors must file proofs of claim, and procedures for the filing of claims When should a creditor file a proof of claim? When it disputes the claim amount scheduled by the debtor When the debtor schedules the claim as contingent, disputed or unliquidated If a creditor fails to file a proof of claim by the claims bar date, that claim will be disallowed if the debtor scheduled it as contingent, disputed or unliquidated, or will be limited to the claim amount scheduled by the debtor NOTE: it is difficult if not virtually impossible to have a late claim deemed timely filed by the Court 21

22 Critical Vendor Status While generally, a debtor is not permitted to make payments to creditors on account of their pre-bankruptcy claims, an exception can be found in the critical vendor doctrine The critical vendor doctrine, adopted by most courts, allows a debtor to pay a portion of its pre-bankruptcy vendors where those vendors are deemed critical to the debtor s ability to conduct business during the bankruptcy As a condition to taking critical vendor payments, vendors are generally required to continue selling goods to the debtor on customary credit terms during the bankruptcy case Critical vendor status can substantially improve the outcome for unsecured trade creditors NOTE: critical vendors do not receive a preference release by virtue of signing a critical vendor agreement 22

23 Claims Reconciliation The Debtor, Committee, or post-confirmation trustee (depending on whether case is a liquidation or reorganization) will often engage in claims reconciliation. This is a systematic review of all the unsecured claims filed in a bankruptcy case. The review will seek out substantive and procedural flaws in claims filed in an effort to reduce the overall amount of claims. Objections can be based on lack of evidence, failure to follow procedures, set offs or other reasons. 23

24 Claims Reconciliation How can you prevent an objection from being filed to your claim? FILE TIMELY! File against the correct debtor (if a multi-debtor case) Include all relevant documentation (account statements, invoices, bills of lading/proofs of delivery) Complete all applicable sections of the proof of claim form Consider drafting an appendix, which explains the nature of your claim and how you calculated it 24

25 Reclamation Reclamation is the seller s right to require a buyer to return goods purchased when the seller discovers that the buyer is insolvent. Rules for exercising reclamation differ in and out of bankruptcy and are subject to many variables (such as what goods are on hand when notice is received, whether the buyer was insolvent when the goods were received, etc.) 25

26 Requirements for Exercising the Right of Reclamation in Bankruptcy The Bankruptcy Code recognizes a seller s reclamation rights if the seller satisfies the following: Seller must make a written demand; Not later than 45 days after the date of receipt of such goods by the debtor; or Not later than 20 days after the commencement of the bankruptcy case, if the 45 day period expires after commencement Seller sold the goods in the ordinary course of business; Debtor was insolvent when it received the goods; and Debtor had possession of goods in an identifiable format at the time reclamation demand received 26

27 Post-Petition Administrative Expenses Under section 503 of the Bankruptcy Code, any claims of a seller of goods or provider of services to a debtor-in-possession arising from post-bankruptcy sales are entitled to administrative expense status Debtors are entitled to pay post-petition invoices in the ordinary course of business and without Court approval All administrative expenses are required to be paid in full as a condition to a debtor s ability to confirm a chapter 11 plan If a debtor fails to make administrative payments, the administrative creditor has a right to assert an administrative claim in the bankruptcy case. This generally requires the filing of a motion with the Bankruptcy Court 27

28 Administrative Expense For Goods Sold Pre-Bankruptcy An addition to the Bankruptcy Code in the 2005 amendments was additional protections for creditors selling goods to debtors in the ordinary course of business Section 503(b)(9) of the Bankruptcy Code allows creditors to obtain an administrative expense for the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor s business Critically, section 503(b)(9) protections apply only to goods, rather than services In order to obtain a 503(b)(9) claim, a motion must be filed with the Bankruptcy Court in most cases Pay attention to bar date orders, which may permit you to file through a proof of claim 28

29 Administrative Expense For Goods Sold in the Ordinary Course Because the Bankruptcy Code does not specify when a creditor must assert administrative expense claims, creditors must often look to the chapter 11 plan (or a separately filed motion to set an administrative claims bar date) to determine such deadlines Therefore, creditors must remain vigilant in filing motions for goods sold in the ordinary course of the debtor s business Even where an administrative expense claim is not as valuable to a creditor as the reclamation of property, this claim is still superior to an unsecured claim on the priority scale 29

30 Enforcing Credit Protections What if you were smart/lucky enough to obtain enhanced credit protections (such as a guaranty, security interest or letter of credit) prior to the customer s bankruptcy? Guaranty: so long as the guarantor is not itself in bankruptcy, the guaranty can be enforced notwithstanding the automatic stay Security Interest: Under certain circumstances, you may be able to retake possession of your collateral. In any event, to extent that debtor is selling/liquidating your collateral, provide notice of your security interest in order to obtain proceeds of sale Letter of Credit: Can be drawn upon notwithstanding automatic stay (in most cases) Security Deposit: Technically part of debtor s bankruptcy estate; cannot be setoff against a claim absent Court approval 30

31 Presenter Contact Information Source: Lynn M. LoPucki 31

32 Presenter Contact Information Thomas Fawkes Partner Phone: (312) Twitter: ThomasFawkesBK Brian J. Jackiw Partner Phone: (312)

33 Questions or Comments? 33