TO BE (A DEBTOR) OR NOT TO BE (A DEBTOR) THAT IS THE QUESTION..

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1 TO BE (A DEBTOR) OR NOT TO BE (A DEBTOR) THAT IS THE QUESTION.. THE THORNY QUESTIONS OF WHEN WHERE WHY HOW WHETHER TO FILE A BANKRUPTCY CASE FOR YOUR DISTRESSED ENTITY OR YOURSELF Marc Albert Taylor Ashworth Alisa Lacey Janet Nesse STINSON MORRISON HECKER LLP

2 TO BE (A DEBTOR) OR NOT TO BE (A DEBTOR) THAT IS THE QUESTION AVAILABLE CHAPTERS OF BANKRUPTCY Chapter 7 (Individual and Corporate) Chapter 11 (Individual and Corporate) General Characteristics of all Chapters The Automatic Stay comes into effect the moment that a case is filed. This stops all action against the Debtor including lawsuits, collection actions, receiverships and foreclosures. The Debtor will be required to file Schedules and a Statement of Financial Affairs. The Schedules provide a snapshot (like a balance sheet) of the Debtor s financial condition on the date of the filing. The Statement of Financial Affairs provides two years of historical information to explain the Debtor s activities prior to the filing. The Debtor will have to appear at a Meeting of Creditors to answer questions under oath. Bankruptcy Courts have broad jurisdiction and are generally more knowledgeable about financial reorganizations, and more sympathetic to Debtors than a state court would be. Chapter 7 is a liquidation case: Often referred to as a straight bankruptcy. A Trustee is appointed to administer assets and will either sell or abandon the assets. The Trustee can operate a business under Chapter 7 but this is unusual, and is usually only a short term occurrence. If the Debtor is an individual, he can keep certain assets or money that are exempt under the law of his particular state. If the Debtor is a business entity all assets are liquidated to pay creditors. Chapter 11 is a reorganization case: The Debtor continues to operate its business as a fiduciary for creditors.

3 The Debtor files monthly reports. Secured lenders can file a Motion for Relief from the Stay to ask the Court for permission to pursue their state court remedies. The Debtor has the opportunity to propose a Plan that provides a method for repayment of some or all of the debt, over a period of time. WHETHER TO FILE A CHAPTER 11 CASE Two primary questions to consider: Is there an asset with value to save; and Is there some reasonable prospect of saving the asset. Five Commandments regarding filing a Chapter 11 Do not file until you to have to. The mere filing of a suit against you or being in default on a loan should not precipitate a filing. Use all other avenues of negotiation and workout before you file. Filing on the eve of a foreclosure is not a bad thing, no matter what lenders assert. Do not file unless you are better off the day after you file, than the day before. Make sure that there is a benefit to filing. This could include releasing of a garnishment, stopping a foreclosure, avoiding an expensive lawsuit, or something of that nature Do not file unless you have an exit strategy. This does not mean that you know every detail of what you intend to do. But you need to understand how you will market the property, how you will pay the lender, how you will fund ongoing operations. Chapter 11s that are filed with no exit strategy in mind, where the Debtor just flails about are doomed from the outset. Bankruptcy does not make money out of no money. If the Debtor has no operating funds and needs them, bankruptcy will not solve that problem. If the Debtor has funds to pay current expenses but not old bills, it is a good candidate. If you have an insider or an outsider that would lend to the Debtor on a priority basis, get them lined up before the filing. Make sure that you do not, and have not, waived the automatic stay. If you have been engaged in workout discussions with a lender, at some point, you may have been asked, as a condition of an extension to waive

4 the effect of the stay, thereby giving the lender the right to foreclose even if you file a bankruptcy. Some courts enforce these agreements, and some do not. You need to know if you signed such an agreement, and if the courts in your jurisdiction will enforce it. There is a wide range of opinion. Advantages of filing a Chapter 11 All adverse actions against the debtor stop. Foreclosures and suits are stayed. Calls from creditors will stop and staff can devote itself to sales and operations instead of fending off the sheriff. You can force a lender to accept a payment arrangement to which they will not voluntarily agree. Features of this can include: 1. Extending the life of the loan without extension fees; 2. Reducing or eliminating default interest; 3. Reducing the lender s secured claim to the value of its collateral (cramdown); 4. Selling property free and clear of liens, encumbrances and clouds on title; 5. Allowing another lender to step in front of the existing lender if it advances additional funds; 6. Lowering release prices. Lenders are sometimes much more cooperative in the Chapter 11 context. The possibility of beating your obligation into acting like a performing loan has been eliminated. A new set of rules is put into place, workout officers are not in charge, along with bankruptcy counsel that may have a more realistic approach to what can be accomplished in a bankruptcy context. This is still a workout scenario, not necessarily an adversarial process. A Chapter 11 may provide a more streamlined process for dealing with claims and lawsuits by suppliers. Warranty claims and class actions such as those brought by homeowners associations, which ordinarily consume a great deal of legal and personnel time and expense can be resolved through the claims process instead of through state court litigation. Additionally, certain properties can be surrendered, allowing the debtor to focus on the crown jewels of its portfolio instead of dispersing all of its efforts addressing myriad properties and claims.

5 After a Plan is confirmed, your sales transaction may not be subject to transfer taxes. This represents a substantial savings in some jurisdiction, depending on the rate of taxation. In a Chapter 11, sales of assets may be free and clear of warranty claims and/or environmental issues that could otherwise impede that sale of the property absent a Chapter 11 filing. Disadvantages of Filing a Chapter 11 Expense can be substantial. Filing fees for each case start at $1000, and you may have to file for a number of related entities. Legal fees will never be less than $50,000 for even the simplest single asset Chapter 11 case, in which you have a general agreement with the major creditors prior to the filing. They can range up to many times that amount in a case or series of cases with multiple lenders. You need to make a determination of whether funds are available for that purpose and whether the asset is worth saving. Springing Guaranties. A review of loan documents may show that the filing of a bankruptcy may trigger a guaranty made either by an individual or another entity. Although some courts have declined to enforce these guaranties as against public policy most courts have upheld them. Time is short. Especially if you are filing for a Single Asset Real Estate entity, you have only a couple of months to file a Plan of Reorganization that will provide for payment of the debts over a period of time unless you are able to service the secured debt in the interim. You only get to do it once. This is your last opportunity to preserve the assets from the lender. You need to provide full disclosure. This includes salaries paid to or for the benefit of insiders, and opens up all actions of the debtor before the filing to scrutiny. This could lead to claims against insiders or other entities controlled by insiders. If your business practices have been sloppy or informal, this will not like aid in a reorganization case, and may lead to the appointment of a Chapter 11 Trustee to run your business. Potential loss of clients and loss of reputation. This is a less significant factor than it has been in the past, but especially with smaller suppliers and individual purchasers special steps may need to be taken to ensure that lack of confidence does not undermine the chance of a successful reorganization. The Court has the power to re-characterize debt as equity. This means that if insiders have loaned money to the debtor, the bankruptcy court could conclude that it was more like an equity infusions, and the insiders should not be paid anything on their obligations unless and until all creditors are paid in full.

6 Issues not Affected by a Chapter 11 Filing Guaranties. In general, the stay of a Chapter proceeding does not protect guarantors. That means even if the suit against the Debtor is stayed, a suit against the principals is not stayed. There are some courts that have issued stays to protect guarantors, but those decisions are not generally accepted and are only issued under unusual circumstances. Case studies It is very useful to see how other entities that have filed for Chapter 11 recently have done since they filed. Caruso Homes, Inc. (Maryland) TOUSA, Inc. (Florida) Levitt Homes (Florida) Woodside Homes (California) Chapter 7 filings There is rarely a good reason to file a business Chapter 7 case. The only reason is to bring a formal end to business operations. There will be a Trustee appointed, who will most likely consent to allow the secured lenders relief to foreclose on their properties.. It is possible that a liquidation through a Chapter 7 Trustee could yield more value than liquidation through a foreclosure sale, if you can convince the Trustee to go through the exercise of selling the assets The Trustee, however, will be looking into the books and records of the company, and will look for transfers and transactions that could be recovered for the benefit of creditors. This may involve claims against the principals and related companies, some of which would not even exist outside the context of a bankruptcy case. Business entities do not retain exempt property, so all assets will be sold for the benefit of creditors. It may be that a principal of an entity or entities that has filed a bankruptcy may need to file a personal Chapter 7 proceeding. A Chapter 7 Discharge would prevent judgments on springing guaranties or ordinary guaranties. The Debtor can retain all property that is Exempt under the laws of the state in which he lives. Some states have very modest exemptions, others allow the Debtor to keep all property that is tenants by the entireties, retirement accounts, and an unlimited amount of homestead property. These rules vary widely among the fifty states, but sometimes a Chapter 7 filing for the

7 principal can alleviate a great deal of stress while a reorganization proceeds, and can eliminate one weapon in the arsenal of the lender. Conclusion Filing of a bankruptcy can be a very effective tool in reorganizing the business of a Debtor, or in ending its operations in an orderly fashion and liquidating its assets. The decision to file involves many factors that are very specific to the particular borrower. It is a decision that entails a great deal of effort and expense and that should not be taken lightly. If used properly, however, and in appropriate cases, the bankruptcy strategy can be the difference between preserving assets rather than losing them or continuing on in business rather than simply giving up.