Distressed companies often assume that

Navigating Today s Environment The Directors and Officers Guide to Restructuring John Wm. ( Jack ) Butler, Jr Consulting Editor Skadden, Arps, Slate, Meagher & Flom LLP Alternatives to bankruptcy under federal and state law Robert S Hertzberg, Kay Standridge Kress, Corporate Restructuring and Bankruptcy Partners, and Deborah Kovsky-Apap, Corporate Restructuring and Bankruptcy Associate, Pepper Hamilton LLP Distressed companies often assume that bankruptcy either filed voluntarily by the debtor, or involuntarily by a group of creditors is the only option. However, officers and directors might consider that a number of alternatives exist under both state and federal law that may result in greater flexibility and costs savings than liquidation in bankruptcy. Foreclosure on real property In general terms, foreclosure is the legal process by which a secured creditor takes title to and possession of collateral securing a defaulted loan. The specifics of foreclosure on real property are governed by state law, and vary significantly from state to state. If you need to foreclose on real property, or are contemplating making a loan secured by it, some key issues to consider include the following. Does the state where the property is located allow non-judicial foreclosures? Is it a one action rule state? Will the state permit you to pursue your deficiency claim if the collateral is not enough to satisfy your debt? Under the state s law, what is the effect of foreclosure on your ability to collect from third-party guarantors? What is the borrower s right of redemption after a foreclosure sale? Judicial versus non-judicial foreclosure Some states laws provide only for foreclosure by judicial sale, while others provide only for nonjudicial foreclosure. A number of states allow the creditor to choose between the two though that choice may be circumscribed by a one action rule, described below. Although there are benefits and drawbacks to each method, it is telling that in most of the states where creditors can choose their remedy, the vast majority of foreclosures are nonjudicial a process that is typically much faster. For example, in California, perhaps the nation s leader in real estate foreclosures, more than 95 per cent are non-judicial. In some instances, however, judicial foreclosure is the better or the only option. Judicial foreclosure procedures A judicial foreclosure is a lawsuit. The secured creditor sues the borrower and all other necessary parties which may include the owner of the property if other than the borrower, anyone else liable for a deficiency judgment under the loan, and the holders of junior interests in the property and records a lis pendens or similar notice against the property. The judicial foreclosure proceeds like any lawsuit, with service of the complaint, discovery, motion practice and trial. Once the creditor has obtained a judgment and order of foreclosure, the sale is conducted, typically by the sheriff or a courtappointed receiver or commissioner. The lender is entitled to protect its collateral from undervaluation at the foreclosure sale by credit bidding its debt. If the sale proceeds are not sufficient to pay off the full debt, the lender can apply for a deficiency judgment, subject to certain restrictions. Some states have anti-deficiency statutes that prohibit a deficiency judgment on a purchase-money loan. (If the original purchase-money loan has been refinanced, it may or may not still qualify for Navigating Today s Environment: The Directors and Officers Guide to Restructuring 1

Alternatives to bankruptcy Pepper Hamilton protection, depending on what state you are in.) Additionally, many states limit the amount of the deficiency judgment to the difference between the mortgage debt and the fair value of the real estate, as determined by the court at a fair-value hearing. In a number of jurisdictions, the borrower may still exercise the right to redeem the property after a foreclosure sale. The redemption period and price varies from state to state, and may run as long as two years after the sale. During that time, the borrower may remain in possession of the property. In states that provide for a redemption period, properties often sell at foreclosure sales at a significant discount (if at all) to compensate for the risk that the borrower may redeem the property. Even after the redemption period has expired, the mortgagee cannot simply take possession of the property unless it has been abandoned (which in some jurisdictions may shorten the redemption period). If the borrower is still in possession, the mortgagee will have to initiate eviction proceedings, which can take up to 90 days depending on the particular state. Length of the judicial foreclosure process Judicial foreclosure provides the borrower with a forum not only to raise defenses but to assert counter-claims against the mortgagee and, like any lawsuit, it can be time-consuming. Even an uncontested foreclosure, where the borrower fails to answer the complaint and the mortgagee is able to obtain a default judgment, can take six months. A vigorously contested judicial foreclosure may be drawn out for a year or more. Add this to the time for determination of fair value at a contested hearing, expiration of the redemption period and eviction of the borrower, and it may be several years before the mortgagee is able to take possession of the collateral. Non-judicial foreclosure procedures Foreclosures by power of sale, also called statutory or non-judicial foreclosures, are typically based on clauses in mortgages or deeds of trust that enable the mortgagee (or trustee, where the instrument is a deed of trust) to initiate a sale without resorting to the courts. The requirements for non-judicial foreclosure are established by state statutes and, again, vary. In general, when a loan default occurs, the mortgagee is required to record a notice of default and notify the borrower about the default status. If the borrower does not cure the default within the specified statutory period, the mortgagee initiates the non-judicial foreclosure sale of the collateral by recording and publishing a notice of sale, posting that notice on the property itself and (usually) mailing it to the borrower. In some jurisdictions, a notice of default is not required; instead, the trustee can start directly with a notice of sale. In other jurisdictions, there is no requirement to inform the borrower directly of the notice of sale; the only requirement is publication. The notice of sale sets the foreclosure sale date, which cannot be until the expiration of a set statutory period that varies from state to state. After the legally required notice period expires, a public auction will be held and the property will go to the highest bidder. As with a judicial foreclosure, the mortgagee will be able to credit bid its indebtedness and thus prevent undervaluation of the collateral. Typically, any winning offer other than a credit bid must be paid in cash or cash-equivalent at or promptly after the auction. Following a foreclosure by power of sale, the borrower has no right of redemption; the sale is final. Length of the non-judicial foreclosure process The biggest advantage of non-judicial foreclosures is their relative speed and efficiency. In many states, they can be completed in as little as two to four months, though the process may take considerably longer if the borrower contests the action in court and seeks a delay of the sale. Nonetheless, most non-judicial foreclosures move much faster than judicial ones, particularly when the lack of a redemption period is factored in. Considering deficiency claims in choosing a method of foreclosure The primary reason for choosing a judicial foreclosure is that this is the only way of obtaining a deficiency judgment. If the mortgagee chooses a non-judicial foreclosure, its recovery will be limited to the value of the collateral. Thus, if the mortgagee believes the property securing its loan is worth less than the amount owed, and the borrower has significant other assets that could be collected, and the loan is a recourse loan, it may be worth the time, expense and uncertainties of the judicial foreclosure process to obtain a deficiency judgment against the borrower. What is a one action rule and why is it important? A handful of states, most notably California, have what is known as a one form of action rule. This 2 Navigating Today s Environment: The Directors and Officers Guide to Restructuring

Pepper Hamilton Alternatives to bankruptcy requires the mortgagee to foreclose on the collateral property, taking either the judicial or non-judicial route, before seeking to recover the debt from the borrower by any other means. In short, if real estate is taken as collateral for a loan, and the collateral is in a one-action-rule state, the mortgagee must foreclose on the real estate security first. (An exception: if the mortgagee is a junior lien holder and the collateral is fully encumbered by senior liens, it will not be forced to go through the futility of foreclosure.) Furthermore, only one action may be brought against the borrower and must be used as the primary source of repayment when collecting the loan. The one-action rule has been subject to particularly broad interpretation in California, and the consequences for failing to adhere strictly to the rule are severe. In Security Pacific National Bank v Wozab, a secured creditor set off approximately $3,000 in the borrower s accounts in partial satisfaction of a $1 million debt, without first foreclosing on the real property securing the debt. The California Supreme Court held that even though the creditor s exercise of its equitable right of setoff was not an action, it nonetheless violated the one-action rule s requirement for relying on the security before trying to enforce a debt. As a result, for setting off just $3,000, the creditor lost its security for the remaining $997,000 owed by the debtor. The moral of this cautionary tale is that it is critically important that a creditor seeks legal counsel before taking any action against a borrower, lest the creditor find itself deprived of its security altogether. Effect of foreclosure on third-party guaranties Generally, if a guarantor is a co-obligor on a note secured by real property, it is entitled to the same protections under anti-deficiency and one-action rules as the borrower. In a one-action-rule state, the mortgagee would be forced to pursue such a guarantor through a judicial foreclosure. On the other hand, if the guarantor is a person or entity who is not the borrower, and the guaranty contains the appropriate statutory waivers for that jurisdiction, the mortgagee should have the right to foreclose judicially or non-judicially on the property, and then pursue the guarantor even in a one-action-rule state. Because the waiver and other requirements for guaranties vary so widely, it is important for a creditor to understand the particular requirements of the state in which it is lending before the guaranty is executed. Assignment for the benefit of creditors Like foreclosure, an assignment for the benefit of creditors (ABC) is a creature of state law. ABCs have long been popular in a few states, most notably California and Illinois, but they are beginning to gain traction in other states as a less expensive alternative to bankruptcy. What is an ABC? An ABC conveys all property, legal and equitable rights of the assignor to the assignee, for the purpose of liquidating the assets and distributing them to creditors according to the priorities established by applicable law (usually the same order of priorities set forth in Chapter 7 of the Bankruptcy Code). Except in rare circumstances, where the assignee operates the business for a short period pending liquidation, an assignment ends all ordinary business operations. Thus, there is no ability to reorganize in an ABC. Selection of the assignee Unlike in Chapter 7, the party making an ABC gets to choose the assignee who will liquidate its assets. If you are the secured lender or a major creditor, you should seek to have input in this important decision, as well as in negotiations with the proposed assignee regarding his fees and expenses, and any discussions about what is likely to happen during the assignment. The assignee will act in a fiduciary capacity for the benefit of all creditors, and should be experienced in liquidating assets and selling businesses in the assignor s particular industry or field. Formation of an ABC Companies cannot be compelled to make an assignment; there is no state-law equivalent of an involuntary bankruptcy. However, companies can be encouraged to do so when it is in the best interests of their major creditor constituencies. As a formal matter, creditor consent is not required for making an ABC, but rather is presumed. In practice, however, since any secured creditor can unwind an ABC by foreclosing on its collateral, most companies will seek the consent and co-operation of their lenders. Some states require a court filing to initiate or complete an ABC, while in other jurisdictions a written instrument is sufficient. A short time after the ABC is made, the assignor must typically provide the assignee with a list of all creditors, an inventory, and the description, location and value of all property and rights assigned. For his part, the Navigating Today s Environment: The Directors and Officers Guide to Restructuring 3

Alternatives to bankruptcy Pepper Hamilton assignee must post a bond in excess of the value of the property. Effect of an ABC By accepting the assignment and taking possession, the assignee becomes the trustee for both the assignor and the creditors, with the duty to administer the trust property so as to pay creditors, and then to account to the assignor for the surplus, if any. Acceptance creates an estate that remains subject to all secured and unsecured claims. It is important to note that because an assignee has the rights of a lien creditor under the Uniform Commercial Code (a version of which has been enacted in all 50 states), the rights of holders of unperfected security interests are subordinate to those of an assignee. The assignee takes the assignor s property subject to all existing liens and interests. From a creditor s perspective, an ABC generally involves little more than submitting a proof of claim form to the assignee by the stated deadline, and then waiting for distribution of the dividend, if any. ABCs compared with Chapter 7 or liquidating Chapter 11 Unlike a bankruptcy, an ABC does not impose an automatic stay of all actions. In practice, however, creditors are prevented from executing on the assignor s assets because those assets have been moved out of their reach by operation of the assignment. Also, unlike a liquidating Chapter 11, the assignor does not receive a discharge in an ABC but rather remains liable to creditors for any deficiencies. All states have enacted some form of the Uniform Fraudulent Conveyances Act or the Uniform Fraudulent Transfers Act. Under these state laws, assignees can pursue actions to avoid and claw back fraudulent transfers, just as a trustee could do in bankruptcy. However, only some states have enacted statutes that allow an assignee to avoid and recover preferential transfers. ABCs may be more attractive to creditors because they do not provide certain protections that debtors would otherwise enjoy in bankruptcy. For example, unlike a bankruptcy trustee or debtor in possession, an assignee cannot sell assets free and clear of interests, or assume and assign executory contracts, without creditor consent. The Bankruptcy Code largely invalidates contractual ipso facto clauses, but those clauses remain in full force and effect in an ABC, allowing creditors to declare a default based on the assignment itself. The Bankruptcy Code caps landlords damages for breaches of real property leases, but no such limitation exists in an ABC. An ABC may also be a preferable alternative to bankruptcy simply because it is likely to be much faster and cheaper. An ABC avoids the need to file multiple motions and seek approval of the bankruptcy court throughout the process, and to pay the fees of numerous professionals. Accordingly, creditors may often obtain a better recovery than through bankruptcy proceedings. On the other hand, those proceedings take place under the watchful eye of the bankruptcy court and with full notice to all creditors and parties in interest. In an ABC, they may or may not receive similar notice. Federal receiverships Secured creditors may, upon default by a borrower, exercise a variety of remedies to enforce their interests. An under-utilized remedy, however, is offered by federal receiverships, which may be the quickest and most cost-effective method of gaining control over the collateral. Foreclosure actions are generally brought in the county in which the property is located, while state receivership actions relate to property in that state. So these remedies present logistical issues when the collateral is in multiple locations. By comparison, federal receivership actions may be commenced in any district in which the federal court has jurisdiction. Generally, they are better able to achieve uniform results and are less costly than a foreclosure action or state receivership. Additionally, unlike foreclosures or most assignments for the benefit of creditors, a federal receivership may maintain the value of the collateral as it will allow the business to continue to operate. The receiver will preserve and protect the collateral as well as the financial integrity of the business as a going concern. Appointment of a receiver A federal court must have jurisdiction in order to be able to appoint a receiver. For example, the courts have federal question jurisdiction to appoint SEC receivers because those cases arise out of the violation of federal laws. By contrast, because a secured party s enforcement of its rights is not usually based upon a federal question, diversity of citizenship between the parties and a minimum amount in controversy exceeding $75,000 must exist in order to invoke the jurisdiction of a federal district court. Once this is established, the federal district court has ancillary jurisdiction to appoint a 4 Navigating Today s Environment: The Directors and Officers Guide to Restructuring

Pepper Hamilton Alternatives to bankruptcy receiver, as well as ancillary subject matter jurisdiction over every suit the receiver subsequently brings in the appointing court to execute his duties. Procedurally, to have a receiver appointed, the secured creditor will first file suit against the borrower for breach of contract. In some jurisdictions, depending upon state law, the complaint will include a count for foreclosure. Then the secured creditor will file a motion to appoint a receiver, supported by an affidavit alleging the basis for the relief requested. The decision as to whether a receiver should be appointed is made by federal standards and resolved by federal law. In their determinations, courts typically weigh factors such as the plaintiff s probable success in the underlying complaint, any fraudulent conduct on the part of the defendant, and any imminent danger that the property may be lost, concealed, injured, diminished in value or squandered. Once appointed, the receiver is required to post a bond, after which he is vested with complete control of all property of the defendant, personal and real, wherever situated, with the right to take possession. A receiver must, within ten days of entry of the appointment order, file a copy of the complaint and the appointment order in each district in which property is located. If he fails to do so, he may be divested of control over the property in those districts. However, the receiver does not need to be separately appointed in each district; simply filing the copy of the complaint and order is sufficient. Thus, maintaining legal control over all property, wherever located, is relatively straightforward. Role of the receiver On appointment, the receiver becomes an officer of the court, managing and operating the property according to the laws of the state where the property is located. In addition, the receiver may be sued with respect to any acts taken, or transactions engaged in, while carrying on the business. However, an action by a third party to gain possession of property held by the receiver can only proceed at the discretion of the court appointing the receiver. The court has broad powers and wide discretion to determine appropriate relief in an equity receivership. These powers enable the court to effectively supervise a receivership and protect the interests of its beneficiaries. As courts of equity, the federal courts have authority in appropriate circumstances to impose broad stays of all actions against the entities in receivership, except by leave of the receivership court. There is no inherent legal limitation on the amount of control that a receiver may wield over the entity and/or the collateral over which he was appointed. The receiver s powers are delineated by the appointment order. Sales of assets by a receiver These sales are governed by statute. Additionally, the power of sale is within the scope of a receiver s complete control over receivership assets a concept firmly rooted in the common law of equity receiverships. The statutory provisions governing the sale of assets are very specific in certain respects (such as notice provisions and appraisals), but vague in terms of the procedures to be employed in the sales, thereby allowing for flexibility and creativity. In addition, under federal law there is no right of redemption from judicial sales. As in a nonjudicial foreclosure, the sale is final when made. The sale of real property by a receiver may be through a public or a private sale. A public sale must occur in the district where the receiver was appointed, unless the court specifically orders that it take place in another district. In addition, the terms and conditions will be as directed by the court. Notice of a public sale must be approved by the court and published at least once a week for four weeks prior to the sale in at least one newspaper in general circulation in the county, state or judicial district where the property is located. A private sale may occur if the court determines that it is in the best interest of the estate. As with a public sale, the terms and conditions will be as directed by the court. In a private sale, however, the court must appoint three disinterested appraisers to appraise each parcel of property. The originally proposed offer will not be confirmed by the court unless the sale price is two-thirds of the appraised value, or unless another offer of at least 10 per cent over the original offer is received. Notice of the private sale must also be approved by the court and published in a newspaper of general circulation at least ten days prior to the hearing on the confirmation of the sale. The sale of personal property is governed by the same rules as that for the sale of real property, unless the court orders otherwise. Courts are generally liberal with respect to receivership sales. A judicial sale that complies with the procedural requirements will not be denied confirmation or be set aside based on the price unless that price is so gross as to shock the Navigating Today s Environment: The Directors and Officers Guide to Restructuring 5

Alternatives to bankruptcy Pepper Hamilton conscience of the court and even then, most courts will require additional circumstances indicating unfairness such as chilled bidding. In one case, the Court of Appeals for the Third Circuit upheld the expedited sale of corporate property that did not comply with the statutory procedures regarding appraisals and certain notice provisions, because of the extraordinary circumstances of the case and the dire financial condition of the corporation. Interplay between bankruptcy and federal receiverships At the commencement of a bankruptcy case, the bankruptcy court has exclusive jurisdiction over the property of the estate, and the automatic stay provisions prevent the continuation of receivership proceedings and action by the district court. In other words, if you have a receiver appointed and other creditors then file an involuntary bankruptcy petition against the debtor, bankruptcy law will trump federal receivership law. You will not necessarily lose the benefits of your receivership, however; you can file a motion asking the bankruptcy court to abstain from the case and, after weighing the equities, the court may allow the receivership to proceed instead of the bankruptcy. The various legal and practical differences between receiverships and bankruptcy proceedings may be significant in certain situations. Some district courts, for example, have enacted local rules specifically pertaining to receiverships, and those should be reviewed. Meanwhile, receivership proceedings are often referred by busy district judges to magistrates. This presents the issue of the parties willingness to consent to a magistrate judge hearing the case and order entry of judgment, or merely making recommendations to the district judge. The receiver s ability to pursue certain causes of action on behalf of the estate also needs to be considered. There is no authority for a receiver to avoid and recover preferential transfers. Nor is there statutory authority to employ the strong arm powers of Section 544 of the Bankruptcy Code to avoid unperfected liens. Equity receivers do, however, have standing to assert fraudulent conveyance theories to recover property for the estate. In addition, a receiver may be able to bring certain actions against third parties that a bankruptcy trustee, debtor in possession or committee cannot bring successfully because of defenses that may be asserted against them. For example, courts have refused to apply the in pari delicto defense to bar a receiver from asserting fraudulent conveyance claims against third parties who had received funds from the receivership entities. Under the in pari delicto defense, the court will not allow a party to seek damages from the other side if that party s own conduct was wrongful. The rationale is that the appointment of the receiver removes the wrongdoer from control and sufficiently changes the equities such that the in pari delicto doctrine loses its sting. By contrast, courts have held that bankruptcy trustees (and other bankruptcy estate representatives) are subject to the in pari delicto defense. On a practical level, another difference between receiverships and bankruptcy proceedings is in the nature of the courts themselves. District court judges tend to be far less experienced than bankruptcy judges in dealing with sales and other estate administration matters. They are often receptive to suggestions as to procedures to be employed on these issues. The district courts often rely on analogous provisions of the Bankruptcy Code and rules for guidance where appropriate, although they are not bound to follow them. In addition, a district court presiding over a receivership is less likely to share the view of many bankruptcy courts that it should not permit a case to go forward (or authorize a sale) if the sole beneficiaries are the secured creditors. Conclusion While officers and directors may assume that bankruptcy is the only available option in times of economic distress, other, sometimes more advantageous alternatives exist under state and federal law. We have discussed three of those alternatives foreclosure, assignments for the benefit of creditors, and federal receiverships in some detail. Before deciding to file for bankruptcy, officers and directors of distressed companies should consider these and other alternatives as they may result in greater flexibility and cost savings than a conventional liquidation in bankruptcy. 6 Navigating Today s Environment: The Directors and Officers Guide to Restructuring

Navigating Today s Environment The Directors and Officers Guide to Restructuring John Wm. ( Jack ) Butler, Jr Consulting Editor Skadden, Arps, Slate, Meagher & Flom LLP Grouped into seven sections, Navigating Today s Environment consists of 45 separate conversations with the leading restructuring voices of our generation. Much of the knowledge and experience conveyed in these pages is relevant to leaders of public and private companies of all sizes, whether small-cap, middle-market or Fortune 1000. Navigating Today s Environment is a resource guide for US officers and directors, as well as those who are interested in and follow the management and corporate governance of US companies. This publication is intended to provide a general guide to business and legal practice. The information and opinions that it contains are not intended to be a comprehensive study or to provide specific professional advice, and should not be treated as a substitute for such advice concerning particular situations. Legal and/or other professional advice should always be sought before taking any action based on the information provided. The content reflects the individual views of the authors, and those views are not presented as those of their firms, other contributors or the editors. The publishers, sponsors and authors bear no responsibility for any errors or omissions contained herein. To view the book in which this chapter was published, and to order hard-copy versions, please go to: www.navigatingtodaysenvironment.com Published by Globe White Page Ltd. Globe White Page 2010