Jun 16, 2020

Consider the Benefits of Restructuring a Business Facing Liquidity Shortfalls under the U.S. Bankruptcy Laws

bankruptcy court

During these turbulent times of global pandemic and widespread lockdowns, many businesses are suffering severe economic distress.  For example, many businesses in sectors such as hospitality, travel, entertainment and retail, have been forced to shut their doors to customers due to various lockdown orders, so they have not been able to generate revenue during the shutdown, even though they may still have continuing obligations for fixed costs such as rent and payroll.  Even as lockdowns end, it may take some time for revenue to reach pre-crisis levels, and business with significant long-term contractual obligations such as rent may find landlords unwilling to renegotiate rent down to market levels, which may now be significantly lower than contracted rates.

In the US, filing for bankruptcy protection could be a good response for companies to a fundamentally changed business environment. While careful examination must be undertaken, Chapter 11 may provide crucial relief from impaired liquidity and inability to meet obligations.

Advantages of a US Chapter 11 Case as Compared to an Insolvency Proceeding in Another Jurisdiction.

Many business owners, and in particular foreign business owners who are familiar with bankruptcy procedures in their home countries, associate the concept of bankruptcy filing with the demise of their business. In the US, however, a Chapter 11 reorganization carries a different tone.  Some of the key aspects of a Chapter 11 proceeding are highlighted below. Most importantly, a Chapter 11 filing in the US does not stigmatize or shame business owners or management, who are rather considered to have merely taken advantage of the benefits made available under US law to distressed companies. Thus, the reorganization route under Chapter 11 and its financial benefits should at least be considered among the alternatives for a company facing a situation of distress.

Commencing a case under Chapter 11 of the US Bankruptcy Code provides significant advantages to companies in reorganizing — benefits that companies may not be able to obtain or obtain so quickly in courts around the world:

  1. Automatic Stay. Upon the filing by a company of a petition commencing a case under the Bankruptcy Code, a stay is automatically imposed which prohibits the taking or continuation of any action to collect a debt arising pre‑petition, any action to enforce any lien securing a debt arising pre‑petition, and any action to take possession or control of any of the company’s property, real or personal. This is different from many other jurisdictions around the world where in some cases either such an injunction is not available or it is only available upon specific rulings by a court.
  2. Management Stays in Control. The company is considered a “debtor in possession,” whose management stays in control of the company during the reorganization process as a, and an outside trustee is not brought in to manage the company unless there are extraordinary circumstances (e.g. fraud, dishonesty, gross mismanagement).  This is also different from most of the jurisdictions around the world, where trustees are usually managing the business until it is wound up.
  3. Availability of DIP Financing. A company may be able to obtain new financing after commencing a Chapter 11 case (known as “Debtor in Possession” or “DIP” financing) that was unavailable before the case, because, with the approval of  the bankruptcy court, a debtor may, if necessary to obtain the financing, secure its DIP financing by a lien that is equal or senior to existing liens on any or all property of the estate.  While existing lienholders may vigorously oppose approval of so-called “priming” liens, and the bankruptcy court will not approve a “priming” lien unless the debtor can demonstrate that the interests of existing lienholders in the debtor’s property will be adequately protected (by reason of the value of the debtor’s equity in the property, by the granting of a replacement lien on other property, or otherwise), the Bankruptcy Code does provide for “priming” liens, and the mere prospect of the approval of a “priming” lien may motivate an existing lienholder itself to provide DIP financing.  This too is something that is not often allowed or provided for in foreign bankruptcy laws.
  4. Avoidance of Outstanding Contracts. Following commencement of Chapter 11 proceedings, the debtor has the option to “assume” or “reject” executory contracts and unexpired leases. For example, if an existing contract or lease is not favorable to the debtor, it may reject the contract or lease. While the other party to the contract or lease is entitled to a claim for breach in the event that its contract or lease is rejected, its claim is typically an unsecured claim, not entitled to priority, and the debtor is relieved from further performance under the contract or lease.  In addition, in the case of real property leases and employment contracts, the other parties’ damage claims are limited, in the case of real property leases, to the accrued and unpaid rent that is due plus the present value of future rent for no more than three years, and in the case of employment contracts, to the accrued and unpaid compensation that is due plus future compensation for no more than one year.
  5. Creditor Approval Threshold. In order to approve a restructuring plan in a Chapter 11, the debtor needs the affirmative votes of the holders of more than one-half in number and two-thirds in amount of the claims in each class of creditors. In many other common law jurisdictions a debtor needs to reach a threshold of 75 percent in amount.
  6. Ability of Debtor to Recover Transfers. Avoidance actions or clawback actions in U.S. Chapter 11 can be very powerful, not only in terms of the scope but in terms of their timeframe. The look-back periods can be very long compared to jurisdictions around the world.

Conclusion.

Before filing a petition under Chapter 11 of the US Bankruptcy Code, a company should diligently consider, in consultation with its legal and financial advisors, the costs (both monetary and intangible) and potential benefits of a Chapter 11 case.  In the case of any financially distressed company, the costs of a Chapter 11 case can be substantial and the likelihood of success uncertain, but a Chapter 11 case may not only be highly beneficial to a distressed company, but it may constitute the only reasonably viable tool available to preserve the business of the company for the benefit of its employees, customers, vendors, and, in a proper case, equity owners.

We include a tabular summary comparing the various remedies available to a company under Chapter 11, Chapter 7 and Chapter 13 of the US Bankruptcy Code. 

Tabular Summary – US Bankruptcy, Chapter 11, Chapter 7 and Chapter 13.

 Chapter 11  Chapter 7  Chapter 13
 Objective  • Continue business and reorganize; or

• Maximize recovery to creditors while liquidating.

 Orderly liquidation of debtor’s property.  Relief to sole proprietorships (i.e., individual Debtors) according to agreed payment plan.
 Applies to
  • Corporations, partnerships, LLCs, individuals.
  • Foreign companies with assets in the US.

Not available to:

  • Stockbrokers, commodity brokers.
  • Municipalities.
  • Insurance companies, banking institutions.
  • Individuals, partnerships, corporations, LLCs.
  • Stockbrokers, commodity brokers.
  • Individuals with regular income.
 How begun and by whom
  • Voluntary petition filed by debtor.
  • Involuntary petition filed by creditors.
  • Voluntary petition filed by debtor.
  • Involuntary petition filed by creditors.
  • Voluntary petition filed by debtor.
 Requirements Voluntary:

  • Good faith.
  • Insolvency not required.

Involuntary:

  • Various procedural requirements.
Voluntary:

  • Good faith.
  • Insolvency not required.

Involuntary:

  • Various procedural requirements.

Individuals:

  • Means test, if debtor’s income is above
Good faith.

  • Insolvency not required.
  • Debts must be below designated thresholds.
 Effect
  • Debtor continues to operate business (unless trustee is appointed) while formulating reorganization plan.
  • Automatic stay of creditor actions.
  • Automatically creates estate of debtor’s assets at time of filing.
  • Trustee appointed to control company and assets.
  • Automatic stay of creditor actions.
  • Automatically creates estate of debtor’s assets at time of filing (individual’s post-petition wages do not form part of estate).
  • Trustee appointed to administer estate.
  • Automatic stay of creditor actions, including stay protecting some co-debtors
  • Automatically creates estate of debtor’s assets at time of filing (portion of post-petition earnings belong to estate and are used to pay prepetition debts).
 Conclusion
  • Plan confirmed if two thirds in amount and more than half the number of allowed claims in each class vote to approve the plan (unless cram down requirements are satisfied).
  • Distributions to creditors under approved plan.
  • Discharge of claims arising before confirmation (subject to some non-dischargeable debts for individual debtors) once plan is confirmed
Discharge of prepetition claims (for individual debtors only, subject to some non-dischargeable debts). Discharge of prepetition claims (subject to some non-dischargeable debts) once payments are made under plan.

 


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