DENTONS US LLP
SELECTED BANKRUPTCY AND INSOLVENCY ISSUES IN THE UNITED STATES
Dentons US LLP
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Dentons US LLP
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Introduction
This outline describes bankruptcy and insolvency issues which frequently arise for trade vendors. This outline is designed to help identify some key items which may be of concern, but it is not a substitute for seeking legal advice on how to address a particular situation. This outline focuses on entities who file for Chapter 11, rather than Chapter 7 straight liquidation (which often involves no ongoing operations and usually little or no prospect for recovery for unsecured creditors) or individual bankruptcy cases under Chapters 13 (wage earners), 11 or 7.
The topics covered in this outline are listed below. We have other materials and research on other topics which are available upon request. Additionally, we can develop materials and research tailored to specific situations.
-Signs of Distress
-Possible Fiduciary Duties to Creditors and Deepening Insolvency
-Forms of Insolvency, Liquidation and Restructuring for Businesses
-Distressed Purchases and Sales of Assets and Businesses
-Contracts, Leases and Licenses
-Creditors and Other Committees
-Preferences
-Reclamation of Goods and 20 Day Priority Claims
-Doing Business with a Chapter 11 Company/DIP Financing-Cash Collateral
-Litigation and the Automatic Stay
-Proofs of Claim
-Involuntary Bankruptcy
-Derivative Contracts Counterparty Rights
-Timeline of Major Events in a Typical Chapter 11 Case
Signs of Distress
Some businesses are fundamentally sound but look for signs of distress with customers or vendors. Others may be experiencing distress themselves. As a general matter, the earlier a financially distressed entity seeks restructuring help (or recognizes a customer or vendor is in financial distress), the more likely it is to preserve value (including for existing shareholders), avoid bankruptcy and survive as a going concern. Unfortunately, a belief that the situation is a “short-term blip” rather than a longer term adverse trend or other denial often sets in. The distress may be a result of (i) financial or overleverage issues, (ii) operational issues, (iii)managerial issues, (iv) general economic, industry or regional issues or (v) a combination of one or more of these issues.
Among signs of distress can include:
-deteriorating financial performance
-loss or deterioration of key customers
-loss of key employees
-general deterioration in the sector
-losing market niche in the sector
-entry of new competitors into market or sector
-need to upgrade business with capital expenditures or otherwise change business model
-adverse developments with lender sources or investors
-litigation, including mass tort claims or class actions or bet the company damages sought in a suit
-forbearance agreement
-lender insisting on a turnaround professional or inventory appraisal being hired
-bondholders or other creditors organizing
-stretching trade creditors
-past due taxes or tax audit
-financial covenants tight or in default
Possible Fiduciary Duties to Creditors and Deepening Insolvency
Issues of corporate governance, including fiduciary duties of corporate directors, are generally governed by state law. The most significant state corporation law is that of Delaware. As noted by Judge Leif Clark of the Bankruptcy Court for the Western District of Texas:
The Delaware courts’ decisions have proved to be immensely influential in the national debate over the shape of causes of action that have their genesis in breach of fiduciary duties on the part of officers and directors.
Medlin v. Wells Fargo Bank, N.A., 2007 Bankr. LEXIS 3329 (W.D. Tex. July 31, 2007).
There has been significant recent activity in both the Delaware Supreme Court and the Delaware Court of Chancery in the area of fiduciary duties of directors of insolvent entities and liability for “deepening insolvency” discussed below.
TheDemise of the “Zone of Insolvency” Concept in Delaware
In May 2007, the Delaware Supreme Court decided North American Catholic Educational Programming Foundation v. Gheewalla, 930 A.2d 92 (Del. 2007). In Gheewalla the court ruled as to corporations not insolvent but in the “zone of insolvency”:
In this case, the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interest of the corporation for the benefit of its shareholder owners….
930 A.2d at 101 (emphasis added).
As to insolvent corporations, the court ruled in Gheewalla that derivative claims by creditors are possible:
When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.
Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation’s insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.” Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.
930 A.2d at 101-102 (quoting Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d at 772, 794 n.67 (Del. Ch. 2004)).
Upon Insolvency, Directors’ Duty is to Maximize the Value of the Enterprise, Not Just Payment to Creditors
In Nelson v. Emerson, 2008 WL 1961150 (Del.Ch. May 6, 2008), the Delaware Court of Chancery emphasized the notion that the directors’ duty upon insolvency is to maximize the value of the firm and not simply to pay creditors:
It is settled Delaware law that “[e]ven when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm.” Filing a Chapter 11 bankruptcy petition is a federally-sanctioned strategy for maximizing the value of an insolvent company. Here, after a full trial, the Bankruptcy Court determined that Repository used that strategy in good faith. Directors of a Delaware corporation do not commit a breach of fiduciary duty against the corporation if they, in good faith, seek to benefit the equity holders by bringing a bankruptcy, in order to recharacterize certain debt as equity. So long as that action is not frivolous, such an exercise of business judgment to advance the interests of the equity holders is not a breach of fiduciary duty simply because the directors do not achieve ultimate success.
2008 WL 1961150 at *8 (footnotes omitted) (emphasis added).
Rejection of the “Deepening Insolvency” Doctrine in Delaware
In August, 2007, the Delaware Supreme Court affirmed the Chancery Court’s decision in Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006). The Delaware Supreme Court specifically approved the “basis” and “reasons” given by the Court of Chancery in its opinion, which had rejected the existence of a tort of “deepening insolvency”:
The concept of deepening insolvency has been discussed at length in federal jurisprudence, perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept’s ultimate emptiness.
Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm.
***
If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.
***
No doubt the fact of insolvency might weight heavily in a court’s analysis of, for example, whether the board acted with fidelity and care in deciding to undertake more debt to continue the company’s operations, but that is the proper role of insolvency, to act as an important contextual fact in the fiduciary duty metric.
906 A.2d at 204-205 (footnote omitted) (emphasis added).
This is developing area of the law and we are closely following new decisions as they come out. There is some limited law from a few other jurisdictions in this area as well, although Delaware law is the most developed in the area.
Forms of Insolvency, Liquidation and Restructuring for Businesses
There are a number of forms that insolvency, bankruptcy, liquidation or restructuring can take. Determining the best option depends on a number of factors, which may include (i) size of business, (ii) prospects for successful reorganization, (iii) location and possible venues of bankruptcy or receivership or similar action, (iv) number of creditors/willingness of creditors to work on consensual restructure, (v) pending judgments or foreclosures, (vi) financing or investor funding, (vii) asset or stock purchasers and their levels of comfort and (viii) cost of restructuring. The forms which may be considered include:
Chapter 11 Bankruptcy: A debtor in a Chapter 11 case may seek a reorganization of the business, a going concern sale of its assets or an orderly liquidation. Management generally remains in charge as a debtor-in-possession. The automatic stay generally protects the debtor and its assets from creditors while in Chapter 11.
Chapter 7 Bankruptcy: A Chapter 7 case is generally a straight “fire sale” liquidation in the hands of an appointed bankruptcy trustee with no ongoing business operations post-filing.
Prepackaged or Prenegotiated Bankruptcy: A prepackaged bankruptcy is a Chapter 11 plan with the required votes to confirm the plan actually solicited before the filing and is designed to provide a quicker and more certain exit from bankruptcy. It is best used to deleverage the balance sheet and not where operational fixes are needed or there are material legacy liabilities. A prenegotiated bankruptcy is where one or more major creditor constituencies are on board with a restructuring of their position when the case is filed but no formal solicitation of ballots has taken place. Sometimes people refer casually to a prepackaged bankruptcy when in fact there is only some notion (not voted upon by the impaired creditors) of an exit strategy.
Out of Court Exchange Offer: An out of court exchange offer can be used to change the terms of bonds and certain other debt to help with a liquidity crunch or otherwise. To minimize holdouts, it is often proposed in connection with the possibility of a prepackaged or other bankruptcy if necessary consent thresholds for the exchange offer are not met so that there is the possibility of a bankruptcy court binding the hold-outs to the same treatment of the class.
Assignment for the Benefit of Creditors: In certain jurisdictions, state law assignments for the benefit of creditors are used as a sometimes cheaper and more flexible alternative to bankruptcy. These assignments are non-judicial in some states and judicially supervised in other states. They are typically used for quick sales (generally within a few weeks of the assignment taking place) or an orderly winddown of smaller companies.
UCC Article 9 Foreclosure Sale of Personal Property: In this situation, a secured creditor can foreclose on property it has a collateral interest in on a fairly quick and non-judicial basis and sell it to a third party buyer. This alternative works best when secured creditor has a blanket first lien on all assets necessary to operate the business and the real estate locations are leased and have a cooperative landlord.
Judicial or Non-Judicial Foreclosures of Real Property: Real property foreclosures tend to take significantly more time than personal property foreclosures under the UCC and are often judicial. Mechanics, materialman or tax liens or junior secured lenders can further complicate and delay most real estate foreclosures.
Out of Court Asset Sale: In this situation, a purchaser buys assets on an out of court basis and gets comfortable with any potential successor liability or fraudulent transfer risks. Generally requires perfected secured creditors to consensually release their lien at closing and consent from counterparties to key contracts, leases and licenses.
Composition of Creditors: In this situation, the company organizes its key creditors on an informal basis and effectuates on a generally consensual basis a restructuring without a court proceeding. Generally need a manageable number of creditors who are realistic and able to cut a deal.
Series of Discounted Settlements with Creditors: Companies can also strike deals individually with creditors for one-off discounts or deferred payments, perhaps using the threat of a bankruptcy, litigation or shut down to obtain concessions.
Receivership: Creditors (usually secured creditors) or dissenting shareholders in some circumstances can sometimes obtain a court appointed receiver to operate the business and perhaps to sell or liquidate its assets.
Dissolution/Shutting Doors: Certain businesses, generally with few assets (like the busted Dot.coms) merely shut down and disappear without any formal bankruptcy proceeding. Corporate or similar dissolution statutes generally provide a mechanism to address creditors claims and any remaining assets and proceeds.
Distressed Purchases and Sales of Assets and Businesses
Especially for buyers who have cash or quick access of cash and the ability to close quickly, purchases of distressed businesses can be a wonderful opportunity to add to their business and portfolio at bargain prices. In evaluating different forms of offer, among the concerns to be considered are (i) any public shares or debts, (ii) successor liability issues, (iii)environmental, pension and other legacy liabilities, especially if they may run with assets or facilities/business lines being acquired, (iv) tort or class action claims, (v) amount and number of holders of secured liens and ability to obtain a consensual release of those liens, (vi) amount and significance of material contracts, leases and licenses to be assigned to the purchaser and (vii)fraudulent transfer risks. Among the terms the asset purchase can take include:
Sections 363 and 365 Sale: Under Sections 363 (for assets) and 365 (for executory contracts and unexpired leases) of the Bankruptcy Code, a business can generally be bought on a free and clear basis and the ability of secured creditors or contract counterparties or landlords to hold up a transaction is limited. The bankruptcy court order often provides for broad protections for the purchaser. The buyer can also have significant input on break-up fees, bid procedures and auction process timing. Most Section 363 are competitive auctions and exclusive private sales are disfavored in bankruptcy cases.
Chapter 11 Sale Plan: A sale can also be effectuated through a Chapter 11 plan, which can provide even broader protections, but is more expensive, time consuming and risky to pursue.
Purchase from Secured Lender: Assuming the lender has a lien on the assets the purchaser wants, the purchaser can buy from the lender at a foreclosure sale or post-foreclosure or may consider buying the lender’s secured position and then exercising remedies itself. Such sales may be public sales or in some cases, private sales under the Uniform Commercial Code.
Purchase from Assignee for the Benefit of Creditors or Receiver: While not as protective as a purchase blessed by a bankruptcy court order, there can be significant advantages of buying assets from an assignee for the benefit of creditors or a receiver over an out of court asset purchase.
Out of Court Asset Purchase: Assuming the purchaser can get comfortable with the successor liability, fraudulent transfer and other risks, out of court asset purchase can work. The primary advantage of an out of court asset purchase is the ability to get an exclusive right to close and to avoid having to deal with court or other processes to close the sale.
Business Judgment Rule: Especially from the prospective of the seller’s board of directors, it is important to have a sound record in approving the sale transaction to provide business judgment rule protection if the sale is later challenged on fraudulent transfer or other grounds.
Contracts, Leases and Licenses
Pre-Petition Termination: As a general matter, pre-petition terminations or expirations of contracts, leases and licenses are effective and bankruptcy does not bring the contract back to life. There are important considerations in how the termination notice is phrased and to the extent allowed by law and contract, the counterparty wants the termination to be either immediately effective or if any time period is provided or required, to be automatically effective at the end of that period with no further notice or action in case there is a bankruptcy filing during the notice period (if any) and the automatic stay is in effect.
Executory Contracts: Executory contracts are generally contracts under which material performance remains on both sides of the contract. If only a payment obligation remains due or the agreement expires, it is no longer “executory.” Generally, the debtor takes until the time of a Chapter 11 plan or a going concern sale to determine whether it is going to assume, assume and assign or reject contracts, although they often reject burdensome contracts earlier. In Chapter 7, contracts are generally deemed rejected 60 days after the petition date absent assumption or waiver.
Equipment Leases: The debtor is required to start paying for use at the contract rate if it does not reject the equipment lease within 60 days of the filing for going forward use and possession. Sometimes debtors take the position that the equipment lease is not a true lease but rather a loan or financing transaction. Having a precautionary UCC filing to that effect can be important for equipment lessors.
Real Property Leases: There is an initial 120 day period to assume or reject non-residential real property leases in bankruptcy, which can be extended for up to another 90 days if the Bankruptcy Court finds “cause” to do so. Any extension of the decision period beyond 210 days after the petition date now requires the landlord’s consent. Landlords are also entitled to payment of post-petition rent pending a decision by the debtor on whether to assume or reject.