A T T O R N E Y S An Overview of the Chapter 11 Reorganization Process THE SECOND FORUM FOR ASIAN INSOLVENCY REFORM (FAIR) Bangkok, Thailand December 16 & 17, 2002 Presented by George Kelakos, Co-Chair of the International Committee of the American Bankruptcy Institute Heller Ehrman White & McAuliffe LLP Introduction Economic Premises of Chapter 11 (Reorganization) Players Strategic Objectives of Players Valuation Issues Heller Ehrman White & McAuliffe LLP Phases Of A Chapter 11 Case Prepetition Initial Phase Middle Phase Final Phase Heller Ehrman White & McAuliffe LLP Economic Premises of Chapter 11 (Reorganization) A business, even though not currently able to meet its obligations, can sometimes be restructured so that creditors receive more from future profits (or a sale of company) than the “auction value” of the assets; excess of “going-concern value” of assets over “auction value” (“going-concern premium”) is usually divided between creditors and stockholders so that in a successful reorganization, both groups do better than they would under Chapter 7. Heller Ehrman White & McAuliffe LLP Economic Premises of Chapter 11 (Reorganization) Chapter 11 case commenced when bankruptcy petition is filed with bankruptcy court Voluntary petition can be filed by Debtor Creditors (with certain requirements) and a foreign representative of a debtor’s estate in a foreign proceeding can file an involuntary petition Heller Ehrman White & McAuliffe LLP Who May Be A Debtor? Bankruptcy remedies are available to all business entities in the U.S. (corporations, limited liability companies, sole proprietorships, and partnerships are all eligible for liquidation under chapter 7 or reorganization under chapter 11) Chapters 7 and 11 are also available to individuals Heller Ehrman White & McAuliffe LLP Who May Be A Debtor? Other chapters include chapter 9 (reorganization of municipalities and other subdivisions of state government), chapter 12 (reorganization of family farms), and chapter 13 (a simplified reorganization available to individuals with regular income and limited debts) Railroad reorganizations have specific requirements under chapter 11 Stock and commodity brokers cannot file chapter 11, only chapter 7 Heller Ehrman White & McAuliffe LLP Cast of Principal Characters Debtor-in-possession (“DIP”) - debtor remains in control (fiduciary, no trustee appointed), and has possession of assets DIP has rights, powers, and duties of a trustee Bankruptcy judge (independent court /“unit” of U.S. District court given decision-making power over bankruptcy cases)-- primary role is to adjudicate disputes U.S. Trustee - officer of department of justice administers cases and performs a number of statutory duties Heller Ehrman White & McAuliffe LLP Cast of Principal Characters Committees “watch dog” for their constituents (may be multiple committees) (fiduciary role), and can file plan Bank(s) Trade creditors (“single shot”/“long-term”) Machinery and equipment lender(s) Landlord(s) Equity security holders Heller Ehrman White & McAuliffe LLP Cast of Principal Characters: Professionals Legal advisors (Debtor/committee/bank/other creditors) Financial advisors (Debtor/committee) Accountants Turnaround management/business advisors Investment banker Valuation/liquidation experts Brokers Heller Ehrman White & McAuliffe LLP Strategic Objectives of Players What are their goals? The debtor keeps business alive (for benefit of equity holders) Banks and M&E lenders maximize return on disposition of collateral Landlord: Rising real estate market: oppose reorganization efforts Falling real estate market: may support reorganization efforts Heller Ehrman White & McAuliffe LLP Strategic Objectives of Players What are their goals? Unsecured creditors: “Single shot” no interest in long-term, oppose debtor “Long run” retain debtor as a customer, support debtor Equity holders: keep business alive Heller Ehrman White & McAuliffe LLP Valuation Issues “Retail”-value (fair market value?) at which collateral can be sold to ultimate user “Wholesale”- value at which collateral can be sold to dealer “Forced Sale”- “quick and dirty” value(necessary with perishables) “Going Concern” or “Enterprise” value”--essential operating assets are sold as an entity (calculate value by applying a multiple to projected profit) Heller Ehrman White & McAuliffe LLP Valuation Issues “Reorganization value” - “going concern” value plus the “upside” (future expectation) Combination of two or more of the foregoing Source: Queenan, James F., “Standards for Valuation of Security Interests in Chapter 11,” 92 Commercial Law Journal at 19, et. seq. Heller Ehrman White & McAuliffe LLP Phases Of A U.S. Reorganization Case Prepetition Strategic considerations Debtor Lenders Trade creditors Heller Ehrman White & McAuliffe LLP Phases Of A U.S. Reorganization Case Initial phase Petition/automatic stay Cash collateral Postpetition borrowing Relief from the automatic stay Heller Ehrman White & McAuliffe LLP Phases Of A U.S. Reorganization Case Middle phase Executory contracts and unexpired leases Assets sales (public/private) Avoidance actions Development of business plan (exclusivity extensions/bar date motion) Heller Ehrman White & McAuliffe LLP Phases Of A U.S. Reorganization Case Final phase Plan confirmation process Elements of a plan of reorganization Disclosure statement Confirmation standards Heller Ehrman White & McAuliffe LLP Prepetition Strategic Considerations Open lines of communication with parties may result in debtor filing case with support of bank and major creditors Parties gain time to prepare voluminous paperwork required for a reorganization case (prenegotiated or prepackaged) Heller Ehrman White & McAuliffe LLP Prepetition Strategic Considerations When events cause an emergency filing of a petition or where the major players (bank/key trade creditors) are not consulted, a number of issues may arise: Immediate cash crunch Increased tensions/lost debtor credibility/diminished creditor confidence Heller Ehrman White & McAuliffe LLP Prepetition Strategic Considerations When events cause an emergency filing of a petition or where the major players (bank/key trade creditors) are not consulted, a number of issues may arise: Creditors may take precipitous action (file an involuntary petition) Emergency may be harmful to debtor’s business/operations Heller Ehrman White & McAuliffe LLP Prepetition Debtor Does debtor have cash reserves? If so, what is the “burn rate” How will case be funded? (cash collateral stipulation/motion/borrowing motion) Are there sufficient funds to cover initial payroll? Can petition be timed to minimize unpaid prepetition wages? Heller Ehrman White & McAuliffe LLP Prepetition Debtor Is an open line of communication maintained with key lender(s) and trade creditors? Have the debtor and its reorganization team begun to prepare the documents and motions necessary for a bankruptcy filing? Does the debtor have an exit strategy? Heller Ehrman White & McAuliffe LLP Prepetition Lender Is lender receiving sufficient information from the debtor (is there an open line of communication)? Does lender “want out” of the credit? If so, lender may take aggressive action forcing debtor to file Does lender want to continue financing a DIP? If so, lender will seek to negotiate key terms of cash collateral/postpetition borrowing stipulation Heller Ehrman White & McAuliffe LLP Prepetition Trade Creditors Strategy may depend on “which side of the fence” the creditor falls “Single shot” creditors may not have an interest in pursuing a long term relationship with the debtor will aggressively pursue collection efforts “Long-term” creditors may wish to maintain debtor as a future customer (make up losses through future sales) will cooperate with debtor and actively support reorganization (extend postpetition credit)? Heller Ehrman White & McAuliffe LLP Initial Phase Petition/automatic stay Cash collateral Postpetition borrowing Relief from automatic stay Summary of strategic consideration Valuation issues Heller Ehrman White & McAuliffe LLP Initial Phase Petition / Automatic Stay Debtors (or creditors) run to court (castle) to seek relief (sanctuary/time/control of asset disposition) Once debtor enters castle gate (bankruptcy petition filed/order of relief is entered), the gate is closed (automatic stay (moratorium) is imposed) Automatic stay stops actions against debtor or property of the estate Heller Ehrman White & McAuliffe LLP Initial Phase Petition / Automatic Stay Automatic stay (moratorium) freezes position of creditors and makes bankruptcy court the sole forum for dispute resolution Relief from automatic stay is granted only upon leave of court Heller Ehrman White & McAuliffe LLP Initial Phase Cash Collateral The problem: Debtors usually face a “cash deficit” at outset of case Cash or cash equivalents are often a secured creditor’s “cash collateral.” They are collections of accounts subject to security interests or proceeds from the sale of pledged inventory or equipment. Heller Ehrman White & McAuliffe LLP Initial Phase Cash Collateral The problem: Unless there is an agreement with creditor to use “cash collateral,” debtor must seek emergency relief to use “cash collateral” Without court relief, there is no hope of a successful reorganization Heller Ehrman White & McAuliffe LLP Initial Phase Cash Collateral The solution: Under U.S. Law, a prepetition security interest does not apply to postpetition property (exception: proceeds) Debtor is allowed to use non-cash collateral (real estate, M&E, inventory) in the “ordinary course of business” Secured creditor is entitled to ask court for “adequate protection” of its interest in the property Heller Ehrman White & McAuliffe LLP Initial Phase Postpetition Borrowing Debtors often cannot operate (or reorganize) without new funding (even use of cash collateral may not be enough to keep business afloat) In U.S., solution is for debtor to obtain a new loan (with court approval) from either the existing lender or a new lender (super priority loan) Heller Ehrman White & McAuliffe LLP Initial Phase Postpetition Borrowing Postpetition Lenders in U.S. Often attempt to attach “onerous” terms to the new loan: Higher interest rates Cross-collateralize prepetition debt with postpetition collateral “Sign off” by all parties on validity/perfection issues/release of claims Assignment of proceeds of avoidance actions Bind future and successor trustees Heller Ehrman White & McAuliffe LLP Initial Phase Postpetition Borrowing Courts in U.S. will often allow economic terms but will strike onerous terms from loan agreement (“level the playing field”) Heller Ehrman White & McAuliffe LLP Initial Phase Relief From Automatic Stay For “cause,” including lack of “adequate protection” Where debtor has no equity in property and property is not “necessary to an effective reorganization” Heller Ehrman White & McAuliffe LLP Initial Phase Relief From Automatic Stay What is “adequate protection”? Protection vs. decline in “value” Common forms of adequate protection: periodic cash payments; replacement lien on postpetition assets Heller Ehrman White & McAuliffe LLP Initial Phase Summary of Strategic Considerations For all - avoid “crying wolf” (your credibility is at stake). Seek and expect only the minimum relief necessary For all - pick your fights carefully (attempt to resolve disputes out of court) Bank - is lender satisfied with debtor’s projection? Does lender intend to continue funding debtor postpetition? Get budget from debtor Heller Ehrman White & McAuliffe LLP Initial Phase Summary of Strategic Considerations Debtor - has the debtor team provided the necessary projections and budget information to lender and to parties in interest (cash collateral)? Has the debtor’s team prepared the necessary backup information for motion to pay prepetition wages and other first day motions (procedural motions / professional retention)? Creditors - preserve creditors’ rights (Court may grant minimum relief -- to preserve balance in negotiating positions) / may want to file proof of claim Heller Ehrman White & McAuliffe LLP Initial Phase Valuation Issues Automatic stay Does debtor have “equity” in collateral above the lien? Has collateral experienced a “loss or diminution of value”? Is proposed “adequate protection” sufficient? Heller Ehrman White & McAuliffe LLP Initial Phase Valuation Issues Use of cash collateral: Has collateral experienced a “loss or diminution of value”? Is proposed “adequate protection” sufficient? Heller Ehrman White & McAuliffe LLP Initial Phase Valuation Issues Postpetition borrowing Valuation of “new” collateral for new loan (risk assessment) Heller Ehrman White & McAuliffe LLP Middle Phase Executory contracts and Unexpired leases Asset sales Examination/pursuit of avoidance actions Development of business plan Valuation issues Heller Ehrman White & McAuliffe LLP Middle Phase Executory Contracts and Unexpired Leases “Executory” contracts or leases - are contracts or leases where performance, to some extent, remains due on both sides If executory, debtor may assume or reject Examples of executory contracts: Franchise or distributor agreements Heller Ehrman White & McAuliffe LLP Middle Phase Executory Contracts and Unexpired Leases Examples of non-executory contracts: Personal service contracts/contracts to make a loan or extend financing Debtor may assume an executory contract or an unexpired lease under the following conditions: Debtor must cure defaults or provide adequate assurances that it will promptly cure defaults, and provide adequate assurances of future performance under the contract/lease Heller Ehrman White & McAuliffe LLP Middle Phase Executory Contracts and Unexpired Leases Once debtor assumes executory contract or unexpired lease, debtor may assign such contract/lease to a third party if such third party provides adequate assurances of future performance Special rules for non-residential leases and other types of contracts Heller Ehrman White & McAuliffe LLP Middle Phase Asset Sales Purpose: Dispose of non-essential assets in a manner generating highest possible return for debtor’s estate Heller Ehrman White & McAuliffe LLP Middle Phase Asset Sales Sales of assets (public or private) outside of a plan of reorganization must be authorized by the court and may be permitted under following circumstances: Assets are rapidly deteriorating (boatload of fish) Notice and opportunity for hearing must be provided Courts require that sale motions provide sufficient background / disclosure to justify sale outside of a plan Courts will test “commercial reasonableness” of proposed sale (method of sale, marketing and Heller Ehrman White & McAuliffe LLP advertising) Middle Phase Asset Sales How will assets be sold (public vs. Private sale)? Professionals (broker/liquidation/valuation expert/auctioneer) will often be employed to maximize return to debtor’s estate How will parties (and court) know that method of sale/proposed sale will generate highest possible return? Parties will seek advice of professional valuation expert to obtain fair market value, liquidation value appraisals to demonstrate that price/method of sale is commercially reasonable and is in best Heller Ehrman White & McAuliffe LLP interest of debtor’s estate Middle Phase Asset Sales Benefits of Asset Sales: Finality (protection for good faith purchases, no unwinding of sale on appeal) Speed Costs/expenses are usually less than alternatives Generally, “clean” title (sale free and clear of liens, encumbrances and attachments) (particularly in real estate transactions) is transferred Heller Ehrman White & McAuliffe LLP Middle Phase Avoidance Actions U.S. law favors fair and equal treatment of similarlysituated creditors in proportion to their claims (as opposed to first come, first served) Prepetition transactions may be “avoided” (set aside) for actual fraud, inadequate consideration (“fraudulent transfers”), or preference of one creditor over others Heller Ehrman White & McAuliffe LLP Middle Phase Avoidance Actions Sometimes assets are transferred within the applicable “avoidance period” for less than fair value $ equivalent of assets may be recovered for benefit of debtor’s estate DIP or trustee can bring avoidance actions Heller Ehrman White & McAuliffe LLP Middle Phase Development of Business Plan The key to a successful consensual business reorganization case is a credible, viable business plan Identify, evaluate: Assets and earning power of business Secured and unsecured liabilities Priority liabilities, including costs of proceeding Heller Ehrman White & McAuliffe LLP Middle Phase Development of Business Plan Determine if business is viable Consider structural approaches; stand alone, sale or merger Design business plan which business can perform and which addresses key economic requirements Develop financial projections for plan model Develop liquidation analysis (needed for plan of reorganization) Heller Ehrman White & McAuliffe LLP Middle Phase Valuation Issues Asset sales: Fair market value and liquidation analyses will be required to support sale of assets outside of a plan Avoidance actions: Parties may seek expert testimony concerning value of assets transferred within applicable avoidance period Heller Ehrman White & McAuliffe LLP Middle Phase Valuation Issues Development of business plan: Plan proponent(s) will require professional assistance in order to generate a liquidation analysis for the plan of reorganization Heller Ehrman White & McAuliffe LLP Final Phase Plan confirmation process Disclosure statement Elements of a plan of reorganization Confirmation standards Heller Ehrman White & McAuliffe LLP Final Phase Plan Confirmation Process The process: Plan proponent files disclosure statement and plan of reorganization Court conducts hearing on disclosure statement Plan proponent(s) disseminate(s) plan (and disclosure statement) to creditors and parties in interest along with: (i) notice of confirmation hearing (deadline to object to plan); And (ii) voting ballot Heller Ehrman White & McAuliffe LLP Final Phase Plan Confirmation Process The process: Court conducts hearing on confirmation of plan Confirmation of plan discharges debtor from any debt that arose before confirmation (some exceptions) Confirmed plan creates new contractual rights, replacing or superceding pre-bankruptcy contracts Heller Ehrman White & McAuliffe LLP Final Phase Disclosure Statement The disclosure statement is a “prospectus” -- a document intended to provide “adequate information” (the debtor’s history, assets and liabilities, operations in the case, description of the business plan, the plan funding, pre and post-confirmation management, avoidance actions, tax issues, risk factors and alternatives to the plan) to creditors/parties in interest to assist them in determining whether to vote for or against the plan Heller Ehrman White & McAuliffe LLP Final Phase Disclosure Statement In contrast to the (often) complex, technical plan of reorganization, a good disclosure statement will describe in “plain language” the business plan embodied in the plan of reorganization along with the risk factors and alternatives to the plan (detailed liquidation analysis) Heller Ehrman White & McAuliffe LLP Final Phase Elements of a Plan of Reorganization Plan of reorganization must be drafted to embody key economic terms/requirements of the business plan The plan of reorganization must provide for: Payment of priority claims (includes administrative costs of case) Classification of claims Heller Ehrman White & McAuliffe LLP Final Phase Elements of a Plan of Reorganization Plan of reorganization must be drafted to embody key economic terms/requirements of the business plan The plan of reorganization must provide for: Satisfy “best interests/liquidation equivalent” requirement on unsecured claims Treatment of equity security holders Economic components (sale, capital infusions, debt modification, designation of plan administrator, prospective management) Heller Ehrman White & McAuliffe LLP Final Phase Confirmation Standards Proposed in good faith Plan and proponent in compliance with code “Best interest of creditors” test plan provides creditors/interest holders with liquidation (Chapter 7) value or greater (valuation issues) “Feasibility” test Acceptance of plan by all classes Heller Ehrman White & McAuliffe LLP Final Phase Confirmation Standards “Cramdown” Requires acceptance by at least one impaired class (majority in number of allowed claims in class, 2/3 in $ amount for which ballots are cast) Plan proponent must show plan treats nonaccepting class “fairly and equitably” and does not “unfairly discriminate” vs. non-accepting class Heller Ehrman White & McAuliffe LLP Final Phase Confirmation Standards “Cramdown” Secured creditors must receive full value of their collateral either in immediate cash or in NPV of payments/time “Absolute value” rule, no junior class will receive or retain property on account of its interest (new value exception?) Heller Ehrman White & McAuliffe LLP Final Phase Confirmation Standards Plan not likely to be followed by liquidation or need for further financial reorganization Heller Ehrman White & McAuliffe LLP Concluding Observations In an ideal reorganization case, parties will use the time afforded by the filing of the petition and the court (sanctuary) to arrive at a consensual plan so that the enterprise can be rehabilitated and emerge from the bankruptcy proceedings Use time wisely (slow reorganization may result in a quick death) Heller Ehrman White & McAuliffe LLP Concluding Observations Keep lines of communication open between constituent groups to arrive at a consensual plan of reorganization Credibility - once lost, it’s almost impossible to regain Pick your fights carefully Heller Ehrman White & McAuliffe LLP Concluding Observations Only when there are points of contention which cannot be resolved through negotiation, should parties resort to the court for assistance Bankruptcy forum affords a central place for the resolution of disputes but resources of the judge should be used wisely (use the judge as a facilitator) Committees can play a very important role in the case, alternating between siding with the debtor or opposing the debtor to negotiate the best economic terms for their constituency (threat of a competing plan) Heller Ehrman White & McAuliffe LLP A T T O R N E Y S Presented by George M. Kelakos Heller Ehrman 601 S. Figueroa St. Los Angeles, California 90017 (213) 689-7652 gkelakos@hewm.com Heller Ehrman White & McAuliffe LLP