by Josiah Daniel, Lawyer Contributor
(EDITOR’s NOTE: The Texas Lawbook asked noted bankruptcy lawyer Josiah Daniel to author a series of articles on the U.S. bankruptcy system for businesses. We invite our subscribers to submit substantive commentary on this article or in response to any article in The Texas Lawbook.)
NOVEMBER 27 — Here we are in 2011, thirty-three years after the enactment of the federal Bankruptcy Code. The economy is struggling, with many Texas business enterprises experiencing reduced revenues and with unemployment at undesirable levels. But the number of Chapter 11 cases being filed this year is significantly down from the levels of the preceding several years. Why?
A generational change may be underway. It is commonly said that a generation is about 30 to 40 years; and the end of one generation and the beginning of another is regarded as a time of change or transition. The present Chapter 11 law was enacted on November 6, 1978, and over the decades, and particularly in the past ten or so years, significant changes have occurred and are continuing in that reorganization law. So at this point it may be said that we have lived through the first generation of the modern Chapter 11.
Coincidentally, I received my law license on the same day the Code was enacted. Having represented debtors and creditors under that law for 30 years, I have some observations about what has been learned in the first generation and where reorganization of financially distressed firms is headed in the second.
Congress intended the new Chapter 11 to significantly improve the prior reorganization provisions of federal bankruptcy law that had been known as “Chapters X and XI.” The major changes facilitated the rehabilitation of troubled companies by making it easier for debtors to formulate and confirm comprehensive plans of reorganization.
The first thing to notice about the past three decades of Chapter 11 is the extent to which American firms —huge public companies and small private firms alike — have accessed the relief it offers. The Administrative Office of U.S. Courts reports that from 1980 to 2010, 1,668,008 companies (and a few individuals) filed Chapter 11 cases. To mention but a few, Texaco filed in 1987; almost all the airlines have passed through bankruptcy court; most companies that ever dealt with asbestos have had Chapter 11 cases; financially collapsed firms such as Enron and Lehman have filed; and of course General Motors and Chrysler recently reorganized through Chapter 11.
The popularity of Chapter 11 is a reflection of its utility for dealing with the problems of troubled firms. Although Congress has amended Chapter 11 significantly three times, Chapter 11 continues to furnish a number of tools that are quite useful for resolving otherwise intractable issues presented by financial distress. In short, Chapter 11 aids the preservation and enhancement of the value of a firm’s assets, the resolution of disputed claims, and the equitable allocation of that value among the enterprise’s constituencies.
Yet Chapter 11 has never been a panacea, and it has limits. It is not appropriate, for example, to use it to deal with a single difficult lawsuit. It is verboten to use Chapter 11 as a stalling tactic to postpone foreclosure of a limited partnership’s sole asset such as an apartment complex. And if the raison d’être of the business has vanished, Chapter 11 will not bring it back.
And, importantly, Chapter 11 is the last, not first, resort. Out-of-court workouts or restructurings can be cheaper and faster. Refinancings of funded debt and sales of non-core assets may be adequate to provide enough relief from financial pressure to ensure the survival of the firm and the fair treatment of creditors.
If an out-of-court restructuring effort flounders, however, Chapter 11, employed as the last resort, is not a bad option for the financially troubled company. The fundamental concepts and benefits are as good and workable today as three decades ago. For instance, the “automatic stay” provided by Bankruptcy Code section 362 stops collection activities and provides a breathing spell for the debtor’s management.
Moreover, the broad definition of “property of the estate” in Section 541 of the Code enhances the wherewithal available for the satisfaction of claims. Section 363 authorizes the sale of estate properties under the imprimatur of the federal bankruptcy court – not just particular assets but even all assets of the firm when necessity dictates – free and clear of liens and claims, thereby significantly enhancing value. Asset purchasers will bid up the price of estate assets because the title is thus cleansed of the taint of prior mortgages and most sorts of claims. Contrast the often poor alternative of piecemeal foreclosure sales.
Chapter 11 also establishes a platform for the debtor and the principal creditors to negotiate for a new “deal,” a plan of reorganization or of liquidation, that, once confirmed by the court, becomes the new contract that binds all creditors and has the force and stature of a federal court judgment. The court will take into account the votes of the creditors to accept or reject the plan; and through the mechanism of the colorfully named “cramdown,” if all the statutory criteria are met, the court will confirm the plan even over the dissent of creditors, secured or unsecured.
This is powerful law, and during the first generation, limits on Chapter 11 have evolved in three ways: by congressional amendment, by Supreme Court interpretations, and through usage of the parties.
The congressional amendments came in several waves, each at the behest of interested creditor groups. The first was in 1984, after the Supreme Court held a portion of the jurisdiction accorded to bankruptcy judges by the Bankruptcy Reform Act of 1978 to be constitutionally infirm. The 1984 legislation tried to fix the jurisdictional problem, and it also strengthened the rights of landlords and limited the options of debtor-lessees with respect to nonresidential real estate leases.
The next serious amendment of Chapter 11 came in 1994, with limits placed on single-asset real estate cases and strengthened rights accorded to vendors.Congress enacted the last and most recent legislative amendments in 2005, including maximum time limits for a debtor to file a plan and for extensions of time to assume or reject nonresidential realty leases, along with other new hurdles to operating-company reorganization.
Second, the Supreme Court has altered Chapter 11 by a series of key holdings that include augmenting secured lender protections, restricting cramdown, and, most recently, trimming the jurisdiction of bankruptcy judges.
Third, the practices and activities of non-debtor parties in restructuring situations have profoundly affected and altered the practice of Chapter 11, particularly since the early nineties. Foremost here is the development of the “Chapter 363 case,” in which the secured lenders encourage, or even force, the debtor to auction its assets very early in the Chapter 11 case, theoretically to preserve and capture going-concern values before they erode.
In such cases, a “stalking horse” or lead bidder is selected in order to set a “floor” for the auction. To “incentivize” a prospective purchaser to put a good foot forward and to commit to make the purchase as the opening price, the debtor typically offers a variety of “bid protections’ to the stalking horse, included a “break-up fee” if it loses the bidding and a set of “bid procedures” that other interested parties must observe to state competing bids. Such procedures include minimum requirements for financial ability, a standard form of asset purchase agreement or “template” for the written offers, and minimum increments for bids. Sometimes the lead bidder seeks measures that can deter or discourage others from bidding, such as the right to “match” any topping offer and break-up fees exceeding the typical 3 percent. After the sale, the case is converted to Chapter 7 liquidation or else a plan of liquidation is confirmed.
For a secured lender, a section 363 sale can be an ideal way to liquidate collateral, far superior to conducting a foreclosure sale or sales under state law. For employees, sometimes the opportunity to retain jobs is accomplished. Typically, the secured lenders are motivated to leave “a tip” on the table for unsecured creditors; most bankruptcy judges have the view that the operation of the Chapter 11 machinery ought not be solely for the benefit of secured creditors.
But a section 363 sale of substantially all assets necessarily precludes a real reorganization under which unsecured creditors could hope or expect to receive payments greater than “a tip” and equity holders might retain, if not full ownership, at least a minority stake in a revitalized firm that could succeed in the marketplace.
Another development that has changed Chapter 11 practice during its first generation is the development and growth of securitizations, in which the revenue streams of “high quality financial assets” such as home mortgages and other receivables are isolated from the assets of a sponsor in a “bankruptcy remote” structure or vehicle, typically a limited liability company. “Ring fencing” is a more extreme form of providing bankruptcy remoteness for the benefit of creditors who extend credit or buy such assets in reliance on never having to go to bankruptcy court. Such mechanisms are generally thought to prevent or avoid Chapter 11 cases.
Moreover, beginning in the 1990s and continuing with increasing force, the “loan to own” strategy has become prominent in Chapter 11 cases. As the traditional commercial banks have become loathe to hold and collect nonperforming loans, a community of ready buyers of “distressed debt” has developed. Such debt buyers often actually prefer to take ownership of the firm – through a confirmed plan of reorganization that converts their debts to full ownership of the reorganized company – rather than receiving payment, even in full, of the loan because they desire the opportunity to manage the firm and to capture the upside, if successful, for themselves.
So returning to the question of the present dearth of new Chapter 11 filings, it may be that historically low interest rates, the reluctance of commercial lenders to initiate default and foreclosure steps and their preference to renew and extend maturities, and the amount of money sloshing around the financial system may be the reasons.
But success of any business enterprise is never assured in the free market system; and at some point in this business cycle, interest rates will rise, the banks will become proactive in enforcing their rights under credit agreements, and the management of financially pressured companies will have to make tough decisions. Managers and general counsel should therefore acquaint themselves in advance with the option of last resort, Chapter 11, and learn about the relief for unpayable debt that, notwithstanding the changes of the first generation, is nowhere else available. In short, Chapter 11 is alive and entering into its second generation.