Changing Face of Chapter 11 January 2014
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The webinar discusses the evolution of Chapter 11 bankruptcy for operating businesses, highlighting a shift from a two-stage reorganization approach to a quicker sale process under section 363, largely pre-negotiated before filing. The document notes a decline in bankruptcy filings and shorter case durations, with an increase in 363 sales as a strategy to expedite bankruptcy proceedings. Additionally, it details the influence of secured creditors and the importance of pre-arranged financing in these rapid sale transactions.
Changing Face of Chapter 11 January 2014
- 1. THE CHANGING FACE OF CHAPTER 11 FOR OPERATING BUSINESSES D. J. Baker, Latham & Watkins Jonathan M. Landers, Scarola, Malone & Zubatov Ted Stenger, Alix Partners January 21, 2014
- 2. Introduction and Scope • Operating businesses today come to bankruptcy ready to roll with major components of their future operating and debt restructure plans in place. A sale pursuant to section 363 occurs quickly, and the case is over except for picking up the pieces that are left. Many well known bankruptcy doctrines and procedures have been swept aside or left behind in the process. This Webinar examines the changes and prepares professionals and clients for the new regime. • The Webinar examines chapter 11 cases involving operating businesses in which the goal is to continue the operating business after the bankruptcy is complete. It does not deal with chapter 11 cases filed simply to liquidate assets. 2
- 3. Introduction and Scope • The Bankruptcy Code was enacted in 1978, effective 1979. Until recently, cases involving the reorganization of an operating business generally proceeded in two stages: (a) Stage 1 was to fix the operating business, introduce efficiencies, discontinue unprofitable lines and close unprofitable or unneeded locations, use the tools of bankruptcy to deal with unnecessary or unprofitable leases or contracts, rationalize employee issues, assert avoiding powers necessary to facilitate an ultimate reorganization, and improve operations and profitability of the reorganized enterprises; and (b) Stage 2 was to negotiate and confirm a plan of reorganization which would implement the business plan and changes described in Stage 1, alter the capital structure (and usually reduce debt), and provide for the treatment of different classes of creditors and holders of equity.
- 4. Introduction and Scope • The new norm is different. Stage 1 has been largely eliminated and is largely carried out before the filing. Upon filing, the Debtor proposes to hold a relatively quick sale under section 363 of the Bankruptcy Code, and usually the Debtor has a proposed purchaser. The Debtor may propose a short sale process or, sometimes, to bypass a sale process entirely on the grounds that a proposed sale was been preshopped and/or one or more secured lender is seriously undersecured and intends to credit bid its debt (more on this later). Generally, the business restructure, proposed sale, and distribution of proceeds have been pre-negotiated and are supported by most major constituencies (often there is a “Support Agreement”). As part of the process, the Debtor obtains a short term DIP Loan, usually from an existing lender. The actual sale takes place in 60-90 days, and thereafter, the debtor either liquidates in chapter 11, converts to chapter 7, or dismisses the case. Lest one think this applies only in small cases with relatively simple capital structures, it actually has been used in the largest cases—GM and Chrysler are examples, but there are scores of cases involving sales of assets valued at $1 Billion or more.
- 5. The Number of Bankruptcy Filings Has Been Falling • The total number of filings has come down from a recent peak of 60,837 in 2009, with 25,505 filings through the third quarter of 2013 • Larger companies have been able to access liquid credit markets to extend maturities and avoid filing • Chapter 7 cases make up a larger proportion of overall filings (62.6% in 1998 vs. 68.1% in 2012) 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013YTD Numberof Bankruptcy Filings 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 1998 2001 2004 2007 2010 2013YTD Type of Filings Total Filings Chapter 7 Chapter 11 Source: Administrative Office of the U.S. Courts: http://www.uscourts.gov/Statistics/BankruptcyStatistics.aspx
- 6. Shorter Case Durations • The duration of bankruptcy cases has been decreasing steadily since 1980 • The revision of the Bankruptcy Code in 2005 (Bankruptcy Abuse Prevention and Consumer Protection Act ) capped a debtor’s exclusivity period at 18 months, putting pressure on companies to reorganize more quickly 0 200 400 600 800 1,000 1,200 1,400 1,600 1980 1985 1990 1995 2000 2005 2010 MedianDays:PetitiontoConfirmation Year of Filing Duration of Bankruptcy Cases Source: UCLA-LoPucki Database as of December 20, 213.
- 7. More Pre-Packaged, Pre-Negotiated Filings • Pre-packaged and pre-negotiated filings are growing in number, further supporting the shorter case durations, but they are not without risks • Due to the short duration of a prepackaged bankruptcy, there often is insufficient time to use all of the tools available under the Bankruptcy Code, such as lease and executory contract rejections 17.1% 60.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 2008 2009 2010 2011 2012 2013 PercentageofChapter11Filings Year of Filing Percentage of Prepack/Prenegotiated Source: UCLA-LoPucki Database as of December 20, 213.
- 8. Smaller Size Companies • The median size of companies filing for bankruptcy in 2013 was $1.1 billion (pre- petition assets), significantly below the 2009 peak of $14.4 billion and also lower than $2.7 billion in 2000 • This most likely reflects the fact that larger companies have greater access to the high yield market, while smaller companies are left with no choice but to file $0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 $16,000 Pre-PetitionAssets($Mil) Year of Filing Median Pre-Petition Assets at Filing Source: BankruptcyData.com
- 9. 363 Sales on the Rise • 363 sales are becoming an increasingly popular strategy to avoid a drawn out bankruptcy process • 34% of all cases disposed in 2013 used a 363 sale process, up from 18% in 2012 34% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 PercentageofCasesDisposed Year of Disposition 363 Sales as % of all Cases Disposed Source: UCLA-LoPucki Database as of December 20, 213.
- 10. Serial Defaults are On the Rise in Spite of Good Times • Despite the US credit market being flush with liquidity throughout most of the past decade, there has been an increase in the number of companies defaulting for the second time or more • This indicates that quick balance sheet fixes are not working, leaving companies with poor underlying operations that can not support their capital structures 0 5 10 15 20 1984 1989 1994 1999 2004 2009 NumberofFilings Year of Filing Chapter 22 and Chapter 33 Filings Chapter 22 Chapter 33 Source: The Journal of Corporate Renewal, February 3, 2010, Post-Chapter 11 Bankruptcy Performance: Avoiding Chapter 22
- 11. Chapter 22 Haven’t Changed Much in 20 Years But… • Serial filings have not changed much over the past 20 years although the increase in out of court restructurings may be acting to reduce serial filings 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Percent Refiling 13% 33% 14% 13% 0% 9% 29% 8% 9% 20% 17% 18% 56% 30% 36% 40% 14% 15% 4% 9% 32% 19% 25% 30% Cos Emerging 8 9 7 8 11 11 14 37 33 20 12 11 16 10 22 25 37 54 53 32 25 16 20 10 0% 10% 20% 30% 40% 50% 60% 70% PercentRefiling Emergence Year Percent of Companies Emerging in Year Indicated that Filed a Second Bankruptcy within Five Years, 1985 ‒ 2008 Source: UCLA-LoPucki Bankruptcy Research Database PercentRefiling Source: UCLA-LoPucki Database as of January 13, 2014.
- 12. The Sale Process Steps in the Process (discussed in detail below) • Before Filing—retain professionals, negotiate and reach agreement with major constituencies, arrange DIP Financing, shop the assets (need a credible investment banker), have a purchase agreement in place with a so-called “stalking horse” bidder (including provisions for breakup fee), have all bankruptcy documents drafted and ready to file, and have a sale timetable. • Filing. Papers include first day order affidavit (explaining the business, what went wrong, and the proposed sale plan), papers relating to financing including financing agreement and budget, motion for preliminary and final approval of financing), motion to approve sale procedures and timetable for sale, and other common motions for first day relief. • First Day Hearing (often held on the day after filing). Court considers various first day motions, including preliminary approval of financing and sale timetable. As discussed below, this is critical because, in effect, the court signs on to the process.
- 13. The Sale Process • Days 21-30. Appointment of creditors committee, final hearing on financing, hearing on sale procedures. • Day 60. Conclusion of any sales effort and final day for submitting bids. • Day 65. Auction (if necessary). • Day 66. Hearing to approve sale; Court order approving sale • Day 67 + Closing. • Post-Closing. Further activities in case including liquidating of remaining assets, possible plan of liquidation, possible conversion to chapter 7, possible dismissal, and prosecution of avoidance actions and other litigation claims not dealt with in the sale process.
- 14. Characteristics of Cases for Which Quick Sale Process Works • Substantial secured debt; generally, secured debt exceeds value of assets. • Secured debt holders willing to compromise; often, not the the original holders but hedge funds and distressed debt firms who bought debt at discount and secured debt holders willing to show flexibility in making arrangements with legally subordinate parties. • Presence of either a prospective purchaser, or willingness of secured debt holders to purchase (either with cash or a credit bid). • Willingness to purchase all or substantially all of the operating assets, and to assume a significant portion of executory contracts and employment arrangements. Buyer will often try to avoid the need to resolve contentious issues by taking more assets and assuming more obligations than would be justified by purely business considerations. • Professionals with experience in these transactions.
- 15. Planning the Process • Major constituencies must agree to terms including sale, price, bidding procedures. Quick sale process doesn’t work if major constituencies must litigate open issues before the sale takes place. • Arrangements are generally incorporated in some form of support agreement which contains the basic terms of the deal and who gets what, and includes a cooperation agreement and an agreement not to oppose. Support agreement may include a consent to credit bidding; this is important since, in a case where the secured debt is substantially higher than the likely sale price, the debtor will often argue that the sale process should be shortened (or that there should be none) because it is highly unlikely that any sale will be at a price that exceeds the amount of the secured debt which will be credit bid.
- 16. Planning the Process • Identifying a prospective purchaser (often called the “stalking horse”), and entering into a purchase agreement which is similar to an asset purchase agreement in a nonbankruptcy situation (the sale is virtually always an asset sale rather than a stock sale). The purchaser may be a third party paying cash, one or more existing creditors paying some combination of cash or debt, and/or an existing secured lender which will credit bid. The purchase agreement must include identifying the assets to be purchased, dealing with employee and contract issues, and dealing with any regulatory or other issues. The purchase agreement will also generally include an agreed set of sale procedures (and provisions for a break-up fee and expense reimbursement). The debtor will seek approval of such procedures at the start of the case. • The quick sale process requires a willing and supportive debtor. Frequently, the purchase agreement will include provisions for favored constituencies such as trade creditors, insiders, employees and customers. It is critical that these be disclosed to the court.
- 17. Planning the Process • In some situations, prospective purchasers seek to buy fewer than all assets, and to have significantly different provisions for dealing with employees, contracts, etc. Debtors frequently urge the stalking horse to avoid loose ends, and frequently will oppose alternative bids on the ground that they are not sufficiently comprehensive.
- 18. Planning the Process • The arrangement must be such that the judge will approve the proposal as submitted or with minor changes, including the financing aspects, at the start of the case. Once approved, the judge has essentially signed on to the program, and there is little opportunity to turn back. The debtor and others will make the case that the price is fair (and often, that there was a marketing/sales effort), that there is really no alternative, that failure to approve will be fatal to the operating business and will cause loss of jobs and loss of benefits to communities in which the business operates, and that committed financing is only available for a short period. Objectors will be characterized a chronic malcontents or professionals trying to churn the case, and it will be implied to the court that disapproval and failure, and all the adverse consequences, will be his/her fault. At the end of the day, most judges will be unwilling to throw the dice and, instead, will bite hard and sign on.
- 19. Financing Arrangements • Normally provided by an existing lender or with the consent of the existing lender. Financing will be secured by priming lien. New financing usually part of a package with use of cash collateral. • Financing arrangements are tied to the quick sale process. Among the common provisions that support the process are: • Short maturities. • Tight budgets, including limited availability of funds for administrative and professional fees. • Roll up of prepetition debt. Important because it in effect gives the lender a veto over any plan of reorganization. • Required timetables for the sale process with significant variance an event of default. • Provisions governing the distribution of sale proceeds. • “The Dive” — i.e., admissions of the validity of liens and the absence of claims. Also may include limits on investigation period, time for filing litigation, and use of DIP proceeds for investigation and/or litigation.
- 20. Financing Arrangements • Waiver of rights of the debtor under section 506(c) to require creditors to pay the freight for the bankruptcy or, at least, the amount necessary for the sale process. • Sometimes, appointment of a CRO friendly to the proposed process and the lenders. • The financing arrangements often contain provisions which increase the cost of failing to proceed quickly or trying to arrange new financing. These include the roll up (discussed above) and substantial up front fees and cost reimbursements to the lender, and also may contain provisions which require payment of the lender’s prepetition debt.
- 21. The Sale Process • Generally, the first day motions include a motion to approve the sale, and a request that the court hold an early hearing on the sale procedures (including bidding procedures, breakup fees and expense reimbursements, rules governing bidding increments). Frequently, the purchase agreement will include a no-shop provision prior to the time the bidding procedures are approved. • Timetable for identifying prospective bidders, diligence (setting up data room), bids and auctions. As noted, this process may be truncated in some credit bid situations. • Diligence may be limited, especially interviews with key officers and managers.
- 22. The Sale Process • Final bids. Generally, the final bids must include either a signed purchase agreement or an expressed willingness to sign the agreement proposed by the debtor with the stalking course, or a proposed “redlined” agreement reflecting changes sought by the non-stalking horse purchaser. • Auction. Generally, the parties conducting the auction seek to have a common purchase agreement and will first negotiate to try to get the parties to make the various proposals as uniform as possible. In evaluating bids, however, the parties conducting the auction will have to consider the economic impact of differences in contractual provisions. • Selection of Winning Bidder. Usually by debtor with advice of investment bankers unless the court has designated a specific party to conduct the auction (e.g., if insiders are in the purchasing group). Winning bid must be highest and best, not just highest.
- 23. The Sale Process • Hearing to approve sale to winning bidder. Losing bidders may use the hearing to attack the process, claim that the auction was not conducted properly and/or claim that their offer was the highest and best offer and should have been accepted. Courts generally uphold the sale unless there is evidence of some form of wrongdoing.
- 24. What Has Changed • Role of Creditors’ Committee • Unsecured (i.e., trade) creditors formerly played a major role in cases but for a variety of reasons, recent cases involve much lower numbers and amounts of trade credit. Frequently, trade debt is assumed as part of the sale. • Unsecured or Partially Secured Funded Debt. These creditors are often part of the quick sale process. In other situations, the actions of such creditors may be severely limited by debt instruments, subordination agreements and/or intercreditor agreements. • As noted, funding for committee activities is often severely limited. • There is a timing issue since the committee is often not formed until well into the process (2-3 weeks). Lots can happen in that period.
- 25. Legal Requirements for Section 363 Sales • Legal requirements have changed from requiring an emergency (i.e., melting ice cube) or special need for quick sale, to a business judgment standard which is easy to satisfy. Debtors often also cite the unwillingness of financers to provide financing for more than a very short period. • Contents of sale orders have changed from matters limited to “pure sale” matters, to provisions commonly found in reorganization plans including provisions relating to executory contracts and cure payments, employees and benefits, management and benefits, treatment of various layers of debt, capital structure changes and issuance of stock, issuance and allocation of warrants, incentive plans, retaining or closing facilities union contracts and related issues, pension obligations, future retirement benefits, abandonment of assets, post-sale administration, claims and causes of action, and prosecution of claims and causes of action and allocation of proceeds.
- 26. Legal Requirements for Section 363 Sales • In cases of multiple debtors, courts have permitted so-called creeping substantive consolidation by which the asset sale and approval processes are done essentially on a consolidated basis, including the initial financing, the assets to be sold, allocation of goodwill, and allocation of proceeds among entities. • Although courts formerly required sale proceeds to be held in escrow pending a plan, recent practice allows for distribution of sale proceeds immediately, at least if there is no challenge to the validity of the security interest. Frequently, debtors provide for nominal amounts to be allocated to unsecured creditors to still objections. Of course, there are no cash proceeds in a credit bid situation.
- 27. Legal Requirements for Section 363 Sales • Courts are increasingly unwilling to hold up sales for the investigation or prosecution of litigation claims, or to fund adequately the prosecution of such claims by the committee. And, a number of recent developments including (a) significantly more stringent pleading rules, (b) section 546(e)’s settlement payment defense, and (c) a certain feeling that the litigation mainly benefits lawyers and that the market should determine outcomes, have made such litigation much less effective in stopping or delaying the sale process. Frequently, potential claims against insiders and parties to the sale are released or litigation claims are transferred to the purchaser or the DIP financer. Overall, litigation claims and litigation generally have become less important.
- 28. Legal Requirements for Section 363 Sales • Several changes in the law have also been partially responsible for the attractiveness of the quick sale process. One was the requirement that creditors who have supplied goods within 20 days of a filing receive an administrative claim. The result has been many fewer claims of trade creditors and diminishing the role of trade creditors in bankruptcy cases. A second was the requirement that leases be assumed or rejected in no more than 210 days (120 days initially subject to extension). This has had a huge impact on retail cases since it effectively requires the plan to be confirmed (or close to it) in less than seven months. It in effect requires fast action, and prevents the long drawn out retail cases that occurred in the past.
- 29. Legal Requirements for Section 363 Sales • An important factor in facilitating the quick sale process has been the sale of loans from original lenders to distress investors and hedge funds. The latter frequently purchase for the express purpose of obtaining the assets in a restructure or bankruptcy (i.e., loan to own). In many respects, the sale of loans and debt trading are determinative in leading to the quick sale process. For a variety of reasons, most distress investors and hedge funds want a quick resolution, and are unwilling to participation in the more conventional two stage process.
- 30. Winners and Losers • Winners. Prospective asset purchasers, senior secured lenders and groups who will benefit from the proposed sale. • Losers. Nominally secured creditors who are totally or largely out of the money, unsecured creditors whose arrangements were not dealt with by the sale and who have not received favored or special treatment, involuntary and tort creditors, environmental creditors, creditors on abandoned facilities and the PBGC, and creditors getting little or nothing who might benefit from a “home run” on litigation claims.