Bankruptcy FAQ: Options Facing Distressed Businesses

September 3, 2020Alerts

The following are questions and answers that a distressed company considering insolvency options, including a potential bankruptcy filing, may find useful.

Q: What is the difference between Chapter 11 and Chapter 7 bankruptcy?

A: Chapter 11 can be used by companies to reorganize, including restructuring debt. Upon filing for Chapter 11, the debtor, as “debtor-in-possession” will be in control of the process. However, a committee representing the unsecured creditors in the case may be formed, and it is possible that a trustee, who would take over operations from the debtor, may be appointed at a later stage depending on how the case progresses. As a long as a trustee has not been appointed, the debtor may continue to operate and conduct business as usual during the bankruptcy process. The debtor must file a plan of reorganization, setting forth how it will restructure and how the various classes of creditors will be treated, including to the extent they will receive distributions of funds. The debtor’s plan is subject to review and objection by all parties in interest, including creditors, the unsecured creditors committee (if there is one) and the United States Trustee. Importantly, through Chapter 11, a company may be able to shed or reduce debt obligations, including by rejecting burdensome leases and executory contracts, or revising collective bargaining agreements and retiree contracts. A debtor has a limited amount of time to propose and confirm a plan, after which time another party may propose a competing plan for creditors to consider. 

Often, a company will utilize Chapter 11 to conduct an orderly sale of substantially all or a portion of its assets. Sales typically include an auction process in order to find the highest and best purchaser. Bankruptcy also allows sales to be “free and clear” of liens and liabilities. The sale process can therefore be used to find a purchaser that will continue all or part of the debtor’s business free of the liabilities that hindered the debtor. Chapter 11 can also be a complete liquidation of the debtor’s business without a going concern emerging from the bankruptcy.

Chapter 7, in contrast, is strictly a liquidation process, in which a trustee is appointed shortly after the bankruptcy filing and will oversee the liquidation of the debtor’s assets, pursue potential claims, and make distributions to creditors. The debtor will cease operating upon the bankruptcy filing except to the extent a trustee determines limited operations are needed to orderly wind-down the company.

Q: What is the bankruptcy “automatic stay?”

A: In both Chapter 7 and Chapter 11, an “automatic stay” is put into effect at the time of filing. The automatic stay prohibits creditors from taking action against the debtor to collect or enforce a pre-bankruptcy debt from the debtor, including against property of the debtor. For instance, the filing of a bankruptcy will stay a pending foreclosure sale. As such, a bankruptcy can be used to provide a debtor with a “breathing spell” from creditors, and provide time in a Chapter 11 case for a debtor to develop a restructuring plan while protecting its assets.

Creditors, however, may request relief from the automatic stay from the bankruptcy court so that they may enforce their rights. For instance, a creditor may seek relief so that it can collect its collateral or resume a judicial proceeding against the debtor. In instances in which the creditor is seeking to enforce its rights as to collateral, the debtor will have to show that the creditor is adequately protected, either because the value of the collateral is in excess of the amount of the creditor’s claim, or because the debtor can make sufficient payments or provide other value, such as a replacement lien, to the creditor.

The automatic stay does not usually apply to non-debtor third parties, such as a guarantor or co-obligor on a debt, although in certain situations the debtor may request that the automatic stay be extended to third parties as a necessary part of the debtor’s ability to reorganize under Chapter 11.

Q: Is there a difference in costs between Chapter 7 and Chapter 11?

A: Generally, yes. While each situation is unique, there can be significant difference in costs between filing Chapter 7 and Chapter 11. In both instances, there will be attorney’s fees for preparing the debtor’s bankruptcy petition and schedules, with the costs varying depending on the size and complexity of the debtor’s business and financial dealings. The preparation fees are paid prior to the bankruptcy filing. Once a Chapter 7 petition is filed, the administration of the bankruptcy estate is in the hands of the trustee, and a debtor’s attorney’s work greatly diminishes or ceases.

The filing of a Chapter 11 petition, however, depending on the company, may require the retention of additional professionals to effectively prepare the bankruptcy petition, including accountants and/or financial advisors. Further, given that the debtor is effectively in control of the bankruptcy process, and may continue to operate, the debtor will need to retain its attorneys and other professionals as part of the bankruptcy, and the professional fees incurred following the bankruptcy filing will be paid on periodic basis as an administrative expense in the bankruptcy case as approved by the bankruptcy court, a time period that spans months or even years.

Q: Are there any special bankruptcy options for a small business that does not want to liquidate in Chapter 7?

A: Congress recently amended the Bankruptcy Code to include special provisions for small businesses with up to $2,725,625 of total debt (secured and unsecured, non-contingent and non-insider) to file under Subchapter V of Chapter 11, effective February 19, 2020. In these cases, a trustee will be appointed to oversee the bankruptcy process, including to facilitate a consensual plan of reorganization. The presence of a trustee, along with the elimination of a disclosure statement, a creditors’ committee and U.S. Trustee fees, and the broader ability to cram down a plan on a faster track, will improve efficiencies, reduce costs and allow more debtors to maintain possession in small business Chapter 11 cases. The CARES Act, passed in the wake of COVID-19, will temporarily (for one year) raise the debt threshold for these Subchapter V small business cases to $7,500,000, almost tripling the number of businesses that can take advantage of this tool for quicker and cheaper reorganizations.

Q: What should a debtor do in preparation for a Chapter 11 bankruptcy?

A:

  • Organize Books and Records: The debtor should organize its books and records as best as possible, as such will save time and expense in preparing for and during the bankruptcy process. The more organized the company is, the less work professionals will have to do to prepare the bankruptcy filing.
     
  • Obtain DIP Financing: The debtor may need to obtain “debtor-in-possession” financing in order to operate in bankruptcy while it attempts to reorganize. If needed, the debtor should negotiate the terms of the financing prior to the filing.
     
  • Find a Stalking Horse Bidder: If the debtor is seeking to sell a signification portion of its assets through a bankruptcy, it should attempt to procure a “stalking horse” bidder prior to filing, as doing so can help expedite the auction and sale process during bankruptcy. This many necessitate the hiring of a third party to market the company’s assets.
     
  • Employees: Companies should be mindful of potential implications of the Worker Adjustment and Retraining Act (the WARN Act). The WARN Act requires employers with at least 100 employees to provide 60 days advance notice of any plant closings and mass layoffs. If a company falls under the WARN Act and it is not complied with, it may face claims for violating the Act.

Q: What happens to a company’s creditors in bankruptcy?

A: It depends on the nature of a creditor’s interest. Secured creditors will have rights in their collateral, but a debtor may attempt to restructure the debt obligation, particularly if a secured creditor has a subordinate claim to collateral and the collateral may not be of sufficient value to fully secure the amount due the creditor. If a creditor has “priority,” as defined by Section 507 of the Bankruptcy Code (e.g. taxing authorities, a portion of employees’ salaries), they stand in line behind secured creditors. Next in line are general unsecured creditors (e.g. utilities, vendors) and last in line are stockholders. Generally, creditors in a category down the line only recover on their claims if the group of creditors before it is paid in full.

Q: What happens to employees when a company files for bankruptcy?

A: In a Chapter 7 case, the company will cease operating at the time of bankruptcy filing if has not already (although a trustee may seek to maintain a limited staff to wind-down the company). The employees will therefore be unemployed and will have priority claims for any unpaid wages, salaries and commissions, earned within 180 days before the bankruptcy filing and up $10,000.

If a company continues to operate after filing Chapter 11, it may seek authority to continue to pay its employees in the normal course and may also seek to continue certain retirement or pension plans, though downsizing may be a part of the reorganizing process. The debtor, however, may also seek to terminate retirement and pension plans.

Q: What if a debtor wants to assume a lease or executory contract in Chapter 11?

A: A debtor can assume a lease or executory contract in Chapter 11, as well as assign an assumed lease or executory contract to a purchaser. In order to assume a lease or contract, all amounts due under the lease or contract must be “cured.” In order to assign an assumed lease or contract, the prospective purchaser will have to provide adequate assurance to the counterparty that it can fulfill the lease or contract’s obligations.

Q:        What other things should a company be mindful of in considering a bankruptcy filing?

A:       

  • Exposure for Third Parties: As noted above, the automatic stay does not protect third parties. While a bankruptcy filing may provide the debtor with a breathing spell, it may also result in a creditor turning its focus to a non-debtor guarantor or co-obligor on a debt.
     
  • Potential “Insider” Liability: To the extent “insiders” of a debtor received payment or benefits beyond their regular salary during the prior year, those individuals may be subject to “preference” claims to avoid and recover those amounts. For a corporate debtor, “insiders” include directors, officers, persons in control of the debtor, general partners and relatives of a general partner, director, officer or person in control of the debtor.

    Insiders and others may also be subject to fraudulent transfer claims to the extent they received value from the debtor without providing reasonably equivalent value in return. The Bankruptcy Code allows such claims to go back two years, but state court statutes may provide longer lookback periods.

    Additionally, directors and officers of a debtor may be subject to claims to the extent an alleged breach of fiduciary duty precipitated the debtor’s need to file for bankruptcy.
     
  • Preference Claims Against Critical Creditors: Creditors may be subject to preference claims for payments they received during the 90 days prior to the bankruptcy filing. Such claims could make a creditor reluctant to continue dealing with a debtor that is continuing to operate in Chapter 11, and this could be a particular concern to a debtor if the creditor provides critical goods or services for the debtor’s business.

    Creditors may have defenses to preference claims, including if (i) the payment was intended as a contemporaneous exchange for new value provided by the creditor; (ii) if the payment was consistent with the ordinary course of dealings between the parties prior to the bankruptcy (e.g. was made for a consistent amount and/or at consistent intervals) or was made consistent with customary industry practices; or (iii) the creditor provided new value to the debtor after the asserted preferential payment was made.

Q: What are potential alternatives to bankruptcy filing?

A: There are several potential alternatives to bankruptcy, depending on the situation. Possible alternatives include:

  • Obtaining New Financing (or Refinancing): Interest rates are currently very favorable, making it easier for a company to take on a new obligation (or refinancing an existing obligation) in an attempt to infuse the company with capital and stave off an insolvency proceeding.
     
  • Obtaining an SBA Loan: The new stimulus bill, the CARES Act, includes significant and broader funding for SBA loans, granting companies with 500 or less employees access to loans that were in many cases previously unavailable. The new law also includes various industry-specific relief (e.g. airlines, hospitality, healthcare, etc.), and a company considering bankruptcy should review the CARES Act to assess if it may eligible for any special relief.
     
  • Workouts: A company can attempt to negotiate with its creditors to restructure the amount or repayment terms of the debt. Given the current circumstances, in the wake of COVID-19, creditors may be more flexible.
     
  • Composition Agreement: In an attempt work out a more global resolution of its debts, a company may try to negotiate a Composition Agreement with several of its creditors that would provide the creditors with pro-rata payments as part of a wholesale simultaneous restructuring of its debt to various creditors.
     
  • Assignments for Benefit of Creditor (ABCs): Although not available in all states, ABCs are essentially state law versions of a bankruptcy liquidation. In an ABC, the debtor/assignor, assigns the company’s assets to an assignee, who then liquidates the assets and makes distributions to creditors. An assignee is similar to a bankruptcy trustee in many respects, although the debtor/assignor can select the assignee.
     
  • Dissolution: A company can be dissolved pursuant to state law.

For any further questions about bankruptcy options or solutions, please contact Mark Hall at 973.548.3314 or [email protected], Michael Herz at 973.548.3330 or [email protected], or any member of Fox Rothschild's national Financial Restructuring & Bankruptcy Practice.