Navigating through Chapter 11 reorganization can be a traumatic experience for any company. Management that is unfamiliar with how the process works can easily become overwhelmed by the intrusive nature of the process and the sheer number of advisors and attorneys involved.
The length and costly nature of Chapter 11 reorganization can put significant strains on a company and its stakeholders. One option that may be available to address these challenges is to accelerate the in-court proceedings by filing a prepackaged bankruptcy.
In a prepackaged bankruptcy, or prepack, the plan of reorganization has been voted on and accepted by the classes of impaired creditors prior to the bankruptcy filing. By filing such a plan, a company can give itself a good chance of maintaining employee, vendor, and customer relationships and ultimately of having a successful restructuring.
Preparing and negotiating a prepackaged bankruptcy allows a company to reduce the time spent in Chapter 11 significantly while simultaneously reducing the legal and financial advisory expenses of the case. According to the Bankruptcy Research Database compiled by Professor Lynn LoPucki at the UCLA School of Law, the average duration for a prepackaged bankruptcy in 2009 was 38 days, compared to 306 days for a non-prepackaged Chapter 11 bankruptcy.
The use of prepackaged bankruptcies has increased during the current recession. According to BankruptcyData.com, 32 companies with publicly traded debt filed prepackaged bankruptcies in 2009, nearly tripling the 12 prepackaged filings by similar companies in 2008. Over the past year the prepackaged bankruptcy strategy was used by a wide spectrum of organizations, including large companies like CIT and small companies like Baseline Oil & Gas, a Texas-based oil and gas exploration and production company (Figure 1). Other notable Chapter 11 cases in 2009 that were arranged with prepackaged bankruptcy agreements included Charter Communications Inc., Lear Corp., and Six Flags Inc.
An abrupt filing, or what is also known as a “free fall” bankruptcy, on the other hand, is a process that by definition does not incorporate an agreement from pivotal creditors or other constituent groups prior to a filing. This can prompt creditors to take adversarial positions in the case, making the bankruptcy proceedings more contentious and more complex. This increases the amount of time needed to reach a consensual agreement on a plan of reorganization and increases the administrative expense of the bankruptcy proceeding because advisors are required to continue negotiations until a resolution can be reached.
In a prepackaged bankruptcy, a debtor develops a plan of reorganization and negotiates its terms with all impaired creditors. The goal is to develop a consensual plan prior to filing. With all reorganizations, plan feasibility is an integral part of getting a plan accepted by the constituents and confirmed by the court. Engaging the various levels of credit constituencies (senior secured, subordinated debt, and trade creditors) early in the process can help to validate a plan’s feasibility.
Upon engaging the creditors in discussions, it is possible to negotiate with the various constituencies revised terms, conditions, ratios, or changes in equity positions. Once a plan is agreed upon, the next step is to establish a voting process. Plan confirmation in Chapter 11 cases requires the acceptance of two-thirds in dollar amount and 50 percent in number of creditors of at least one impaired class. In some cases, parties enter into a “lock-up agreement” as part of the plan of reorganization to ensure that various key constituencies remain committed to the agreement.
The cases of two similar sized companies that filed for Chapter 11 protection in 2009 illustrate the disparity in costs between a prepackaged and a free fall bankruptcy.
Lazy Days RV Center Inc. is a company that engages in the sale and service of new and pre-owned recreational vehicles. Lazy Days filed for bankruptcy on November 5, 2009, in the District of Delaware with assets and liabilities listed at $100 million to $500 million. A committee representing Lazy Days’ floor plan lenders and an ad hoc committee representing 82 percent of its bondholders agreed to a restructuring that enabled the company to eliminate all of its $137 million bond debt through a prepackaged bankruptcy. The court approved its reorganization plan less than five weeks later, on December 8, 2009, allowing it to speed through bankruptcy in 33 days. The brief stay in Chapter 11 kept the published administrative expenses at less than $1.5 million.
TXCO Resources Inc., an independent oil and gas exploration company, filed for Chapter 11 protection in the Western District of Texas on May 19, 2009, with assets and liabilities listed at $100 million to $500 million. Due to the lack of consensual agreements prior to the filing, the case became very contentious as each creditor tried to maximize its recovery. The value of the company was debated extensively, which extended the proceedings.
On January 27, 2010, the court confirmed the second amended plan of reorganization. This plan was based on a definitive agreement to sell a substantial portion of TXCO’s assets to Newfield Exploration Company and Anadarko E&P Company LP. The reorganization took almost a year and, before accounting for the fees from the sale of the company, administrative expenses for advisors in the case totaled more than $8 million.
While there are cost advantages to a prepackaged bankruptcy, a potential debtor must also understand its shortcomings. If an operational restructuring is contemplated, it typically must be completed in advance of the financial restructuring. 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. For instance, a retailer that needs to close stores and reject leases may not have sufficient time to analyze and renegotiate those contracts properly during the limited course of a prepackaged bankruptcy. This could result in the reorganized entity experiencing many of the same operational difficulties that it did before it restructured.
Another potential drawback to a prepackaged bankruptcy is that soliciting creditor acceptances for a plan of reorganization before a filing will reveal the company’s intentions. This can increase the likelihood of some creditors attempting to circumvent efforts to negotiate a consensual plan of reorganization by filing an involuntary bankruptcy case. Advance notice can also result in creditors attempting to tighten their credit terms or even ceasing to provide trade credit altogether. These types of changes in credit terms are likely to reduce the debtor’s working capital and exacerbate its existing financial distress.
In practice, prepackaged bankruptcies are best-suited for situations in which sophisticated creditors hold most of the debt. Companies with a relatively small number of and few classes of creditors are the most ideal candidates for a prepackaged bankruptcy. Significant logistical issues can arise from trying to negotiate with different classes of creditors that may have different and competing priorities.
Companies with complicated capital structures, significant operating issues, creditors with opposing interests, or other matters in which it is not possible to reach a consensus among all constituents are examples of situations in which prepackaged bankruptcy may not be practical. In such circumstances it may be better to file an ordinary Chapter 11 so that the debtor can maintain control over the bankruptcy process and ensure its ability to reorganize.
A prepackaged bankruptcy can be a viable option when developing a strategy for reorganization. It gives a debtor the ability to reduce the duration of its bankruptcy and lowers the administrative cost of the process. It is also typically less disruptive to the business and is more appealing to creditors because it can reduce their internal expenses. Because of their potential benefits, prepackaged bankruptcies are likely to be used increasingly going forward.