Why Companies File for Chapter 11 and Remedies Available to the Troubled Debtor

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With the recent evidence that the U.S. economy is slowing and possibly facing the risk of a recession, there is a renewed focus on bankruptcy. While the economic slowdown is likely to push more companies into bankruptcy and increase the demand for bankruptcy lawyers, the reality is that there is always a role for the restructuring/bankruptcy lawyer—even in a generally stable economic environment—as certain industries experience instability in times of economic prosperity.

For example, over the past two years, while the economy was generally thriving, the steel industry suffered from the adverse impact of high levels of low cost foreign steel imports, which resulted in the Chapter 11 bankruptcy filing of six steel companies during that period, including Acme Metals, Laclede Steel, Gulf States Steel, Northwestern Steel and Wire, Wheeling-Pittsburgh and LTV.

In addition, companies file for Chapter 11 for many different reasons that may be wholly unrelated to the economy or financial conditions, such as to eliminate burdensome contractual obligations or to handle mass tort litigation. For example, Columbia Gas Transmission Corporation (TCO), a natural gas pipeline, filed for Chapter 11 protection in order to reject certain above-market long-term "take or pay" contracts with producers of natural gas. TCO effectively used the bankruptcy process to eliminate those burdensome and costly contractual obligations and to effectuate a global settlement with the producer parties to those contracts.

Why Do Companies File For Chapter 11?

Excessive Debt. One reason many companies file for Chapter 11 is the need to restructure their balance sheet because they are too highly leveraged. Sometimes this can be accomplished through an out-of court restructuring or workout, which is a non-judicial process pursuant to which a distressed debtor and its significant creditors agree on an adjustment of the debtor’s obligations, such as debt forgiveness or an exchange of debt for equity. Where the debtor is a publicly traded company, it may exchange its existing securities for new securities through a consensual exchange offer or other written consent. Since most public debt indentures require unanimity in order to amend the payment terms of the security, an exchange offer or other out-of-court restructuring may not be feasible where there are a significant number of dissenters. Under a Chapter 11 case, a confirmed plan of reorganization (receiving a two-thirds in amount and majority in number vote of the necessary classes of creditors voting on the plan) will bind dissenting creditors and shareholders.

Often, an exchange offer may be combined with a proposed Chapter 11 plan to be used if 100 percent acceptances of the exchange offer are not received. In such a case, a "prepackaged plan" is used. A prepackaged Chapter 11 involves the negotiation and solicitation of acceptances to the debtor’s Chapter 11 plan of reorganization prior to the commencement of the Chapter 11 case.

Finally, the debtor can also effectuate a restructuring through a "pre-arranged” Chapter 11, in which case, as of the commencement of the Chapter 11 case, the debtor will have reached agreements on the terms of a plan of reorganization with all its major creditor constituencies, but will not yet have solicited acceptances of the plan. Usually, the plan and disclosure statement are filed together with the Chapter 11 petition, putting the case on a relatively fast track toward confirmation.

The case of Marker International (Marker), a manufacturer of ski bindings, is a good example of a pre-negotiated Chapter 11 proceeding. Prior to the filing, Marker negotiated a series of lock-up agreements with its major creditor constituencies pursuant to which each major creditor agreed to its treatment under a proposed plan of reorganization. In addition, prior to the filing, Marker negotiated a sale of substantially all of its assets, which sale was to be effectuated pursuant to Marker’s plan of reorganization. Marker filed its bankruptcy petition together with its proposed plan and disclosure statement, and confirmed its reorganization plan a little over two months after it filed for bankruptcy.

Lack of Adequate Financing/Liquidity. Often, a debtor’s financial crisis is precipitated by a default under its working capital agreements where the lenders refuse to lend additional monies or ease borrowing restrictions unless a restructuring is effectuated. A debtor may often find it easier to obtain access to additional financing in conjunction with a Chapter 11 case than in an out-of-court workout. The reason is that the Bankruptcy Code allows a debtor, subject to bankruptcy court approval, to obtain secured or unsecured credit on a "super-priority" basis, meaning that the claims of the DIP lender take priority, or are paid first before all of the debtor’s other creditors subject to certain carve-outs for professional and other fees. In addition, once a company files for Chapter 11, it may also obtain more favorable unsecured trade credit terms since the Bankruptcy Code affords administrative priority treatment to those suppliers who supply the debtor with goods and services post-bankruptcy.

Mismanagement/Fraud. A third reason companies may falter and be forced to file for bankruptcy is internal mismanagement and/or fraud. Generally speaking, it is contemplated that the debtor’s management stay in place during a Chapter 11 case (hence the term “debtor in possession”). However, the Bankruptcy Code does provide for the appointment of a trustee "for cause" or "in the best interest of creditors" in which case management is ousted. Under the Bankruptcy Code an "examiner" may also be appointed to investigate fraud or address other complex issues in the reorganization. Other times, management is replaced or supplemented by a specialized turnaround management firm acceptable to creditors.

Strategic/Tactical Reasons. Another reason companies seek bankruptcy protection is for strategic or tactical business reasons. Most recently, several companies, including, most notably, Owens-Corning and Armstrong World Industries, filed for Chapter 11 in order to deal with their increasingly massive asbestos liabilities. Other companies have filed for Chapter 11 in order to utilize the contract rejection provisions of the Bankruptcy Code, which allow debtors to disaffirm contracts or burdensome long-term leases in bankruptcy. Bankruptcy termination of leases and executive contracts, store closings and the like may result in reduced damages to the company.

The Advantages of Chapter 11

Automatic Stay. Upon the filing of a Chapter 11 case, an "automatic stay" arises which enjoins all persons from commencing or continuing any judicial, administrative or other proceeding or action against the debtor that could have been commenced before the Chapter 11 filing. The automatic stay of Section 362 of the Bankruptcy Code prevents creditors from commencing or continuing any lawsuit to recover on any pre-petition debt or claim or to obtain property of the debtor or to enforce a judgment against the debtor. The "automatic stay" is intended to provide the debtor with a "breathing spell" during which time it can negotiate a plan for the restructure or re-payment of its pre-petition debts owed to its creditors.

Cessation of Post-petition Interest. Generally, once a debtor files for relief under Chapter 11, interest ceases to accrue on its unsecured (and under-secured) debt. Over-secured creditors, however, are entitled to accrue and may be entitled to current payment of post-petition interest.

Rejection/Assignment of Contracts. A debtor, subject to court approval (upon a showing that that the rejection is an exercise of its sound business judgment), may reject any executory contract or unexpired lease. In addition, debtors can generally assign their contracts or leases to third parties, notwithstanding anti-assignment provisions in such contract or leases, which prohibit or restrict assignment. In retail cases, such as in the Barney’s case and in the Planet Hollywood case, these provisions were utilized often as those debtors, after evaluating their store operations, chose to close certain store/restaurant locations and either rejected or assigned those leases. Upon rejection of an unexpired lease or contract, the non-debtor party will have an unsecured claim against the debtor for damages arising from the rejection which claim is treated as a pre-petition unsecured claim to be paid like other unsecured claims pursuant to the plan of reorganization. In order to prevent huge lease rejection damage claims or insider claims from overshadowing all other unsecured claims in the case, the Bankruptcy Code (Section 502(b)) sets a cap on damages allowed for rejection of employment contracts and real property leases.

Claims Estimation. Where a claim against a debtor cannot be liquidated in a timely manner and will prevent administration of the reorganization, the Bankruptcy Code (Section 502(c)) provides that contingent and/or unliquidated claims may be "estimated" by the Bankruptcy Court. Sometimes the estimation procedure is used only for plan voting purposes, and other times it is used for plan distribution purposes. Claims estimation is useful in cases involving large numbers of complex damage claims, such as those arising from contract rejection, product liability or other similarly large and complex claims.

Obviously, Chapter 11 does not per se provide a panacea for poor markets, adverse economic conditions, obsolete products or other such fundamental business problems, but does provide a forum for implementing a new business plan. The debtor protection provisions of the Bankruptcy Code briefly described above can make Chapter 11 a strategic and viable business option for a distressed debtor.