by Douglas M. Foley, James E. Van Horn
(TMA International Headquarters)
The current surge in bankruptcy filings has led to the renewed use of prepackaged Chapter 11 plans, or “prepacks.” According to BankruptcyData.com, only four prepacks were filed in all of 2007. Through June 30 of this year, however, nine were filed, and February alone saw four filed by publicly traded companies collectively holding assets greater than $2 billion.
This trend, coupled with the tightening of credit markets and expectations by restructuring professionals of increased restructuring and bankruptcy activity in 2008,1 point to the likelihood of even more companies using prepackaged bankruptcies to facilitate Chapter 11 reorganizations in the coming months. This article provides an overview of prepackaged Chapter 11 plans and summarizes the associated benefits and risks that a company and its professionals should consider in determining whether to use a prepack to accomplish a reorganization.
While it can take various forms, a prepack typically is a Chapter 11 reorganization plan for which a debtor has solicited sufficient acceptances from its creditors to confirm prior to filing for bankruptcy. U.S. Bankruptcy Code Section 1126(b) permits courts to accept votes on a plan that was solicited before the commencement of the case, provided that (i) the pre-petition solicitation was in compliance with applicable nonbankruptcy law, rule, or regulation governing the adequacy of disclosure in connection with such solicitation, or (ii) if there is no such applicable nonbankruptcy law, rule, or regulation governing adequacy of disclosure, that the solicitation conducted occurred after disclosure of “adequate information,” as defined in Bankruptcy Code Section 1125(a)(1).
Debtors choose prepacks for a number of reasons. Among them are:
Speed. In a typical Chapter 11 bankruptcy, a debtor proposes a plan after the bankruptcy filing and negotiates its terms with creditors. While enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) ended a debtor’s ability to receive numerous deadline extensions to file a reorganization plan, a debtor can still take as long as 18 months to file a plan under the provisions of BAPCPA.2
A prepack is often an attractive option because it provides the potential for a prompt reorganization within Chapter 11 and a quick exit from bankruptcy since the debtor has consensually come to terms with its creditors before filing. By way of example, five of the nine prepacks filed this year were confirmed by the end of June.3
Cost. An obvious benefit to a shorter period of time that a debtor must remain in Chapter 11 is the potential for significant cost savings. By filing a prepack, a debtor can minimize the typical expenses associated with a Chapter 11 case, such as preparing monthly operating reports and paying the fees and expenses of court-approved professionals while negotiating the terms of a reorganization plan with its creditors. In certain circumstances, a debtor filing a prepack also may avoid having to pay any fees and expenses associated with statutory committees of its creditors.
Bankruptcy Code Section 341(e) provides that upon the request of a party in interest and after notice and a hearing, the court may order for cause that the U.S. Trustee not convene a meeting of creditors or equity security holders if the debtor has filed a plan solicited prior to the commencement of the case. This provision, enacted as part of BAPCA, also can contribute to a speedier reorganization because there is no longer a requirement in all circumstances that a statutory committee of creditors meeting be scheduled and take place when a plan already has been filed and accepted by the creditors.
Control. Section 1107(a) of the Bankruptcy Code provides that, subject to limitations or conditions the court prescribes, a debtor in possession has all the rights and powers of a Chapter 11 trustee and is required to perform all of the functions and duties of a trustee, subject to certain exceptions. Although the debtor commences its Chapter 11 case with all of these rights and powers, one of the perils inherent in entering Chapter 11 is the possibility of losing partial or even complete control of the company.
At a minimum, a Chapter 11 debtor is subject to a great deal of oversight and scrutiny from many different parties in interest. These include statutory and/or ad hoc committees of creditors, the U.S. Trustee and, of course, the Bankruptcy Court. Accordingly, minimizing the amount of time a debtor remains in Chapter 11 by and large reduces the likelihood of creditor constituencies second-guessing and potentially unreasonably influencing the multitude of decisions a debtor must make.
Beyond the normal oversight and scrutiny every Chapter 11 debtor encounters, a debtor may lose some actual control if it is forced by a creditor constituency to replace one or more members of senior management and/or if the period of exclusivity either expires or is terminated for cause by the Bankruptcy Court, resulting in any party of interest filing its own Chapter 11 plan. At worst, a debtor may lose complete control of the company if the Bankruptcy Court orders the appointment of a Chapter 11 trustee or converts the case to Chapter 7.
By negotiating a consensual plan of reorganization with its creditors prior to filing for bankruptcy, a debtor reduces the possibility of losing control of the company to these same creditors during the bankruptcy. In addition, the less time a debtor must remain in bankruptcy, the less potential there is for a disgruntled creditor to attempt to wrest control of the company away from the debtor during the Chapter 11 proceeding.
Risks of a Prepack
As a logistical matter, prepacks are far easier to put together if a debtor is negotiating with a relatively small number of creditors to receive the requisite creditor acceptances to confirm a plan of reorganization. Indeed, in practice prepacks are generally achieved in situations in which a sophisticated bondholder group holds most of the debt and an indentured trustee can negotiate with the debtor on behalf of the bondholders.
In contrast, when a debtor has a large number of creditors representing very different types of claims (e.g., trade vendors, bondholders, landlords, and employees, among others), and who are almost certainly not organized, it is often simply too difficult for a debtor to negotiate plan terms with enough of its creditors to obtain the requisite number of acceptances of a plan.
Additionally, specific facts and circumstances surrounding a debtor’s financial distress may require it to seek Chapter 11 protection promptly to gain sufficient leverage over its creditors to negotiate an acceptable plan of reorganization. For example, if a debtor is burdened with costly executory contracts or leases, it might be in its best interest to file first, reject its burdensome contracts and leases and translate them into general unsecured claims, and then negotiate a plan. Similarly, a debtor that has defaulted on a debt obligation and/or is a defendant in significant litigation may find it beneficial to file immediately to take advantage of the automatic stay to halt all judicial and non-judicial proceedings against the company.
Even in instances in which a debtor has determined that the potential benefits of a prepack outweigh those of immediately filing for Chapter 11, certain risks inherent in a prepack must be considered. By soliciting creditor acceptances for a prepackaged Chapter 11 plan, a debtor lets the cat out of the bag that it intends to file Chapter 11. This advance notice to creditors may increase the likelihood that some of them may attempt to circumvent efforts to negotiate a consensual plan of reorganization by filing an involuntary bankruptcy case against the debtor.
Advance notice also may result in creditors tightening their credit terms or even ceasing to provide an open account trade credit altogether, forcing the debtor to pay on a cash-in-advance or cash-on-delivery basis for goods and services. These types of changes in credit terms most likely would reduce the debtor’s working capital and exacerbate its existing financial distress.
Even if a debtor obtains the requisite number of acceptances for its prepackaged Chapter 11 plan, the risk remains that a Bankruptcy Court ultimately may rule that the debtor’s pre-petition solicitation and/or disclosure statement were not “adequate” under Bankruptcy Code Section 1125(a). In this situation, a debtor would have to resolicit plan acceptances after remedying the inadequacies. But because the debtor solicited a disclosure statement that had not been previously approved by the Bankruptcy Court, it may not be able to take advantage of the safe harbor protections of Bankruptcy Code Section 1125(e). These provisions shield a person soliciting acceptances or rejection of a plan from liability for violating applicable laws, rules, or regulations governing the solicitation of acceptances or rejection of a plan.
Weighing Options
A debtor considering using a prepack must carefully consider the risks involved and whether the benefits it may realize outweigh those it may achieve through filing a typical Chapter 11 and negotiating a plan after the bankruptcy filing. Under the right circumstances, however, a prepackaged Chapter 11 plan can be an efficient means for a debtor to reorganize its business for the benefit of the bankruptcy estate and creditor body.
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1Source: Turnaround Management Association’s Annual Trend Watch Poll, October 2007.
211 U.S.C. Section 1121(d)(2)(A).
3Holley Performance Products, Inc., et al., Case No. 08-10256 (Delaware); DJK Residential LLC, et al., Case No. 08-10375 (SDNY); Ziff Davis Media, Inc., et al., Case No. 08-10768 (SDNY); Hilex Poly Co. LLC, et al., Case No. 08-10890 (Delaware); The Wornick Company, et al., Case No. 08-10654 (SD Ohio).