Traditionally, Chapter 11 of the U.S. Bankruptcy Code was used to facilitate management’s rehabilitation of a troubled company, while Chapter 7 offered a streamlined process for liquidating a business under the supervision of an appointed trustee.1 Today, debtors increasingly are filing for bankruptcy protection in Chapter 11 with no intention of reorganizing in the traditional sense.
Tucked within its pages, Chapter 11 offers an alternative to reorganization — the Chapter 11 liquidation. Principal among the advantages it offers a business for which reorganization is an unlikely option is the ability of management to continue operating the business in bankruptcy. The downside lies in the fact that along with continued operations come increased administrative costs and the challenge of either confirming a plan of liquidation or facing conversion of the case to Chapter 7.
Some might argue that a sweet spot between Chapter 7 and Chapter 11 lies in the following strategy:
- Step 1: File Chapter 11
- Step 2: Operate the debtor as debtor-in-possession and attempt to sell the business as a going concern for a higher value than would be realized in Chapter 7
- Step 3: Convert the case to Chapter 7 and let a trustee administer the remaining pot of cash. After all, the process of soliciting votes on and confirming a Chapter 11 plan is complicated, time-consuming, and expensive, isn’t it?
Recent research on the relative costs, length of the process, and recovery of Chapter 11 liquidations versus Chapter 7 liquidations yielded interesting results [“Business Liquidation,” 81 Am. Bankr. L.J. 65, 83 (2007)]. One study of 449 businesses that liquidated in bankruptcy during 1994 showed an average duration of 631 days for liquidations in Chapter 7 compared to 369 days for liquidations via a confirmed Chapter 11 plan.
Even more striking, converted cases — those originally filed under Chapter 11 and later converted to Chapter 7 — took an average of 1,875 days, or more than five years, to complete. The same study also showed that Chapter 7 cases provided an average recovery to unsecured creditors of less than 1 percent, whereas Chapter 11 liquidations on average provided close to a 20 percent recovery to unsecured creditors. So the file-sell-convert strategy seems less than ideal. Chapter 11 liquidations appear to provide unsecured creditors with the opportunity for more substantial recoveries faster than in Chapter 7.
So what’s the new strategy? In any liquidating Chapter 11 case there are several milestones that must be reached to confirm a plan, maximize any distribution to creditors, and stave off a potentially costly conversion to Chapter 7:
- Operations must be stabilized in bankruptcy
- Assets must be liquidated
- A plan of liquidation must be confirmed
- Claims must be evaluated and, when appropriate, challenged
Each of these could be the subject of an article, a chapter, or entire book (indeed, some of them have been). This article attempts to describe through these four waypoints the arc of a successful liquidation in Chapter 11, from commencement to confirmation and beyond.
The ability to retain management in place to sustain continued operations in bankruptcy represents perhaps the single most valuable distinction between Chapter 11 and Chapter 7. It gives the liquidating debtor a tremendous advantage over a Chapter 7 trustee in their common goal of obtaining the greatest possible value for the assets of the estate.
It can mean the difference between realizing the value of an operating franchise over a dark food service building, or a thriving distribution business over a warehouse choked with inventory and outdated office equipment. It can give the debtor the time it needs to market its assets properly without falling victim to the “garage sale” atmosphere that often accompanies a Chapter 7 liquidation.
Transitioning from normal operations to bankruptcy operations, however, can be a delicate undertaking when cash flow — which already is likely to be suffering — is further drained by added professional fees and a potential dip in revenue as customers turn away. Employees must be paid, benefits continued, utilities provided for, and vendors mollified.
For a company of any size, the first step is to mesh operational needs with the requirements of the Bankruptcy Code. The traditional approach is to address the issues in the array of first day motions that accompany the filing of many Chapter 11 business cases and can facilitate a more seamless transition to bankruptcy.
Among the most common are orders authorizing a debtor to honor pre-petition wage and employee benefit obligations, maintain existing bank accounts, and use available but encumbered cash collateral. With these orders in place, a debtor can maintain payroll, honor employee benefits, and reassure vendors that invoices rendered post-petition will be paid.
By obtaining relief from the obligation to open new bank accounts, a business can save the trouble of shifting its entire cash management and accounts collection systems at a time when uninterrupted cash flow is especially critical.
Of course, all of this comes at a cost. In Chapter 11, vendors that previously extended 30-day credit terms may insist on being paid cash on delivery (COD) for post-petition invoices, and the expense associated with administering a case imposes an added burden to an already stretched cash flow model.
In cases in which the sale of the business at a sufficient value appears likely, post-petition financing may be available to bridge the shortfall. In other cases, the debtor may be forced either to streamline operations and cut expenses, or accelerate the collection of outstanding receivables to generate the necessary cash flow. In any event, if the anticipated value to be obtained by liquidating the business in Chapter 11 is insufficient to cover the added expense, Chapter 7 is all but inevitable.
Having stabilized operations, which in certain fast-paced cases may precede this phase by only a few days, the next step is to market, auction, and sell the business’s assets, either as a viable going concern or on a piecemeal basis. This stage likely will determine whether the gamble has paid off and the business will be able to realize a sufficiently high value to confirm a Chapter 11 plan.
To successfully exit Chapter 11 in a liquidation scenario (i.e., via confirmation of a plan), a debtor must realize at least sufficient proceeds to pay in full any debts secured by the assets, including secured tax claims, and all administrative expenses and priority claims, including all post-petition operating and administrative expenses. It is critical, therefore, for the liquidating Chapter 11 debtor to have a good estimate of the obligations that must be satisfied to confirm a plan.
This claims hurdle will play a significant role in a debtor’s decision whether to set a formal minimum bid. This is a point of some tension in any debtor’s strategic analysis. Setting a minimum bid equal to or greater than the claims hurdle ensures that any qualifying bid submitted for the business will suffice to fund a confirmable Chapter 11 plan. On the other hand, if interest in the property is expected to be low or if a debtor’s cash need is high relative to its estimated value, then a minimum bid may dissuade bidders who might otherwise be willing to submit a lower offer and withhold higher bids until a competitive auction is held. This decision is critical and should not be passed over summarily.
Bankruptcy auctions typically follow a traditional format based on the solicitation of open, ascending bids, although sealed bid auctions are occasionally employed. That said, certain practical considerations may result in the preference of one format over another in a given case, so thought should be given to alternative formats. For example, sealed bids may generate higher values when bidders are aware of the existence of competing bidders, but they may generate lesser values if the bidder knows that competing bids are unlikely.
File a Plan
Whereas the ability to maintain operations offers a business tremendous advantages in Chapter 11, the quid pro quo for this benefit lies in the inescapable requirement to solicit votes on and obtain confirmation (i.e., court approval) of a plan. At least 11 different sections of Chapter 11 define the procedures and requirements that must be followed to satisfy this burden, and these requirements become even more difficult to meet in a liquidation scenario. Notable requirements are the “best interests of creditors” and “administrative solvency” tests found in Sections 1129(a)(7) and (9), respectively.
The administrative solvency test embodies the real price of admission to Chapter 11. Section 1129(a)(9) requires the debtor to pay in full the “administrative expenses” incurred both in operating the business post-petition (e.g., vendor invoices) and in funding the costs to administer the case (e.g., professionals fees).
As a result of the code amendments contained in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 amendments, administrative expenses now also include so-called 503(b)(9) claims equal to the value of goods sold in the ordinary course of business and received by the debtor within 20 days before the bankruptcy case was commenced.2 While more service-oriented businesses, such as health care providers, may face a lesser threat from this provision, businesses that rely more heavily on a steady influx of raw materials or finished products may find its impact to be devastating.
With certain limited exceptions, the Chapter 11 debtor must pay all administrative expenses in full to remain in control of its business and attempt to liquidate through the Chapter 11 process. Administrative insolvency — that is, the debtor’s inability to pay all administrative expenses — may well constitute the single most common reason for the failure of liquidating Chapter 11 cases. Unless administrative expense claimants agree to a lesser treatment, it represents a nonnegotiable obligation that any Chapter 11 plan must satisfy.
The best interests of creditors test further conditions plan confirmation on the requirement that each unsecured creditor, for example, either accept the plan or receive plan distributions with a total value that is not less than the amount that creditor would receive if the debtor were liquidated in Chapter†7. Put another way, a company’s decision to file Chapter 11 cannot leave its unsecured creditors worse off than if it had simply filed Chapter 7 to begin with. As such, Section 1129(a)(7) presents a unique problem for companies seeking to liquidate rather than reorganize in Chapter 11.
In the typical liquidating Chapter 11, as in Chapter 7, a debtor’s assets are sold, leaving a finite sum for distribution. This is the point at which Chapter 11 liquidations either succeed or fail. As noted earlier, Chapter 11 combines the benefit of selling the debtor’s business as a going concern with the burden of incurring the greater costs that typically accompany a Chapter 11 case. To satisfy the “best interests of creditors” test, the debtor must obtain a sales price that is sufficiently higher than what would have been obtained in Chapter 7 to make up for the added costs incurred in Chapter 11.
There are only two ways to split a pie into larger shares: bake a bigger pie or set fewer places at the table. In the finite world of “pot” plans, the same holds true. To maximize distributions to creditors, the debtor and its advisors must either find more assets to distribute or render fewer creditors to share them.
Depending on the level of interest in the debtor’s assets, management may have little control over the ultimate sale price that the business brings. Absent competing bidders to drive up the price in an auction, there is often little a liquidating debtor can do to bake a bigger pie. The process of evaluating claims and objecting to improper ones, however, can reduce the number of places at the table and have a significant impact on remaining creditors’ recovery.
That said, there is often little point in aggressively pursuing claim objections, regardless of the legitimacy of filed claims against the estate, until the debtor can ascertain with some confidence that it can make a meaningful distribution to unsecured creditors. After all, if a debtor does not expect to make a distribution to unsecured creditors, objecting to essentially worthless claims becomes a pointless exercise that may waste valuable estate resources.
As with most rules, however, there’s an exception: challenges to objectionable administrative claims and secured claims should be addressed as soon as possible in a liquidating Chapter 11 in which their disallowance would permit more dollars to flow downstream to unsecured creditors. One way to ensure the issue is addressed is to request the setting of a bar date for the filing of Section 503(b)(9) claims, which should be ascertainable immediately following the commencement of a Chapter 11 case. By addressing these claims promptly, the debtor can resolve any doubts about this critical component of its administrative solvency before getting too far down the Chapter 11 path.
Similarly, although Chapter 11 debtors frequently must waive any objections or challenges to the claims and liens of their pre-petition secured lenders as a precondition to the use of cash collateral, they sometimes find themselves in the unusual position of having viable challenges to the claims or liens of a pre-petition secured lender whose consent is not required to obtain cash collateral. As with administrative expenses, secured claims effectively carry a dollar-for-dollar value in bankruptcy, so any such claim that can be successfully disallowed or at least reduced to the level of a general unsecured claim contributes real dollars to the potential successful confirmation of a liquidating Chapter 11 plan.
Not for Everyone
Not every business is right for Chapter 11 liquidation, and not every Chapter 11 liquidation is successful. The key lies in determining whether the business may fetch a higher value as a going concern marketed by existing management rather than as a collection of assets sold off by a Chapter 7 trustee. For those businesses that hold this potential, however, liquidation in Chapter 11 may hold the key to achieving it.
1Unless otherwise noted, chapter and section references are to the Bankruptcy Code, 11 U.S.C. 101-1532 (2008).
2The nickname for claims of this type comes from the Bankruptcy Code section that created them.