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Resuscitating the comatose firm: changing management responsibilities under Chapter 11.

Several articles on management under bankruptcy have appeared in the management literature concerned with issues of "image"|1~ and the characteristics of firms most likely to go bankrupt.|2,3,4~ This paper contributes to that literature by specifying some of the operational and strategic implications of operating under bankruptcy, particularly under Chapter 11, which allows protection from creditors of the firm.

A corporation that files for Chapter 11 is usually laden with debt and starved for cash. Under Chapter 11, creditors are barred from pursuing the debtor pending a bankruptcy court's approval of a plan for restructuring the corporation's debts.|5~ Restructuring means determining the order in which creditors will be paid, how much each creditor will be paid, and the time period over which each creditor will be paid.

A corporation's attempt to reorganize by filing for Chapter 11 bankruptcy creates an instantaneous change in the obligations of management. The duty of management to make decisions in the best interests of its shareholders is overruled. Instead, bankruptcy law requires management to give paramount importance to the interests of the corporation's unsecured creditors, followed in importance by the other creditors. Management is required, in essence, to disregard the shareholders' interests.|6~

This change in management's obligations springs from an iron-clad rule: In return for the protection of Chapter 11, the corporation must sever its attachment to its shareholders and devote itself to its creditors.

This rule is implemented in several ways. One method is the imposition of a new standard of conduct for officers and directors. Another is the requirement that many "normal" corporate business decisions be pre-approved by the bankruptcy court, which protects the interests of unsecured creditors.

A third method of implementing the rule is a severe restriction on the power of a reorganizing Chapter 11 corporation to give its shareholders anything of value for their shares until it completely pays the claims of unsecured creditors.|7~ This means that shareholders (whose shares in the bankrupt corporation are usually canceled) can expect to lose most or all of their investment.

The first two methods of implementing the rule favoring creditors have the greatest impact on the day-to-day work of officers and directors. These two methods (a new rule of conduct for officers and directors and court supervision of business decisions) are discussed here in more detail, followed by a look at the impact on officers and directors.

New Rule of Conduct for Officers and Directors

The new rule of conduct takes effect at the corporation's bankruptcy filing and is as follows: All management decisions must be made for the benefit of the corporation's creditors and meet the "fiduciary duty" standard of conduct. This standard of conduct exceeds the ethical standard by which officers and directors are normally judged.

The normal ethical standard of conduct for officers and directors outside bankruptcy is the "business judgment" standard. This means that an officer or director cannot enrich himself personally at the corporation's expense. For example, he cannot obtain a loan from the corporation which he has no intention of repaying, cause the corporation to trade with a profit-making company he owns at non-market prices, or steal a business opportunity from the corporation for personal profit. However, the officer or director is normally free to make wrong business decisions in good faith without fear of liability. During a Chapter 11 bankruptcy, however, the "business judgment" rule for officers and directors is replaced by the stricter "fiduciary" rule.|8~ The fiduciary rule implies a high degree of good faith and competence by the officers and directors, who are said to hold a great trust. The fiduciary standard is exemplified, in another arena, by the high ethics and competence required from a bank serving as trustee for a half-million dollar trust. Like a trust, the subject assets must be managed strictly for the benefit of others. The only difference between the obligations of the bank and the obligations of corporate management in bankruptcy is that the corporation must now be managed strictly and competently for the benefit of its creditors.

An example of conduct which violates the fiduciary rule is as follows: Dew Company (a hypothetical corporation) manufactured and marketed plastic and cloth items to hospitals. To expand its volume and market, Dew Company opened a branch sales office in a nearby state. It did poorly. Dew was forced to file bankruptcy and attempt to reorganize.

During bankruptcy, Dew's directors authorized the branch office's relocation to yet another state, where it failed miserably. The second branch office's expenses made further operations impossible for Dew. The corporation was liquidated and paid less than five cents per dollar to its unsecured creditors.

Dew's directors authorized the branch office relocation in a special directors' meeting. The directors rubber-stamped management's plans without inquiry, not wanting to offend the president, who presented the plan. No examination of the feasibility or expense of the relocation was presented at the meeting.

Questions by the directors would have elicited from the president the following information: (1) Dew's strongest competitor was headquartered in the relocation state; (2) shipping to this market could be exorbitantly expensive; (3) Dew's salesmen all bitterly opposed working in the relocated branch office; and (4) Dew had been advised by an accountant hired to review its situation to reduce expenses and rely on its established markets.

Dew's president, however, envisioned himself at the head of a revitalized Dew operating from the relocation state (his wife's home state). Disregarding the accountant's advice, the president felt that employing all of Dew's remaining assets in this venture was justified. He merely advised the board that this relocation was the first step in his rebuilding program.

Dew's directors are in trouble. Whatever the acceptability of their conduct outside bankruptcy, during bankruptcy the directors must conserve corporate assets for the benefit of creditors and diligently investigate corporate expenditures before authorizing them. They must manage as if the money they spend is their own.

The directors' penalty will be personal liability for the money Dew lost in its doomed second branch office (assuming a lawsuit is brought). If they had diligently overseen Dew's activities, they would not have permitted this expenditure. Thus, they should repay Dew's bankruptcy estate themselves. Additionally, in litigation one can also expect an attempt to hold them liable for the damages from the failure of the entire company!

Court Scrutiny of Business Decisions

Court scrutiny of business decisions is the second method of implementing the corporation's devotion to its creditors during Chapter 11. The power to oversee the decisions of officers and directors is held by the bankruptcy court.|9,10~

The general guidelines for court scrutiny of business decisions during bankruptcy are as follows:

* Officers and directors may make and implement routine business decisions without obtaining prior approval of the bankruptcy court.

* Non-routine transactions are not permitted until the bankruptcy court has given its approval (some transactions will never be approved).

* Transactions in the gray area between "ordinary" and "extraordinary" involve some risk if they are implemented without prior court approval; the risk varies by the type of transaction and the sums involved.

Routine Decision Not Requiring Pre-Approval

Decisions which can be implemented without court approval are those related to ordinary matters necessary to the conduct of business. Examples include hiring replacements for departing, non-key staffers, acquisition of inventory at normal times and in normal quantities, and normal expenditures for ordinary office supplies.

A rule of thumb for assessing whether a decision requires the court's approval is if the decision is not directly related to the business being conducted by the bankrupt corporation or is not within a dollar range that is routine for that business. In these two instances, court pre-approval should be considered.

Non-Routine Decisions Requiring Pre-Approval

Certain decisions or actions during bankruptcy require prior permission from the bankruptcy court. Examples include new corporate debt, most sales of corporate assets, and the use of pledged assets.

All new corporate debt must be pre-approved, unless the debt is unsecured and in the "ordinary course" of the corporation's business. An example of unsecured debt incurred in the "ordinary course" is the routine credit shipment of manufactured goods to a retail chain for resale. On the other hand, a 60-day bridge loan to the retail chain to meet expenses when operating funds have dried up is not incurred in the "ordinary course." The loan must be pre-approved by the bankruptcy court.

Almost any sale of the corporation's assets must be pre-approved, unless the sale is in the ordinary course of the corporation's business. An example of an "ordinary course" sale is the sale of a phone system by a corporation that markets and installs phone systems. However, sale of the same corporation's fleet of automobiles, which it has maintained for years for its chief officers and top salesmen, is not a sale in the "ordinary course." The sale must be pre-approved.

Any use of corporation bank deposits or other funds must be pre-approved if the funds have been pledged to the bank or another creditor to secure the corporation's indebtedness.|11~ The following example illustrates a situation where pre-approval is necessary.

Caddy Corporation (a hypothetical firm) sells and installs office phone systems. It once employed 50 to 100 people at its main office in Dallas and its branches in Houston and Kansas City. By the time Caddy files for Chapter 11 bankruptcy, only 12 Dallas employees remain. All that is left in Houston is a Caddy-owned warehouse, containing some old inventory. All that remains in Kansas City is furniture and office equipment in abandoned leased offices.

All remaining Caddy employees are owed back pay, since Caddy was unable to meet payroll ten days ago. Caddy plans to meet the next payroll (due in four days) with a large receivable it collected pre-bankruptcy and deposited in its payroll account at the bank. All bank accounts are pledged to repay Caddy's bank loans, which are severely delinquent. Caddy's operating account is hopelessly overdrawn, and the bank is angry because Caddy filed bankruptcy before it could seize the payroll account and apply the funds to its loans.

Caddy's president has been cultivating the CEO of an ambitious new lender in town. He thinks the lender might be convinced to lend three months' operating money if Caddy cuts expenses to the bone and pledges its warehouse in Houston to secure the loan. The court must approve this new corporate debt for two reasons: first, the loan would be secured by a significant mortgage, and second, the loan would not be incurred in the ordinary course of Caddy's business (which is selling and installing phones).

Caddy needs to dispose of the furniture and office equipment in Kansas City and vacate the leased premises. The lessor has suggested, in one of its pre-bankruptcy collection calls, that it might take the equipment off Caddy's hands for $20,000, to be credited against the $216,000 it is owed for rent.

Prior court approval of this arrangement is required because this exchange of assets for debt reduction is effectively a "sale" of assets. Such a sale is not in the ordinary course of Caddy's business. This sale also compromises a creditor's claim against Caddy. All compromises of claims against a bankrupt corporation must be approved by the bankruptcy court.|12~ This compromise would never receive court approval because it violates a cardinal rule of bankruptcy: after filing bankruptcy, the corporation can make no payments on pre-bankruptcy debts outside a court-approved reorganization plan.

Also, Caddy's president plans to make payroll from the receivable deposited into the payroll account before Caddy filed bankruptcy. Use of money deposited in an account pledged to the bank is use of "cash collateral." Use of cash collateral requires either the consent of everyone claiming a security interest in the funds or a court order compelling the creditors to permit the use. Assuming the bank will not consent to the use of the payroll account, Caddy, to obtain a court order compelling the use of cash collateral, must convince the court that the bank will not be irrevocably damaged if the pledged funds are used. Otherwise, the bank will be given the benefit of its original agreement with Caddy, and it will be permitted to seize the pledged funds to satisfy delinquent loans.

Many other actions during bankruptcy must be pre-approved by the bankruptcy court. Some require approval because they are specifically regulated by the Bankruptcy Code. Examples include hiring a consultant to analyze Caddy's financial or tax situation, settling pre-bankruptcy claims against the corporation, and hiring the lawyers to represent the corporation in bankruptcy.

Some corporate actions which might be unfair to creditors require prior court approval in principle but are unlikely to receive it. Examples of these actions are declaring a dividend to shareholders during bankruptcy, or selling assets to a creditor for a fraction of their value in return for the cancellation of a personal guaranty given by the corporation's CEO.

The penalties for this latter kind of conduct, a breach of fiduciary duty, can include personal liability for the money the corporation loses. If the conduct was also fraudulent, the guilty party's repayment obligation will follow him the rest of his life, even surviving the personal bankruptcy of the guilty officer or director.

"Gray" Actions Which May Require Pre-Approval

Many business actions that seem necessary or desirable during bankruptcy are not clearly "ordinary," nor are they clearly "extraordinary" actions. Thus, it is not clear whether court pre-approval is required.

Actions which fall into this category include exercising a purchase option at the end of the lease of the building which houses corporate headquarters, investing in new product development and hiring a new CEO during bankruptcy.

The rule of thumb for assessing whether to seek court pre-approval in these instances is to measure the risk of going forward without court approval against the delay and cost of seeking approval. You cannot consult the bankruptcy judge privately, so the best policy is to talk with someone familiar with bankruptcy practices in your area of the country.

Impact on Officers and Directors of Changes in Management

Obligations Successful corporate reorganization under Chapter 11 is difficult. Assuming competent corporate leadership is in place at the commencement of bankruptcy, these leaders must then adapt. As illustrated by some of the points already mentioned, the situation is not "business as usual." There will be problems with sheriffs, suppliers, the telephone company, and the banks. Each problem is a potentially fatal crisis--thus it instantly becomes the burden of the debtor's highest officers. The weight of these problems is compounded by the officers' reduced business control and disruption of their normal business routine. For example, 16 months into the bankruptcy case of A. H. Robins, the pharmaceutical company that manufactured the Dalkon Shield, its chief financial officer wearily lamented that decisions which normally would take a day or less could now take over a month, watched over by numerous outsiders. The daily disruption was compared by Robins' executive vice president to an endless minefield, which kept exploding just when they thought they had made it through. He estimated that he spent "70% of the time worrying about Chapter 11 and 50% of the time on other matters."|13~

Officers and directors of a newly-bankrupt corporation will also find their dealings with lawyers increased exponentially. The debtor corporation's top management will spend many hours huddled with bankruptcy lawyers. Court appearances, depositions, and reviews of past transactions will occupy additional management time; and formulating a reorganization plan will consume many more hours. Under this pressure the management of the business suffers and so does management's former independent control.

Conclusion

While the commencement of corporate bankruptcy under Chapter 11 leaves existing corporate management in office, management no longer works for and answers to shareholders. By law, management must operate the corporation for its creditors. Management must also meet the fiduciary standard of fairness and adapt to "fishbowl" conditions that often require outsiders' pre-approval of corporate decisions. Finally, officers and directors must cope with continually exploding "minefields" which create a never-ending crisis atmosphere. These conditions invariably require consultations with bankruptcy attorneys; the time and energy required for these consultations diverts attention from normal management duties.

The burdens generated by Chapter 11 bankruptcy must, of course, be weighed against the opportunities it provides. Chapter 11 is frequently the only way to reduce debt and allow the corporation to survive.

Dr. Minor's research interests include marketing strategy and management of the external environment; Ms. Stevens-Minor specializes in bankruptcy law. They published "China's Emerging Bankruptcy Law" in The International Lawyer, Winter 1988.

References

1. Sutton, Robert I. and Anita L. Callahan (1987). "The Stigma of Bankruptcy: Spoiled Organizational Image and its Management." Academy of Management Journal 30, (September), 405-436.

2. D'Aveni, Richard A. (1990). "Top Managerial Prestige and Organizational Bankruptcy." Organizational Science 1, (May), 121-142.

3. D'Aveni, Richard A. (1989). "The Aftermath of Organizational Decline: A Longitudinal Study of the Strategic and Managerial Characteristics of Declining Firms." Academy of Management Journal 32, (September), 577-605.

4. D'Aveni, Richard A. (1989). "Dependability and Organizational Bankruptcy: An Application of Agency and Prospect Theory." Management Science 35, (September), 1120-1137.

5. Herzog, Asa S. and Lawrence P. King (1990). 1990/1991 Bankruptcy Code. New York: Matthew Bender.

6. Cook, Michael E. and Carolyn S. Schwartz (1987). "Bankruptcy Law: At a Troubled Company, Officers and Directors Owe Creditors First." National Law Journal (March 16), 22-24.

7. Peeples, Ralph A. (1989). "Staying In: Chapter 11, Close Corporations, and the Absolute Priority Rule." The American Bankruptcy Law Journal 63, (Winter), 65-107.

8. Nimmer, Raymond T. and Richard B. Feinberg (1989). "Chapter 11 Business Governance: Fiduciary Duties, Business Judgement, Trustees and Exclusivity." Bankruptcy Developments Journal 6, (1), 1-72.

9. Epstein, David G. and Jonathan M. Landers (1982). Debtors and Creditors. St. Paul, Minn.: West Publishing Co.

10. Kaplan, Harold L. (1987). "Bankruptcy as a Corporate Management Tool." ABA Journal (January 1), 62-68.

11. Prager, Mark L. (1990). "Financing the Chapter 11 Debtor: The Lender's Perspective." The Business Lawyer 45, (August), 2127-2150.

12. Herzog, Asa S. and Lawrence P. King (1990). 1990/1991 Bankruptcy Rules. New York: Matthew Bender.

13. Steptoe, Sonja (1986), "At A. H. Robins, Chapter 11 is Part of the Daily Routine." The Wall Street Journal (December 17), 6.
COPYRIGHT 1992 Society for the Advancement of Management
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Minor, Michael; Stevens-Minor, Karen J.
Publication:SAM Advanced Management Journal
Date:Mar 22, 1992
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