Winding your way through Chapter 11 disclosure statement and plans of arrangements.
In this milieu, mid-level financial executives such as controllers and credit managers, along with outside insolvency counsel, provide Plan and Disclosure Statement analysis and distillation, along with an explanation of such poor results, to senior management.
Chapter 11s in a Nutshell
The overall purpose of a Chapter 11 according to judicial sentiment is to arrange a Debtor's financial affairs and provide a return to its creditors. Such arrangements may consist of an extention program, which means a long-term payment plan; a compromise, which means, usually, a one-time payment of a percentage of the debt; or issuance of securities in the Debtor or new entity, and sometimes a combination of all three. The legal test is that creditors should receive the anticipated dividend due under a Chapter 7 liquidation.
Alternative Field of Litigation
The preconceived view is that Chapter 11s provide an opportunity for a financially distressed debtor (usually a corporation) to resolve its financial difficulties with its creditors who are represented through a creditor's committee who may retain an attorney. The Debtor and Committee engage in fruitful discussions to resolve a Debtor's financial dilemma. A Debtor through court supervision returns to financial health through the medium of shedding unprofitable operations and assets, paring down unnecessary payroll and finding, hopefully, its inner core of success.
The process in exiting a Chapter 11 is through a disclosure statement, which is analogous to a stock prospectus in spelling out the Debtor's entire financial history and laying out its plan for the future repayments of its debts, and the Plan of Arrangement which is the legal format for executing the repayment agreement.
Some of these statements are true and some are very artful fabrications. A Debtor may abuse the plat form of Chapter 11s to rearrange its financial affairs in which the rules (Chapter 11 statutory and case law) uniquely favor a Debtor both in providing a different set of legal rights and in the bankruptcy setting itself which provides ample opportunities for the Debtor to aggressively expand these rights. In short, the Chapter 11 process serves as an alternative and unstated platform of litigation in which creditors may find themselves very disappointed and short-changed.
A Disclosure Statement should provide a creditor with sufficient information to vote on a plan and assess its benefits, usually comprising a cash dividend. Theoretically, a creditor in evaluating a Plan should be able to extract from the Disclosure Statement such fundamental information as the Debtor's history, the reason for its financial demise, current financial condition, the identities of operating officers, the gist of the plan, benefits to creditors, the future operating officers who will oversee performance under the Plan, and a liquidation analysis. From a Debtor's point of view, this information when presented will be skewed to present a most favorable light in voting on the Plan. Most Plans have a liquidation analysis which virtually by rote states that the liquidation of the company will generate a recovery far less than the anticipated recovery under the proposed Plan.
Disclosure Statements become the frequent subject of contested battles between the Debtor who provides either skimpy or distorted information and the Committee who demands extensive information. The typical attitude of the Debtor is to propose the minimal amount and see if the Committee will respond or default.
Similarly, a Debtor, whose corporate principals are shareholders and therefore participants in the proceedings, will propose the most aggressive plan at the outset which will generally provide the creditors with a return equal to the benefits under a Chapter 7, a minimalist approach. The analysis in calculating a proposed dividend is based upon accounting and financial advisors' reports, which are frequently biased and very partisan.
This Chapter 7 net benefit test is frequently resolved in a trial setting in which the bankruptcy judge will take and accept evidence in a contested setting. Even though the Plan is subject to voting by amount and percentage, creditors who contest their proposed treatment may be subject to cramdown which means that the judge may even impose the Plan.
Type of Payment Arrangements
The starting point for any Plan is the type of payment: extension, compromise, or stock. Extension programs usually generate some percentage on the dollar dividend over a protracted period of time, ranging between 12 months to 10 years. The average repayment schedule hovers about 36 months. Repayment agreements do not necessarily mean that the creditors will receive payments promptly. Many plans provide that priority (if they agree), tax, secured, and administrative creditors (if they agree) will be paid first from the stream of payments. In some cases, creditors would not even receive any benefit from this extension program for years to come.
However, the largest risk of payment programs is certainty. Obviously management's foibles caused the debtor to fail, prompting the Chapter 11 proceeding. The likelihood of payment is problematical if the same management continues to operate the Debtor, post confirmation.
Compromise programs mean that the creditors have agreed to receive in cash some percentage of the claims. The risk to these plans is whether the Debtor has procured a source of cash for this cash pay-off. Many of these plans are strictly dependent upon the sale of an asset, such as a building, business, subdivision etc., which may be subject to prior and senior liens, or recovery from a contested lawsuit, preference actions, or fraudulent conveyances. Typically, a plan will provide for a pro-rata distribution from the net proceeds of an asset; other plans provide for a guaranteed percentage return to creditors from an asset sale. In some cases, corporate principals simply offer cash funds to provide for a one-time cash payment.
The issues become whether the creditors are receiving a guaranty of a percentage on the dollars (say, about 20 percent), the net proceeds from an asset sale (which may never close); or whether the Debtor can guaranty from other assets some type of recovery. If the Plan is dependent upon the sale of an asset or victory in a contested lawsuit which may be protracted by years of appeals, these plans become very speculative. Real estate and litigation-funded plans bear the greatest risks.
In larger cases, the Debtor will offer stock of a newly formed company in favor of the creditors usually on a percentage of debt to common stock. The issue in virtually every stock plan is straightforward. Can this stock be sold? If not, the likelihood of any value from the Plan is very remote, and the liquidation value of the Debtor might well exceed the value of any stock distribution.
Net Profit Plans
To sweeten the pot, the Debtor may well offer a substantial recovery to creditors, but payable from net proceeds or net profits. Without a binding definition to fix "net," or guaranteed minimum payments, or a certitude that the Debtor will be successful in generating these "net" proceeds, these plans are usually a loser.
Gross Profits Plans
Gross profits or proceeds plans are far more attractive in calculating the dividend based upon a percentage of gross sales (or gross profits) to provide a fixed percentage on the dollar for creditors. Typical plans provide for creditors to receive up to 25 percent of their claims based upon a spin off between 10 to 20 percent of gross sale proceeds or gross profits.
As long as the Debtor is both obligated to continue with its sales and the gross percentage is not subject to later negotiations, these plans generally are productive. A crafty debtor (or its principals) feeling the onerous nature of a virtual creditor tithe will abandon the corporate debtor form, commence a competing business, and dare the creditors to sue for unfair competition, which is a very unlikely proposition as most creditors have written off the obligation itself and have little interest in further litigational expenses. The general manner to prevent this debacle is to include in any plan covenants not to compete or long-term employment agreements.
Revestment of Assets in Hands of Debtor
Absent a special provision, the Debtor becomes revested with its assets. The Debtor's only obligations to its creditors are delineated under the Plan. If the Debtor has not agreed to incur any further debts, or sell its assets, or enter into a new business venture, the debtor is generally free to take these types of actions. The Plan in granting free-wheeling autonomy to the Debtor would not protect the creditor body from any subsequent act, such as a sale of the Debtor's assets to a new entity who may (or usually not) assume the Debtor's liabilities.
During the course of the Chapter 11, a debtor will purchase goods and services on credit. To persuade creditors to continue with credit arrangements, a debtor will claim that the bankruptcy court guarantees the bill or says that the court stands behind the check. Surprisingly, these statements are not true and credit arrangements sour into bad debt (administrative debt). Purchase- and credit-intensive businesses such as restaurants and supermarkets are notorious for incurring large amounts of administrative debt as Chapter 11 debtors. Attorneys and accounts for the debtor and committee will also generate administrative debt. Disclosure statements will reflect this type of debt; they are paid through the plan before pre-petition creditors. The impact is dramatic. These debts waste estate cash, reflect incompetent management, and suggest that the business is still failing.
Contingency of Default
This issue in the average Chapter 11 proceeding is probably the most under evaluated issue. If the Debtor fails to pay "net," "gross," or any payments, fails to sell the building, fails to pay creditors, fails to collect the millions from the pending litigation, fails to perform under the Plan, the creditor's sole remedy is left under the Plan. Most Plans generically provide for liquidation (conversion to a Chapter 7) which is a useless remedy for creditors. The damage is already done. The Debtor defaulted under the Plan either due to financial ineptitude or fraud, the likelihood of any recovery by a successor Chapter 7 trustee is probably slim.
A committee, which is usually represented by counsel, participates with a Debtor in formulating a Chapter 11 plan and disclosure statement. A committee recommendation will go a long way in asuaging concerns of a creditor in evaluating a plan. However, Committees recommend many plans simply because the Plan will permit the individual members of the committee to continue to sell to the Debtor on a C.O.D. basis and create and maintain a captive customer. Although contrary to law, individual committee members are motivated to recommend and vote for plans they perceive as maintaining a captive customer.
The Debtor has promised through a compromise plan for payment of a percentage of the creditor's claims either a stated percentage on the dollar, net proceeds or profits, or gross plan. The mark of a good plan is that the Debtor has granted to all of the prepetition creditors a blanket lien upon the Debtor's current and pending assets to assure payment. Plan covenants which restrict the Debtor's continuing business activities, such as assets sales, salary increases, sale of subdivisions, and financial reporting all enhance the viability of a plan. The absence of any of these provisions likewise would mark a doomed plan.
Feasibility and Risks
Feasibility means whether the Debtor has the financial ability by which to perform under the Plan and moreover whether a further reorganization would be contemplated. The Debtor's prior financial and future projections would aid in this analysis, except the Debtor would state that the prior financials would not forecast the future in that prior management was in charge of the company. A forecast of the future likewise is just a best guess.
Feasibility really means whether a debtor can easily perform operating the business on a minimal level. A Plan predicated upon an asset sale is very uncertain. Suffice it to say, the asset is probably Debtor's white elephant whose successful sale may wait till the millenium.
This is the biggest risk of any Chapter 11 proceeding. Aggressive practitioners will provide both for the release (discharge) of the Debtor from its obligation, but in many instances will provide for the discharge of guarantors, partnerships, corporate affiliates, principals, and subsidiaries all of whom would be acceptable targets of collection litigation for any shortfall. Some plans would state in the following words, "this discharge will relieve any person of liability for the debts owed by the Debtor," a virtual complete discharge which would give these third parties a more than colorable claim to defend on claims of guaranties and sureties.
The discharge provision should be studied carefully to avoid the pitfall of a complete loss of third party liability.
Chapter 11s, instead of providing a forum for fair and equitable treatment of creditors, serve as an alternative platform in which a Debtor may aggressively litigate its rights to prosecute the most favorable and attractive plan in which the Debtor will pay the least amount, over the longest period of time, with the least restrictions on its conduct.
David J. Cook is a partner in the law firm of Cook, Perkiss, & Lew, San Francisco. [C]David J. Cook, Esq., 1995). Reprinted with the permission of International Newspaper Financial Executives.
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|Title Annotation:||reprinted from the International Newspaper Financial Executives|
|Date:||Jul 1, 1995|
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