In this Christmas season children are eagerly awaiting prepackaged presents. That’s an odd locution, isn’t it? We usually refer to the gifts as wrapped rather than prepackaged. I chose the word “prepackaged” because when something is prepackaged it’s all wrapped up. What does this have to do with Chapter 11 bankruptcy? A little background will help to put the answer in perspective.
I. Chapter 11 Bankruptcy
The Bankruptcy Code (title 11 of the United States Code) is divided up into chapters. The first three chapters (1, 3, and 5) are foundational chapters. Their content comes along for the ride no matter which chapter under which the case is ultimately filed. The remaining chapters (7, 9, 11, 12, 13, and 15) are the chapters under which bankruptcy cases are actually filed.
Side Note: Why The Shortage Of Even-Numbered Chapters?
You may wonder why almost all of the chapters have odd numbers. The answer lies with Congress. Congress has been wrestling with budgetary problems for some time, and has been unable to afford even numbers, which are more expensive than odd numbers. As a special treat it got one even number, 12, but for now that’ll have to do. And if you believe that, I have some real estate on the moon I would like to sell you.
The real reason has to do with the passage of the Bankruptcy Reform Act of 1978. Prior to that, the bankruptcy statute had even-numbered chapters. However, Congress felt that some of them had been abused (i.e., sections of the Uniform Bankruptcy Act of 1898, not members of Congress), in some cases by creditors, in others by debtors. Therefore, it jettisoned the offending sections, which turned out to comprise all of the even-numbered chapters. In the 1980s the need of family farmers for bankruptcy relief was not being satisfactorily addressed with the remaining chapters, so Chapter 12 was temporarily added. But it had to be reauthorized every two years. Then in 2005 the entire Code underwent revision. As part of that revision, Chapter 12 was made permanent, and its ambit was expanded to include, not only family farmers, but also family fishing operations.
Back To Chapter 11:
Chapter 11 was originally envisioned as a corporate restructuring provision, though it is now available, not only to businesses, but also to individuals and married couples.
The big picture goal in a Chapter 11 is to deal with debt in a way that allows the debtor to reorganize so that is can continue to participate in the economy. Some debt may be wiped out, some may be reduced to pennies on the dollar, some assets may be liquidated, and the debtor reorganizes its financial affairs. The main vehicle for Chapter 11 restructuring is the Chapter 11 plan. (I am ignoring the idea of a total liquidation Chapter 11 plan.)
A. Timing Of The Filing Of The Chapter 11 Plan
1. The General Rule
As part of the Chapter 11 case, some time after the filing of the case the debtor proposes a plan of reorganization. I say, “some time” because, unlike a Chapter 13 case, the debtor need not file the plan right away. Instead, the debtor is given some statutory breathing room, pursuant to 11 U.S.C. § 1121. 11 U.S.C. § 1121(b) provides the general rule: “. . . only the debtor may file a plan until after 120 days after the date of the order for relief under this chapter.” However, per § 1121(d)(2)(A) this period may be extended to up to 18 months with the Court’s permission.
2. The Small Business Exception
In the case of a small business debtor, § 1121(e)(1) replaces 120 days with 180 days, and 18 months with 300 days. A small business debtor is:
a person engaged in commercial or business activities (including any affiliate of such person that is also a debtor under this title and excluding a person whose primary activity is the business of owning or operating real property or activities incidental thereto) that has aggregate noncontingent liquidated secured and unsecured debts as of the date of the filing of the petition or the date of the order for relief in an amount not more than $2,000,000 (excluding debts owed to 1 or more affiliates or insiders) for a case in which the United States trustee has not appointed under section 1102(a)(1) a committee of unsecured creditors or where the court has determined that the committee of unsecured creditors is not sufficiently active and representative to provide effective oversight of the debtor; and . . . does not include any member of a group of affiliated debtors that has aggregate noncontingent liquidated secured and unsecured debts in an amount greater than $2,000,000 (excluding debt owed to 1 or more affiliates or insiders).
Huh? The gist is that the business must have total debt that is less than $2,000,000, not counting debts owed to the business’s insiders. And the debt must be both noncontingent ― i.e., it already exists and is not contingent on some triggering event occurring ― and liquidated ― i.e., the dollar amount of the debt has been established, perhaps through a lawsuit that has proceeded to judgment.
A very important difference between the more common Chapter 13 bankruptcy (which is only available to individuals and married couples per 11 U.S.C. § 109(e) and a Chapter 11 bankruptcy is the fact that in a Chapter 11 bankruptcy the creditors vote on whether or not the plan should be confirmed by the Court. This creates an incentive for the debtor to craft a plan that is acceptable to the creditors.
1. Classes Of Creditors
As part of the Chapter 11 plan, the debtor must divide the creditors up into classes. The statutory requirement is found in 11 U.S.C. § 1122(a): “[A] plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class.” When the creditors vote, they vote as members of their respective classes. (A creditor may simultaneously be a member of more than one class. For example, under certain circumstances a creditor whose claim is only partly secured by an asset of the debtor’s estate may have a secured claim to the extent of the value of the collateral, and an unsecured claim to the extent that the claim exceeds the value of the collateral.)
2. Impaired Versus Unimpaired Claims
If the plan proposes to treat a creditor differently from the way it would be treated outside of the bankruptcy case, that creditor’s claim is referred to as an impaired claim. 11 U.S.C. § 1124. Otherwise, the claim is unimpaired.A class of unimpaired creditors is deemed to have voted in favor of the plan (11 U.S.C. § 1126(f), so only impaired creditors get to vote on the plan.
3. Creditors Voting In Favor Of The Plan
A(n impaired) class is deemed to vote in favor of the plan if at least two-thirds of the total dollar amount of the class’s claims and more than one-half of the number of creditors in the class vote in favor of the plan. See 11 U.S.C. § 1126(c). A simple example will illustrate this idea:
Suppose there are three creditors (C1, C2, and C3) in a class, with claims of $300,00, $25,000, and $30,000, respectively. This means that the total dollar amount of the class’s claims is $355,000 and the number of creditors is three.
If C1 votes in favor of the plan, then $300,000, i.e., more than two-thirds of the dollar amount of the class’s claims have voted in favor of the plan. However, if C2 and C3 vote against the plan, then less than one-half I number of the class has voted in favor of the plan, so the class has not accepted the plan.
If C1 votes against the plan, but C2 and C3 vote in favor of the plan, then more than one-half in number have voted for the plan, but less than two-thirds in dollar amount have voted in favor of the plan, so the class has not accepted the plan.
If C1 and either of the other two creditors vote in favor of the plan, then more than two-thirds in dollar amount and more than one-half in number have voted in favor of the plan, so the class has voted in favor of the plan.
4. The Absolute Priority Rule
If an impaired class votes against the plan, can the plan still be confirmed by the Court? The answer is yes, but with an important serious problem for the owners of the business.
In bankruptcy not all debts are treated equally. The law distinguishes linguistically between secured and unsecured debts. A secured debt ― a debt that is secured by collateral that the creditor can repossess in the event of a default ― is not treated the same as an unsecured debt because the secured creditor has special rights attached to the collateral securing the debt.
Even among unsecured debts there are distinctions. Some are given priority over others, and the various priority classes are listed in 11 U.S.C. § 507(a). This distinction sets the stage for the so-called absolute priority rule for chapter 11 (there is no analogue in either chapter 7 or chapter 13).
If a class of similarly situated impaired creditors does not vote in favor of the plan, then the Court will only confirm the plan if either:
a. The dissenting creditors will be paid in full through the plan, pursuant to §1129(b)(2)(B)(i), or
b. No one with a claim or interest that is junior to the claims of the dissenting creditor will get or retain anything under the plan, pursuant to § 1129(b)(2)(B)(ii). This second provision is referred to as a “cram down.”
In simple terms, if a class of creditors is not getting paid in full, then any lower priority class gets nothing. This is somewhat analogous to the idea in real estate law, where after a foreclosure sale the first mortgage holder gets paid in full before the second gets a penny, the second gets paid in full before the third gets a penny, etc.
In practical terms this usually means that if there is a cram down, then the owners ― i.e., the shareholders ― of a company in Chapter 11 will see their interest become worthless. For example, when GM went into Chapter 11, the common GM stock was wiped out.
The only way for an owner of the old stock to have an ownership interest in the new company in a cram down is to add new value to the reorganized company. Then the new ownership interest is equal to the new value added. However, if the opportunity to purchase new value in the reorganized company is not given to more than just the old equity holders, the new value exception to the absolute priority rule is unavailable to the old owners. See Bank of America Nat. Trust and Sav. Assn. v. 203 North LaSalle Street Partnership, 526 U.S. 434, 37 (1999) (“We hold that old equity holders are disqualified from participating in such a `new value’ transaction by the terms of 11 U. S. C. § 1129(b)(2)(B)(ii), which in such circumstances bars a junior interest holder’s receipt of any property on account of his prior interest.”)
Keep in mind that if either all impaired classes vote in favor of the plan, or the dissenters all get paid in full, then there is no cram down, and the old equity holders may still retain some value in the reorganized company. However, because equity is at the bottom of the barrel on the priority scale, it is usually wiped out.
5. Limitations On Vote Solicitation
Once the debtor files for Chapter 11 protection, the debtor is not permitted to solicit votes for the plan except in a limited case:
An acceptance or rejection of a plan may not be solicited after the commencement of the case under this title from a holder of a claim or interest with respect to such claim or interest, unless, at the time of or before such solicitation, there is transmitted to such holder the plan or a summary of the plan, and a written disclosure statement approved, after notice and a hearing, by the court as containing adequate information. The court may approve a disclosure statement without a valuation of the debtor or an appraisal of the debtor’s assets.
This means that the debtor cannot lobby in favor of the plan unless the creditor has a copy of the Court-approved disclosure statement ― it lays out the prepetition history of the debtor and sets the stage for the plan ― and the plan. To avoid having several plan iterations, with the Court participating in each iteration, it may be better to find out what the creditors are willing to live with before drafting the plan in the first place. That is the point of a prepackaged Chapter 11 plan.
II. The Prepack
Prior to filing the bankruptcy papers, the debtor ― or more likely the debtor’s attorney ― can meet with the creditors, lay out the debtor’s financial problems, and propose a solution that will be memorialized in the debtor’s Chapter 11 plan. In the dynamic back and forth of that sort of discussion, the debtor can make its case and convince the creditors to vote in favor of the plan before the bankruptcy is filed. This makes the plan confirmation process much faster and smoother than it otherwise would be.
A. Compare The Plan To A Chapter 7 Liquidation
In a business Chapter 7 bankruptcy all of the debtor’s assets are liquidated by the Chapter 7 Trustee assigned to the case, and the proceeds are distributed to the creditors according the Bankruptcy Code’s priorities (see 11 U.S.C. §§ 507(a) and 726(a)). Therefore, the debtor may be able to convince the creditors to vote in favor of the Chapter 11 plan by showing them that they would fare better in the Chapter 11 ― i.e., end up with more money ― than in a Chapter 7. Then the threat of a Chapter 7 might be enough to get the creditors to commit to vote in favor of the plan that the debtor is proposing prior to filing the bankruptcy case.
B. The Problem Of Anger, Bitterness, And The Desire For Vengeance
Economists generally argue that a party involved in a financial transaction will seek to maximize its financial benefit. As Adam Smith put it: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.” As a general principle, this invisible hand is ubiquitously true.
However, sometimes anger and bitterness can cloud a person’s judgment, and that can happen in the Chapter 11 context. If a creditor is motivated by vengeance rather than financial self-interest, then even the most eloquent presentation in favor of the plan can fail. If that happens, an additional sweetener may be necessary to craft a successful prepack.
In this post I have only scratched the surface of a prepackaged Chapter 11. And as you can see from the post, the topic is complicated, and involves detailed planning. Don’t go it alone. Hire a highly skilled bankruptcy attorney to get you the relief to which you are entitled.