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The Chapter 11 Filing

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A "work-out" is a form of proceeding that is not administered by the court, but generally results in the same solution as a Chapter 11 reorganization. In a “work-out,” the debtor company approaches its creditors with a plan for altering the company’s debts – paying parts off and changing terms of the debt – in order to avoid a full bankruptcy proceeding and its corresponding costs.

Priority / Seniority: 
In a bankruptcy proceeding, certain creditors may have rights that are superior to those of other creditors. Those creditors with rights superior to other creditors are known as “senior” or “priority” claimants. Seniority is usually either a product of having a collateralized debt, a preference created by the law, or of having a type of preferred stock with what is known as a “liquidation preference”. If a certain debtor has other claims that are senior to his claim, the creditor with lower priority is known as a “junior” creditor.

Overview to Chapter 11 “Reorganization” Filings

A company that files for a Chapter 11 “reorganization” is a company that is in a financial state that is in between that of a healthy company and that of a company that requires a Chapter 7 Liquidation. In the process of a Chapter 11 filing, the debtor company and its creditors will workout an arrangement whereby the debts are paid. While that may sound like a simple process, the reality is that a Chapter 11 filing can be a long, drawn-out process, that results as often in a liquidation proceeding as it does in a reformed and revived company at its conclusion.

The Process

The process involved in a Chapter 11 filing is similar to what we have already encountered in a liquidation filing. The proceeding may be initiated voluntarily by the company, or alternatively, may be brought by the company’s creditors. Note, however, that there are some differences between the Chapter 7 and the Chapter 11 filings.

1. The First Plan
An interesting feature of a Chapter 11 filing is that the company seeking bankruptcy protection may come to court on the date of filing with a pre-arranged plan as to how it intends to extract itself from its financial situation. See 11 USCS § 1121. Often, in the case of such a proposal by the company, the court may grant a temporary stay as to actions by creditors and then allow the debtor to go and deal with the creditors on its own. Such a situation, known as a “work-out,” is the preferred method of handling a Chapter 11 filing from the company’s perspective. Not only do courts tend to respect such a plan if it is reasonable, but it will probably also allow the company latitude in executing the plan and arranging the bankruptcy process on the company’s own terms. In this manner, all parties involved can be satisfied while avoiding the long, drawn out process of a bankruptcy proceeding.

EXAMPLE: Crumbling Co. knew that it was in trouble financially and would soon be forced into a Chapter 7 liquidation by its creditors if it failed to act fast. Given the situation, management decided to take the first step and file for a Chapter 11 reorganization. However, before going to court, management first prepared its own bankruptcy plan, indicating the steps that it would take – including asset sales, layoffs, changing benefits plans, etc. – in order to raise the cash necessary to begin paying down debt prior to a full bankruptcy proceeding.

2. The Debtor in Possession
After the filing, the typical Chapter 11 case will have the debtor remaining in possession and operational control of the business. At this point, the debtor is referred to as a “debtor in possession” ("DIP"). See 11 USCS § 1107. However, the company in such a circumstance will be required to act as its own trustee – selling, mortgaging, and distributing assets for payment to creditors. Note, however, that like a trustee in a liquidation proceeding, the company will not be allowed to make any fraudulent or otherwise undervalued transfers (transfers in which it is receiving less than fair value for its asset), nor will it be allowed to favor one creditor over another. The debtor in possession has fiduciary duties to the creditors to the same extent as a bankruptcy trustee would. See In re Thurmond, 41 B.R. 464 (U.S. Bank. Ct. Dist. Oregon 1983). Any behavior inconsistent with such fiduciary duties is likely to result in the court placing a formal trustee over the proceeding.

EXAMPLE: As Crumbling was still hoping to turn around its operations to become financially viable, they remained as a "Debtor in Possession" of the firm while the bankruptcy process got underway. In the meantime, the firm’s management continued to run the daily operations of the firm and the company’s manufacturing process continued to run as normal.

3. Creditors’ Committees
Shortly after the filing – whether involuntary or voluntary and regardless of whether or not a work-out was proposed – the debtor in possession must meet with various creditors committees. See 11 USCS § 1103(d). These committees, formed by different groups of creditors interested in protecting their rights, will present their demands and put forth suggestions for how the company can repay its debts. See 11 USCS § 1102. If these suggestions are not effective or if the debts continue to go unpaid by the debtor company, these committees, either individually or in combination, are likely to present their own plans for the entire reorganization process. See 11 USCS § 1121(c).

EXAMPLE: Shortly after Crumbling’s Chapter 11 filing, creditors committees began to form in preparation for organizing their interests in the action. Several groups were formed, each representing a different interest. One group, representing bond holders, began clamoring for payment of bonds first. At the same time, several suppliers began organizing their own committee in an effort to obtain priority in the asset distribution.

4. The Reorganization Plan 
Once the parties are aligned, the committees formed, and interests have been discussed, a plan is proposed by the debtor or, under some circumstances, by a creditor, to get the debtor company on track. This plan, known as the “reorganization plan” must be designed to accomplish several things. First, it must go about defining and describing the various types of claimants that the company needs to pay off. The claimant creditors are divided, by the plan, into individual “classes” of claimants based on their interests. Next, the plan must define the way in which the reorganization will address the concerns and find means of payment for each class. The standard rule is that, while different classes of claimants may be treated differently, no member of a class can be treated (i.e., paid) in a manner that is different from any other similarly situated member of the class. Finally, and most importantly, the plan must specify a means for executing the proposed payments and orchestrating the entire proceeding.

After the plan has been submitted to the court, it is then distributed to all classes and all creditors for approval. Each class must accept the plan for it to pass. For a plan to be accepted by a class, creditors that hold an aggregate total of two-thirds of the debt held by the entire class must vote to approve the plan. The court, on its own accord, may block the plan or request its reformation if it feels that it is not in the best interest of each class of creditors despite the approval of each class. Conversely, the court may also use what is termed as its “cram-down” power to force the plan on all creditors after only one class has accepted the plan. However, in such a case, the court must demonstrate that the plan is not discriminatory against any class. See 11 USCS § 1126.

EXAMPLE; Having had sufficient time to fully modify and reorganize its plan after meeting with the various creditor committees, Crumbling provides the court with a final draft of its plan. The court, in turn, distributes the plan to the creditor committees for review and sets a date by which all the committee members must have indicated their assent or rejection of the plan. Because Crumbling is making an honest effort to survive the bankruptcy process and would like to keep its creditors as happy as possible, the company provides a fairly strong plan to the court. The plan, which is generally favorable to most creditors, is approved by each committee – the bond committee, suppliers committee, etc. – each approving the plan by two-thirds of that class’ claims in terms of value. For example, the Bond Committee, which represented total creditors with claims against the company of $100,000, passes the plan with the approval of bond holders who are owed a combined $66,667 by Crumbling.

A Note About Timing

One of the critical factors in a reorganization that makes them popular with companies is the degree of control that the debtor company has over the entire process. For the first 120 days after the initial filing, only the company is allowed to propose a reorganization plan. See 11 USCS § 1121(b). After that period, any interested creditor, class of creditors, or other party to the proceeding, may file its own reorganization plan. This 120 day period may, upon a showing of need, be extended by the court. See 11 USCS § 1121(d)

EXAMPLE: During the negotiations between Crumbling and its creditors, several creditors who knew that they would not be paid under Crumbling's plan wanted to create their own plan. However, since Crumbling still had not completed its final plan draft, the court disallowed the publication of any such plan by the creditors, even though more than 120 days had passed since the filing of the bankruptcy petition.

This time period gives the company some leeway in negotiating with creditors and gives it time to prepare itself for the bankruptcy process. Thus, an extension of this time period may be warranted where the issues involved in the case are particularly complex. See In re Washington-St. Tammany Electric Cooperative, Inc., 97 B.R. 852 (U.S. Bank. Ct. E.D. La. 1989). It is important to note, however, that if the company’s plan is rejected by the creditors or by the court, it may well put the company in a very dangerous position, as it leaves the creditors in a strong position to dictate the company’s fate.

Chapter 11 and Organized Labor

Perhaps one of the single most important reasons why a company that is otherwise in fairly sound operational shape would choose to file for reorganization is to release itself from various organized labor or collective bargaining agreements. See 11 USCS § 1113. Chapter 11 allows a company intent on surviving a downturn in business the opportunity to release itself from any of its previous commitments to its workers or collective bargaining agreements. Moreover, the courts have been known to impose certain restrictions on an organized labor group’s attempt to abandon a company after it has filed for Chapter 11.

This collective bargaining tactic can be a huge bargaining chip for a company. In any firm that requires a great deal of labor – such as those operating in the manufacturing or service industries – where the labor is unionized or otherwise organized, labor virtually always represents the firm’s single greatest expense. The power of unions to drive up the cost of labor is a chronic problem for management of firms in such labor intensive industries. The potential of filing for Chapter 11 bankruptcy represents a strong weapon in the arsenal of management in its negotiation with labor unions.

Ultimately, however, labor agreements cannot simply be left out and ignored while a company goes through a Chapter 11 proceeding. The unions will, in all likelihood, represent an independent class in the reorganization plan. See In re Schatz Federal Bearings Co., 5 B.R. 543 (Bank. Ct. S.D.N.Y. 1980). Moreover, the courts have made it clear that a company can only release itself from collective bargaining contracts under the following circumstances:

  1. The company has proposed contract modifications to the union that would alleviate the need for the bankruptcy
  2. The union has rejected the contract modifications without good cause
  3. The union was given sufficient information as to the situation and the reason for the modifications and
  4. The company acted in good faith in the negotiations with labor.

See In re Allied Delivery System Co., 49 B.R. 700 (Bank. Ct. N.D. Ohio 1985).

These standards, as stated, are not particularly stringent and can be readily met by the company. Thus, it is not uncommon for a firm to file for Chapter 11 protection simply to gain negotiating leverage with an otherwise entrenched, hostile, and stubborn labor union.

EXAMPLE: One of Crumbling’s goals in its reorganization was to obtain a release from a contract that it had negotiated with its employees’ labor union five years earlier. The terms of the contract were onerous and required substantial pay raises to employees each year. Abiding by the terms of the agreement would have effectively destroyed Crumbling’s competitive position in the market. As such, the Chapter 11 filing allowed the company to avoid the contract with the labor union and begin fresh negotiations to redo the contract with terms more favorable to the firm.

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