CHAPTER 2 When Is Bankruptcy the Best Option?

• Jurisdiction: United States

CHAPTER 2: When Is Bankruptcy the Best Option?

CONTRIBUTING AUTHORS:

Allen G. Kadish (DiConza Traurig LLP)

David D. Cleary (Greenberg Traurig, LLP)

Nancy A. Mitchell (Greenberg Traurig, LLP)

Kaitlin R. Walsh (Greenberg Traurig, LLP)

Victoria Watson Counihan (State of Delaware Department of Justice)

Brian J. Fox (Alixpartners LLP)

Rebecca A. Roof (Alixpartners LLP)

Pilar Tarry (Alixpartners LLP)

Upon being retained as CRO in a financially distressed situation, it is best to consider whether bankruptcy is a viable option or whether there are other non-bankruptcy options available to the company.

A. BRIEF OVERVIEW OF OUT-OF-COURT RESTRUCTURING ALTERNATIVES

1. UCC ARTICLE 9 SALE

A "friendly foreclosure" by a secured lender may be effectuated through a sale of collateral pursuant to Article 9 of the Uniform Commercial Code. A borrower may be motivated to simply turn over the collateral to the lender in a private surrender by the presence of a personal guaranty, or by a desire to save jobs and preserve the business. An Article 9 sale may be a quick means of effectuating the resolution of a crisis between lender and borrower, but it must happen pursuant to commercially reasonable terms and through a commercially reasonable process. The lender sends a notice of sale to the borrower; typically, the sale is pre-arranged to an asset-buyer who participates in the process.

Because there is no court process, and therefore no court approval, the buyer runs the risk of successor liability. However, to the extent that the lender and buyer follow the state law-mandated processes, the risk of liability is reduced. This process is used less frequently than the § 363 sale process conducted in a chapter 11 bankruptcy case because often a chapter 11 sale will insulate a buyer from successor liability and claims against the assets. However, chapter 11 is a much more expensive and public process, and, while quicker than disposition through a chapter 11 plan, a § 363 sale still requires a certain amount of time depending on each court's local rules and the vagaries of each judge and case.

2. ASSIGNMENTS FOR THE BENEFIT OF CREDITORS

An assignment for the benefit of creditors (ABC) is a state law proceeding that is somewhat similar to chapter 7 liquidation, but it is a liquidation that is conducted in state court. The legislatures of 34 states have enacted an ABC statute.¹⁵ Even where there is an ABC statute, and certainly where there is none, ABCs are often without structured guidance or reliable case law and thus can be fraught with uncertainty as to outcome and potential liability to the assignee.

In an ABC, the company ceases to operate and the assets are assigned to a chosen assignee, who then disposes of the assets to or for the benefit of the creditors. ABCs do not provide for the discharge of debts, just the disposition of collateral and the payment of the proceeds (after satisfaction of the assignee's fees and costs) to creditors in their state law order of priority. The assignee is a third party (often an attorney, accountant or professional turnaround advisor) and is a fiduciary to the creditors, accounting to them in the disposition of the assets of their debtor. In some states, an ABC is accomplished within the framework of a court-supervised action. Other states have little or no direction on how to conduct an ABC at all. When there is uncertainty in the process, buyers are discouraged from taking advantage of the process. Thus, ABCs are generally little-used tools, but they do serve their own purpose in the proper scenarios.

3. RECEIVERSHIP

In a receivership, a court directs all property subject to dispute to be administered by a court-appointed receiver, who becomes the sole fiduciary of the assets pending resolution of the dispute. Receiverships are rare and can be an unusual byproduct of litigation before a state or federal court in certain circumstances. A receiver may also be appointed in drastic circumstances where there is fraud, waste or a dispute that prevents the operation of the business. Thus, a receiver might be appointed to operate a business upon the indictment of a principal for conducting fraud through an enterprise. A receivership may be absolute, such as when a fiduciary is appointed to take full control of and operate pending the liquidation of a business contaminated by fraud or criminal behavior of its principals (in which case the receiver displaces the directors or officers as the court may direct), or temporary, such as to maintain an asset subject to dispute pending disposition of litigation.

The receiver is a fiduciary to the beneficiaries of the receivership as determined by court order, and the scope of the receivership is usually spelled out in the court order appointing the receiver. Because the receivership is governed by an action pending in the court and regulated by the scope set out by the court, most major decisions, such as disposition of property, claim disputes and distributions, are conducted upon court approval. This gives the receiver and transaction parties, as well as the beneficiaries, the assurance that the receiver has adequately done its job and that the act will not subsequently be questioned or reversed.

Sale of the business or its assets through the receivership and pursuant to court order may insulate the buyer from subsequent liability depending on the terms of the court order; sometimes a receiver will file the business into bankruptcy for further proceedings to sell assets, organize claims and pursue causes of action. In such an event, the receiver serves as the sole manager of the company and operates as the debtor-in-possession of the business in bankruptcy pending further action or order of the court.

4. OUT-OF-COURT WIND-DOWN/COMPOSITION

An out-of-court wind-down, or composition, is essentially a self-liquidation. It is sometimes self-administered by a company in conjunction with state law corporate dissolution provisions, if any. A CRO can be uniquely helpful to a business if he/she is tasked with the authority to direct this discrete activity.

The process of an out-of-court wind-down tends to be time-consuming for the company's management and board, who remain in place and manage the liquidating process, especially in situations where there are a large number of creditors. The process generally works best when there are relatively few creditors who have a high degree of confidence in the company's management. Creditors generally need to be convinced that their interests will be best protected in an out-of-court wind-down through reduced administrative costs as opposed to a more formal process of resolving disputes between the debtor and creditors, such as in a bankruptcy.

Even during an out-of-court wind-down, a minimum of three creditors may subject the company to an involuntary bankruptcy at any time.¹⁶ In addition, disgruntled creditors can also bring litigation at any time, setting off a race for the company's assets.

Management must not only liquidate assets but determine the amount of claims against the company, as well as the appropriate distributions of sale proceeds. Management will often consider a consensual agreement among creditors with respect to the percentage distribution, along with the appropriate releases.

Neither the board nor management receives a court order approving the liquidation and wind-down steps taken, as would be the case in a bankruptcy. Buyers may be reluctant to acquire the assets of a distressed company absent the protections offered through a liquidation proceeding. Therefore, out-of-court wind-downs depend on creditor confidence and participation.

B. CHAPTER 7 LIQUIDATION

In a chapter 7 case, subsequent to the date of the bankruptcy filing, complete control over the company and its assets is turned over to an independent chapter 7 trustee and is no longer in the hands of the pre-bankruptcy management, board of directors, or CRO if one was employed pre-petition, all of whom are wholly displaced by the trustee.¹⁷ Chapter 7 of the Bankruptcy Code governs much of the activity of the estate in bankruptcy.

A chapter 7 trustee is automatically appointed at random from a panel maintained by the Office of the U.S. Trustee (UST), an arm of the U.S. Department of Justice, without being specifically chosen by the court or the company.¹⁸ The chapter 7 trustee is bonded, and oversight is conducted by the UST. The chapter 7 trustee determines the course of the liquidation of the company, including what assets are sold...