Chapter 11 of the Bankruptcy Code: an Overview for the General Practitioner
| Publication year | 1991 |
| Pages | 6 |
| Citation | Vol. 4 No. 9 Pg. 6 |
PART II: THE REORGANIZATION PROCESS
Ronald W. Goss, J.
I. Operations in Chapter 11
A Chapter 11 debtor, though left in possession of its business, is not allowed to operate as it did before filing the bankruptcy petition. After filing, the debtor is known as a debtor in possession and has many of the powers and duties of a trustee.[1] Its board of directors and executive officers are responsible for carrying out these duties and must act as a fiduciary for the creditors, as would a trustee.[2] The debtor in possession will decide what causes of action to pursue or settle, what claims to contest or not to contest, what assets to utilize and what assets to liquidate or abandon, and what contracts to assume or reject. In short, the debtor in possession must conserve, protect and maximize the value of its business.
Section 1108 of the Bankruptcy Code authorizes the debtor in possession to operate its business without any order from the court. Thus, the bankruptcy court does not supervise the operation of the business during the reorganization case. Section 363(c)(1) authorizes the debtor to use, sell or lease property, and enter into transactions in the ordinary course of business without notice to creditors and a hearing in the bankruptcy court. The purpose of the ordinary course of business rule is to allow a business to continue its daily operations without the burden of obtaining court approval or notifying creditors for minor transactions, while at the same time protecting creditors from dissipation of the I estate's assets by requiring notice and a hearing to approve actions outside the ordinary course of business.[3]
In determining whether notice to creditors and a hearing are required before the debtor can use property of its bankruptcy estate, the phrase "ordinary course of business" is critical. Generally, courts will consider the debtor's pre-petition practices and conduct, as well as the general practice in the relevant industry.[4] Where the debtor in possession merely exercises its business judgment with respect to ordinary business matters, its actions are not subject to creditor scrutiny or judicial control.[5]
The importance of notice in Chapter 11 proceedings cannot be overemphasized, for notice is the due process component that gives all parties in interest an opportunity to be heard. In most instances, proposed actions involving the use of property outside of the ordinary course of business may be taken without an actual hearing and an order of the court, if proper notice is given and no creditor objects.[6] Actions not in the ordinary course of business that require notice to creditors and a hearing if objections are raised include obtaining secured credit or incurring secured debt, abandoning burdensome property, assuming or rejecting executory contracts or unexpired leases, selling property outside of the ordinary course of business, and compromising or settling disputed claims.
II. Post-Petition Financing
During the Chapter 11 case most debtors require some form of financing to maintain business operations, make payroll, pay rent, utilities, insurance premiums and other crucial operating expenses, and to otherwise preserve the assets of the estate. Often the only cash available to the debtor in possession is cash collateral, which may not be used without the consent of the secured creditor or authorization from the bankruptcy court.[7] Cash collateral is defined in the Bankruptcy Code as "cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents" in which a creditor holds a security interest.[8] Generally, cash collateral will include rents, accounts receivable and proceeds from the sale of collateral, to the extent they are subject to a perfected lien. The debtor in possession must segregate and is prohibited from using cash collateral unless the secured creditor consents or the bankruptcy court, after notice and a hearing, authorizes its use.[9] Upon a finding by the bankruptcy court that the secured creditor is adequately protected, cash collateral may be used to pay rent, wages and other operating expenses during the case.
It is common for the debtor to file an "emergency" motion to use cash collateral simultaneously with its bankruptcy petition and request a hearing on abbreviated notice. The court will schedule a hearing "in accordance with the needs of the debtor, " but may treat it as a preliminary hearing and authorize limited use of cash collateral only "to the extent necessary to avoid immediate and irreparable harm" pending the final hearing.[10]
The court's inquiry regarding the use of cash collateral focuses on whether the secured creditor is adequately protected and whether the debtor should be allowed to use the proceeds. Typically, as adequate protection for the use of its cash collateral, the secured creditor will be granted a replacement lien against the debtor's post-petition accounts receivable. Although the secured creditor's property rights is the primary concern, the interests of all other creditors and the benefit to them from a successful reorganization also have a bearing on whether cash collateral should be used.[11]
A cash collateral order permits the debtor in possession to use existing proceeds, such as accounts receivable, but does not provide for new advances by the lender. Often a Chapter 11 debtor will need additional working capital financing during its reorganization. Such post-petition financing may come from a pre-petition lender. An existing lender may seek to reduce its exposure and improve its collateral position by providing new financing. The post-petition secured lender can insist, as a condition to extending new credit, that the financing order provide that its pre-petition liens and security interests are valid, properly perfected and enforceable. This will protect the lender from subsequent challenges to the validity of its liens. Debtor in possession loans typically are several points above the prime rate and are among the most secure available.[12] Some courts have made post-petition financing even more attractive by allowing the lender to "cross-collateralize", i.e., receive additional, post-petition collateral as security for both the new post-petition debt and the existing pre-petition debt. Such arrangements often are approved even though the debtor must make significant concessions that affect the interests of other creditors.[13]
Section 364 of the Bankruptcy Code encourages lenders to extend post-petition financing to the debtor in possession through an escalating series of inducements.[14] First, under 364(a) creditors who are willing to extend unsecured credit in the ordinary course of business are entitled to an administrative priority allowable under 503(b). If a creditor is willing to extend unsecured credit outside of the ordinary course of business, such credit may be authorized by the court, after notice and a hearing, pursuant to 364(b). Under rare circumstances, if a lender has made a post-petition loan without first obtaining court approval, the bankruptcy court may grant retroactive approval of the unauthorized loan.[15] However, only the most foolhardy lender would take a chance on such approval being granted.
If lenders are unwilling to extend unsecured credit to the debtor in possession, other inducements are available.[16] The court may, after notice and a hearing, grant a "super-priority" over any and all administrative claims under 364(c)(1).[17] To warrant approval of a super-priority financing arrangement, the court must make clear findings that the debtor cannot obtain unsecured credit, the funds are necessary to preserve the estate, and the arrangement is in the best interest of the estate. As an alternative financing arrangement, the court may also grant the post-petition lender a lien on any unencumbered property of the debtor pursuant to 364(c)(2), or a junior lien on encumbered property in accordance with 364(c)(3). Finally, 364(d) permits the bankruptcy court to grant the post-petition lender a senior, or "priming" lien on property already subject to an existing lien, provided the debtor is otherwise unable to obtain credit and the holder of the existing lien is adequately protected.
III. Executory Contracts and Unexpired Leases
In most reorganization cases, the debtor will be a party to various executory contracts, such as an option, purchase agreement, license, right of first refusal, franchise, or settlement agreement, and may also be a party to unexpired leases, such as equipment and vehicle leases or a commercial lease covering its business premises. Section 365 of the Bankruptcy Code provides that the debtor in possession, subject to court approval, may assume or reject any executory contract or unexpired lease. Rejection of an executory contract or unexpired lease is designed to make the debtor's rehabilitation more likely by relieving it of burdensome obligations while it attempts to recover financially and develop a plan to repay creditors.
The Bankruptcy Code does not define "executory contract", but the term generally is taken to mean any agreement in which substantial performance obligations remain on each party.[18] There must be a contract in existence at the time of filing, otherwise there is nothing left to assume or reject. A contract is not executory within the meaning of 365 unless it is executory as to both parties. If a material breach occurred before the bankruptcy, the contract may not be executory and subject to assumption or rejection because the debtor has no further duty to perform.[19]
The 1984 amendments to the Bankruptcy Code introduced several provisions designed to protect lessors of nonresidential real property from nonpayment of rent during a...
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