PRIMER: Chapter 11 Bankruptcy

Chapter 11 of the US bankruptcy code is designed to allow a debtor to rehabilitate and to provide an orderly process for creditors and equity holders to recover assets in an orderly manner. Corporations tend to file Chapter 11 if they require time to restructure their debts, and while a Chapter 11 bankruptcy allows a debtor a fresh start, they are required to fulfill the terms in order to successfully exit the process.

Chapter 11 is a tool used to accomplish a very specific goal. "The endgame of Chapter 11 is a plan of reorganisation that establishes a framework of what a company's capital structure should look like, what kind of debt it can sustain, and what creditor recoveries will be. The process can afford companies the opportunity to rework their balance sheets or deal with the operational issues necessary to come out of the other side," says Nicole Greenblatt, partner at Kirkland & Ellis.

Businesses that are in financial distress, either because they have too much debt or because they don't have the ability to make sufficient profit, use Chapter 11 for respite. Corporations enter into a coordinated playing field in which the company can address stabilities and determine what recovery packages different creditors should receive, and where everyone knows the rules and statutes required to reorganise the company's assets and liabilities.               

Under the bankruptcy code you don't have to be insolvent to file for Chapter 11. This means you do not have to be in the process of paying your debts or have run out of money, but you have to be in need of financial restructuring. "Bankruptcy is primarily used when companies cannot carry their debt load, have debt that they are not going to be able to repay or refinance and when it appears that the company has more liabilities than assets," says Damian Schaible, partner at Davis Polk. "It is a way to appropriately allocate the assets of the company amongst different creditors."

There are a lot of different reasons why companies could end up in Chapter 11, sometimes it is an overburdened balance sheet from an initial public offering that has gone badly, or a poorly established capital structure. "As a practitioner the fun part of being involved in the Chapter 11 process is getting to look at the whole puzzle, to put the pieces together and look at different industry sectors and countries while helping to guide a management team and a board through a challenging time," says Greenblatt, all the time figuring out a solution that works for the reorganisation of the particular business.

A company that seeks bankruptcy and files for Chapter 11 has generally overleveraged on a balance sheet basis. Its operations may be fine, it may be struggling a little bit and it may not require extensive and operational fixes but instead just needs to deleverage because its current EBITDA isn't sufficient to leverage its existing debt.

"That type of distressed company might file for Chapter 11 in order to deleverage its capital structure pursuant to a plan of reorganisation by converting a substantial portion of its debt into equity, a less restrictive junior debt instrument or by paying off such debt at pennies on the dollar," said Rick Levy, partner at Latham & Watkins.

It is not possible to confirm a Chapter 11 plan without being able to cover administrative costs so it can be an expensive process. The goal is to reorganise businesses that are relevant and should continue to operate, but need to be fixed either operationally or financially.

See also: PRIMER: market risk – a banking regulation perspective

Using Chapter 11 rather than another chapter of the bankruptcy code is largely just a function of the statute. Corporates would use Chapter 11 for reorganising, but for liquidation they would use chapter 7, while municipalities would use chapter 15. The goal of a Chapter 13 bankruptcy is to eliminate debts, but uses a plan to repay debt over three to five years. Individuals can file under Chapter 11 if they have too much debt or income to qualify under Chapters 7 and 13.

One of the most important aspects of Chapter 11 is that managers stay in control of the company.

Chapter 7, on the other hand, is a liquidating process where corporations physically sell off assets, there is no concept of a management team or board remaining in place and using the tools of the bankruptcy code of the US to effectively develop a solution that provides for an ongoing business. It is more the case that the company will take whatever existing assets exist, appoint a trustee and liquidate everything as quickly as possible. It is a less interesting process and less promising for the company, but is focused on recovering assets for the creditors. 

Very broadly speaking, although Chapter 11 is a US based law, Section 109 stipulates that the definition for who can be a Chapter 11 debtor has very wide parameters. Unlike the rules in many jurisdictions in foreign courts, it is not a necessary stipulation that a company be domiciled in the US in order to file for a Chapter 11 bankruptcy in court. The court is able to direct the restructuring of a company's finances and operations regardless.

A company need only be either domiciled in the US, have a branch or location in the US, or possess US assets in order for it to be eligible for Chapter 11.

The US Bankruptcy code would confess to have jurisdiction over debtor assets worldwide. "The practical point is that, while US bankruptcy law applies to a debtor’s property wherever it is located, outside the jurisdictional boundaries of US territory, a debtor may experience enforcement issues against third parties located in foreign jurisdictions," says Jeff Pawlitz, partner at Willkie Farr & Gallagher. "Notwithstanding the broad application of US bankruptcy law to a debtor’s property located domestically or abroad, there are a number of instances where, from a practical perspective, a debtor can't rely upon that kind of breadth of the authority to protect its property interests."

Even though the law professes to travel across the globe, there are going to be instances where companies have to think about how they are going to protect those assets if another jurisdiction isn't going to respect US law.

How you address foreign subsidiaries depends on the extent to which it is the subsidiary that is creating the issue that you are trying to resolve using the bankruptcy process.

"If the foreign subsidiaries - as is often the case – are not guarantors of the parent's  indebtedness they may have their own trade creditors and their own borrowed-money indebtedness, but that may not be what is creating the real source of the insolvency or the problem the enterprise is dealing with," says Levy. "You often would not put those companies into bankruptcy, especially if a firm is trying to expedite the bankruptcy process and avoid the need for separate foreign insolvency proceedings," he adds.

See also: PRIMER: a comparison of EU and US bank resolution regimes

Within the remit of Chapter 11 of the bankruptcy code, there are three distinct routes that a company must choose between when proceeding with the reorganisation; pre-packaged, pre-arranged and free-fall cases.

Pre-packaged means that a company has voted to approve a plan of action before it is filed in a court. An important part of a Chapter 11 is to have all your creditor classes vote on the plan.

This type of bankruptcy is a very effective tool for dealing with hold outs, unlike in a court 100% approval is not necessary, as long as two-thirds agree, ahead of a filing, that it is possible to enter a bankruptcy on a pre-packaged basis. This means the company will inform the judge that the deal does not affect any other creditors, the ones who are being affected are. For example, those converting debt to equity as part of a deleveraging plan who have agreed and consented to the plan with the requisite voting levels. It eliminates the need for a lot of the notice and due process requirements that tend to accompany the Chapter 11 process.

In turn, a pre-arranged plan means a company hasn't actually put a plan out to vote but has secured support from at least one impaired consenting clause. In this instance, a company would need to confirm the plan and then try to get the vote through quickly and keep the case relatively short. In this instance financial and institutional creditors will participate in the decision to file (and when) as well as how creditors will be treated during the prepetition preparation phase of the case.

The third alternative is what is referred to as a free fall Chapter 11 case. In this situation a firm doesn’t necessarily know how it will proceed, nor has a plan in place, and has little in the way of backing or support. It is a case of trying to figure things out once you enter into the bankruptcy proceedings.

In the last few years there have not been any specific legislative changing to the bankruptcy code per se, but that is not to say that it has not undergone changes. Chapter 11 is a like the US constitution in that it is a living document, there are situations where the market changes, or the world changes, and the statute has to keep up.

"The US Bankruptcy code was drafted and put in place a number of years ago, and has been amended from time to time, but it is not necessarily amended in real time and it is not always amended perfectly," says Schaible. 

"There are myriad ways in which the US Bankruptcy Code doesn't fit perfectly in the modern world of corporate debt and operations; however, the beauty of the system is that there is an underlying statute and a constantly developing body of case law analysing and interpreting the statute.  The case law catches up with the market better than the actual statute does," he adds.

Although there is no specific reform pending, Congress and lobbyists often focus on issues related to the cost of bankruptcy, and dedicated professionals address areas as well as insider payments. "They need to understand how important certain individuals are in helping to develop the end game when they think about those kinds of changes, says Greenblatt.

"From our perspective, even though it is still a bullish market, nationally there has still been a lot of restructuring work to do, mostly because of technology and how disruptive it has been to certain businesses, consumer demand and expectations that products will be delivered instantaneously," she adds.

Recent issues have been industry specific, in distressed sectors like retail, and oil and gas.

Looking at a Chapter 11 bankruptcy case now compared to 10 years ago, things have become more sophisticated. Things like liability management have become more creative, and what that has done is delayed what would have been, most likely, an earlier filing a decade ago. However, in the event that there is an inevitable filing, this has created more complexity. Based on these kinds of transactions leading up to the bankruptcy, players are able to navigate a formal process through a consensual and formal out-of-court process with the sophistication of the lenders. " If the ‘liability management’ exercises ultimately prove unsuccessful, however, and a formal restructuring process becomes necessary, these complex front-end transactions may likely create more traction for third parties seeking hold-up value or otherwise looking to disrupt the process for their benefit," says Pawlitz.

This could be due to the sophistication and proactive nature of the lenders and advisors, in as far as identifying opportunities and reaching out on the lenders’ side to work through the process. An overall increase in sophistication has led to a number of these observed practical changes.

See also: PRIMER: bank capital