Rethinking the Concept of Success in Bankruptcy and Corporate Recovery

Rethinking the Concept of Success in Bankruptcy and Corporate Recovery

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In the past few months, two important studies have been published highlighting the prospects for achieving a successful reorganization. Both studies indicate that the odds are still against most bankruptcy petitioners, but shorter than previously thought. In view of these findings, alternatives for the speedy resolution of creditor claims against an estate should be explored and utilized if they will result in increased creditor recoveries.

The definition of "success" in a bankruptcy proceeding is a subject of much debate. In most studies, "success" appears to be defined as the confirmation of a plan and the reorganization of the entity. The definition of success can be broadened to include ceasing the feeding frenzy over the debtor’s assets, maximizing the recoveries to creditors and resolving the affairs of the debtor’s estate. Defining success in this broader context is difficult to empirically analyze, and the authors encourage the submission of articles expanding the discussion. This examination of "success" begins with an exploration of two recent empirical studies and available non-judicial remedies.

EOUST Study

The February 1998 issue of the ABI Journal published the findings by Gordon Bermant and Ed Flynn from data released by the Fee Information and Collection System (FICS), run by the Executive Office for the U.S. Trustee (EOUST). This data represents the most comprehensive source of case statistics available for cases of all sizes. Heretofore, the most comprehensive source of information on national confirmation rates is a 1989 report by the Administrative Office of the U.S. Courts (EOUST) on cases filed from 1979-1986 in 15 judicial districts. The EOUST study traced the outcomes of chapter 11 cases filed from 1989 through 1995. As of December 31, 1997, fewer than 30 percent of these cases resulted in a confirmed plan of reorganization. More than 70 percent were converted to liquidation or dismissed as follows:

Outcome No.

Cases

Rate

Confirmed

33,879

25.8%

Converted

46,368

35.4%

Dismissed

46,241

35.3%

Unknown/Still Open

4,601

3.5%

Total

131,089

100.0%

Source: FICS database, EOUST

While the confirmation rates for cases filed in 1995 (the most recent data) achieved an all-time high of 29.5 percent versus cases filed in preceding years, these statistics still indicate that the odds are against most debtors successfully emerging from chapter 11.

Furthermore, the length of time typically experienced to adjudicate cases continues to range from one to two years. In 1997, 50 percent of confirmed cases reached confirmation in 429 days or less. The 1997 intervals from the filing date to outcome date for confirmed, converted or dismissed cases are as shown in Table I.

Bankruptcy Research Database

Professor Lynn LoPucki recently published results from the Bankruptcy Research Database in the March 10, 1998 issue of Bankruptcy Court Decisions. LoPucki concluded that for large public companies (assets greater than $100 million in 1980 dollars, or $190 million in 1997 dollars), the average time in chapter 11 shortened dramatically from 1980 to 1994. Nevertheless, based on the latest data for chapter 11 cases resolved in 1994, the interval from the filing date to outcome date was approximately 21 months for all cases excluding pre-packaged plans. When including pre-packaged chapter 11s, the average duration for all cases dropped to 13 months.

TABLE I
Maximum Days from Filing
by Percentage of Cases

Outcome

80%

50%

20%

Confirmed

696

429

275

Converted

573

265

120

Dismissed

462

207

77

Source: FICS database, EOUST

Alternatives to Filing Bankruptcy

In evaluating "success," a study of alternatives to filing bankruptcy is crucial. Many creditors are unaware that alternatives to bankruptcy exist when dealing with an insolvent business. Other options such as assignments for the benefit of creditors, state court receiverships, federal equity receiverships, and the use of out-of-court workouts and agreements are alternatives that need to be discussed and analyzed. This is particularly important with the release of the new data on bankruptcy filings and case resolution.

Assignments for the Benefit of Creditors

Although governed by state law, assignments are generally out-of-court proceedings used to consolidate and liquidate a debtor’s property for the sole purpose of repaying creditor claims. Under an assignment, the debtor (or "assignor") voluntarily transfers title of all assets through a trust agreement to a trustee (or "assignee") who liquidates the assets and distributes the proceeds on a pro rata basis among the creditors. While the trust agreement is not necessarily recorded with the state court, the assignment may be recorded in the county where it was executed.

Some states regulate the assignment. Most, however, operate under common law precedent to determine the standards of performance for an assignee. Generally, the assignee’s duties include the following:

•Controlling the debtor’s cash, accounts receivable, inventory, real property and other assets;

•Identifying fraudulent transactions that can be prosecuted under state statutes;

•Liquidating the debtor’s assets by selling assets through the ordinary course of operations, going concern sales of businesses, private sales and/or public auctions; and

•Distributing proceeds from the liquidation to creditors.

Although creditors are the beneficiaries of the trust, their consent is not required to validate the trust. Lack of creditor support is often a difficult problem that can impede the use of assignments. Most states do not require formal acceptance by the creditors, and creditors are not necessarily asked for their consent; however, creditors must refrain from filing an involuntary bankruptcy petition for an assignment to be effective. Asset turnover provisions §§543(c)(3) and 543(d)(2) generally limit this action to within 120 days after the execution of the assignment. Generally, if no creditor has taken action within 120 days, the assignment is considered binding. If, however, the debtor is unable to obtain support of all significant creditors, it will be impossible to proceed with an effective and binding assignment.

Assignments may be faster, simpler and less expensive than bankruptcy cases. They essentially only involve execution of the trust agreement and do not include the forms, schedules, hearings and other activities necessary to commence a bankruptcy case. Although assignments vary in length, they generally conclude faster than chapter 11 or chapter 7 liquidations, lasting between six weeks and eight months. Finally, assignments do not involve the litigation of bankruptcy proceedings and are less expensive. On the other hand, assignments may be viewed by the creditor body as an attempt to conceal transactions or avoid liability. In addition, many states do not allow assignments without judicial supervision.

State Court Receiverships

State court receiverships provide more supervision over the case through the appointment of the receiver, the selection of other professionals, the conduct of the liquidation and the distribution of the proceeds to creditors. The receiver is appointed at the state court’s discretion as a fiduciary to preserve assets pending the liquidation of the debtor’s business operations. Requests for appointments of receivers typically occur when a secured creditor with a mortgage in the debtor’s real property commences a foreclosure action on the mortgage. The receiver is appointed in the county where the foreclosure action was brought. The receiver is generally appointed if the following conditions are met:

•The property is in danger of being lost, removed or materially injured;

•The property may not be sufficient to discharge the mortgaged debt;

•The secured creditor has requested the appointment of a receiver;

•All or a portion of the property is leased;

•Rents or profits in controversy are in danger of being lost, removed or materially injured; or

•The corporation is insolvent, in danger of being dissolved, or has otherwise forfeited its corporate rights.

The receiver is empowered to bring and defend actions with respect to the property, to take possession of the property, to receive rents, collect debts and perform all other acts with respect to the property that the court authorizes to ensure that adequate security is maintained for the mortgagor. As such, the receiver is required to provide an accounting to the court of the assets and liabilities involved, and any use of the assets must be approved by the court. The receiver is not permitted to sell property without the consent of the secured lender and the court, since the receiver is appointed to preserve and protect the property from loss or destruction. The debtor’s consent to a property sale also may be required unless a successful foreclosure has been achieved by the secured lender.

In the event a bankruptcy is filed, §543(b) requires that the receiver turn over control of the property to the bankruptcy trustee. If the debtor is in control of its own assets, the receiver must turn over control of the property to the debtor for the purpose of preserving the debtor’s right to propose a plan of reorganization while controlling its assets. If the debtor is not likely to reorganize, has no long-term interest in preserving the assets and the prospect for reorganization is remote, then the bankruptcy court may permit the receiver to continue controlling and operating the assets under §543(d). A bankruptcy trustee may be appointed to administer claims and pursue preference and fraudulent conveyance actions during the pending sale of the debtor’s property.

Benefits of receivership primarily include: (i) court supervision of the property, (ii) assets are sold or disposed more quickly, and the secured lender’s collateral is more quickly adjudicated, (iii) notification of creditors is simplified, (iv) the lender has greater control over the disposition of assets and management of the case since the lender compensates the receiver, (v) distributions to secured creditors generally proceed faster since subordinate classes of creditors typically receive no distribution, (vi) the lender is shielded from liability to third parties for negligence resulting from possession and (vii) time required to eject a borrower is shortened under a receivership versus a foreclosure action.

Federal Equity Receiverships

The scope of federal equity receiverships has diminished with the expansion of federal bankruptcy and state receivership statutes. Today, federal receivers are most often utilized in connection with stockholder derivative suits or at the request of government officials regarding specific legislation such as the Securities and Exchange Commission or prosecutions of federal racketeering cases. Federal receivers are also used in businesses such as interstate motor carriers, railroads or pipelines where the debtor’s fixed property extends into different states. Cases where the United States is a property holder or lien claimant also may qualify for federal receivership. As in state court receiverships, any creditor demonstrating an existing interest in the property, such as secured creditors, lien holders and mortgagees filing a foreclosure action, may request the appointment of a federal receiver in federal district court to administer the property. Tests employed to determine whether a receivership is appropriate include: (i) the debtor has engaged in fraudulent conduct, (ii) property is in imminent danger of being lost or diminished, (iii) available legal remedies are inadequate, (iv) plaintiffs have a probability of success in related legal actions, and (v) the possibility exists of irreparable injury to the creditor’s interests in the property.

Federal equity receiverships are governed by the Federal Rules of Civil Procedure Rule 66. As such, federal rules apply in all matters except the actual administration of the receivership estate. Local rules exist in less than half the districts, but virtually all local rules provide that the receiver shall administer the estate similar to a bankruptcy case. The receiver can bring actions in the district court regarding the property, provide the court with an accounting of the assets, and perform all other tasks and activities necessary to protect and preserve the property. In practice, federal receiverships resemble bankruptcy proceedings, but have none of the formal requirements and procedures that make bankruptcy a more costly alternative.

Appointment of a federal receiver is considered an extraordinary remedy. Although notice of the appointment is generally given to parties that may be affected by the appointment, notice is not specifically required. Since federal receivers are appointed to preserve and protect the property in question, the receiver’s fees and expenses, to the extent that they were incurred for the benefit of the estate, are charged against the parties requesting the receivership and for whom the receiver was appointed.

To summarize, the benefits of federal receivership are similar to the benefits of state court receivership. In addition, federal receivership permits the administration of fixed property in multiple states in the interests of preserving uniformity and continuity in the administration of the estate. However, as mentioned above, federal receiverships are an extraordinary measure.

Out-of-court Workouts

Compositions, extensions, standby agreements, combinations and other out-of-court workouts and agreements can be made between the debtor and creditors’ committees, trustees and individual creditors without incurring the time and expense of a courtroom proceeding. Out-of-court workout agreements are used to reorganize a debtor by preserving and continuing to operate the debtor’s business. They are often appropriate when reorganizing a debtor after the occurrence of a non-repeating event, where the interests of all parties are best served by continuing an otherwise viable business.

A composition agreement is a contractual agreement between the debtor and its creditors whereby the creditors discharge a portion or all of their claims against the debtor in exchange for payment of a lesser amount than what is actually owed. In contrast, under an extension agreement, only the payment terms are revised, thereby permitting the debtor to repay its obligations for a negotiated period of time. Other types of agreements such as standby, moratorium or stand still agreements preserve the status quo by delaying repayment of the debtor’s outstanding obligations for defined periods without interest or penalties.

Use of out-of-court agreements is advantageous because they permit the continuation of the business without incurring the time and expense of a legal proceeding. They also can be directed to apply to specific issues rather than calling all business transactions, relationships and the overall viability of the business into question. Since these agreements are governed by contract law, the application of the agreement will generally be uniform among most states.


...while bankruptcy may not be viewed as an initial option, its strengths as a system should be kept in mind along with its inherent limitations and attendant cost.


The major disadvantage of these agreements is the inability to bind all creditors to the terms of the agreement. Non-consenting creditors are not bound by the agreement and are not prohibited from using other means to assert their claims against the debtor. Therefore, these agreements are most appropriate when a key secured creditor holds the vast majority of the security interests in the debtor and where that creditor’s claims negatively impact the recoveries of the other creditors in the event the agreement is not consummated.

Advantages of Alternatives Over Bankruptcy

Often out-of-court or state court proceedings have the advantage of being faster, simpler and less expensive than bankruptcy court proceedings. Specific advantages are as follows:

•Out-of-court workouts are generally simpler to consummate than bankruptcy cases since they typically only involve the execution of a negotiated agreement. Bankruptcy involves court supervision, numerous forms, schedules and procedures that require substantial time, effort and cost to prepare, affecting management’s ability to remain focused on stabilizing the business. This will not be possible if a large number of disparate interests exist in the creditor body.

•State court assignments and receiverships and federal equity receiverships generally conclude faster than chapter 11 reorganizations or chapter 7 liquidations since the acts of the assignee or receiver are not subject to stringent bankruptcy court supervision. Although assignments and receiverships will vary in length, they usually last between six weeks and eight months in duration, whereas an average bankruptcy may last two years.

•Bankruptcy can be a much more expensive alternative than either state court actions or out-of-court workouts. The additional costs of bankruptcy stem from professional fees associated with litigating cash collateral orders, chapter 11 plans of reorganization or chapter 7 liquidation issues. A key benefit of bankruptcy is the ability to control and resolve disputes in an ordered, procedural and adjudicated format.

Debtors will usually prefer either an out-of-court or state court approach since the debtor will typically have the ability to influence the selection of an assignee or receiver or will retain greater control of the business. In contrast, the U.S. Trustee selects and appoints the creditors’ committee and/or the trustee for each case under the authority of the bankruptcy court. State court actions will often involve less adverse publicity than bankruptcy. Finally, the debtor’s principals may be able to reduce certain personal tax liabilities through payment of tax claims on a priority basis before general unsecured debt.

Creditors may prefer non-bankruptcy alternatives primarily because they receive larger distributions in a shorter period of time. In addition, the creditors can control isolated hostile creditors whose interests may be adverse to all other creditors by purchasing their claims.

Finally, assignments or receiverships can be an effective means of selling a company’s assets to a third party since the assignee or receiver can continue operating the business so that it can be sold as a going concern, whereas a chapter 7 trustee generally terminates business operations and liquidates the assets. Without an assignment or receivership, potential purchasers may be reluctant to acquire assets which may not be free and clear of creditor claims.

Advantages of Bankruptcy

Bankruptcy offers many advantages, including increased powers for the court to investigate the business and its conduct, the bankruptcy court’s ability to void preferential transfers and fraudulent conveyances, supervision of professional fees, and the court’s ability to discharge the debtor from its debts.

•Creditors and/or debtors may prefer to file under chapter 11 of the Bankruptcy Code seeking time to facilitate a reorganization process or to litigate the liquidation decision. The underlying premise of assignments and receiverships is that the business is not reorganizable and must be liquidated or sold. In addition, court authorization of debtor-in-possession financing may enable the debtor to obtain badly needed working capital over the objections of creditors, thus buying time for the reorganization decision to be adjudicated.

•Although non-bankruptcy approaches may be expeditious, economic and sensible, out-of-court workouts, state court actions and other non-bankruptcy alternatives can be inappropriate in cases involving alleged fraud or cases requiring extensive investigation. The authority of the bankruptcy court will be necessary to pursue and collect preferential payments and fraudulent conveyances. Debtors may favor the automatic stay provisions to prevent commencement, continuation or enforcement of actions against them. In addition, the bankruptcy court provides a single forum for negotiating, litigating and resolving creditor disputes.

•Although non-bankruptcy alternatives typically involve lower legal fees than bankruptcy, they are not subject to the strict court supervision of professional fees, including those of lawyers, consultants, auctioneers, brokers, etc. The bankruptcy court may disallow fees and expenses as it deems appropriate. State courts generally possess no such mechanisms.

•State laws do not discharge debts, and the automatic restraining provisions of §362 are not applicable. In addition, a debtor cannot be discharged from its debts through a state action unless individual creditors elect to accept the distribution as full payment toward their outstanding claims. A debtor must file a bankruptcy petition in order to obtain a full discharge and be relieved from its debts or to assume or reject disadvantageous leases or executory contracts.

•Time and money may be wasted on non-judicial reorganization attempts where only a bankruptcy filing would resolve creditor or inter-creditor disputes. The chances of non-judicial "success" should be carefully analyzed at the onset of negotiations with the debtor.

Conclusion

Some new and interesting statistics regarding chapter 11 bankruptcy filings and the "success" of case outcomes may be creating a different view of judicially supervised proceedings. This data comes on the heels of the National Bankruptcy Review Commission’s study and report on the bankruptcy system, which itself engendered a thorough analysis of bankruptcy law. The emerging data suggests a far greater chance of "success," as narrowly defined by chapter 11 confirmations, than was suggested in previous studies.

The authors believe that a broader definition of "success" could yield even brighter statistics. A review of available alternatives to court supervised proceedings and a cost/benefit analysis of each would seem appropriate at this juncture. This article was not intended to discuss all the alternatives to bankruptcy. Options such as the use of replevin actions, bulk sales of assets, deeds in lieu of foreclosure, exchange offers, mediation, arbitration, and other methods exist. Yet, while bankruptcy may not be viewed as an initial option, its strengths as a system should be kept in mind along with its inherent limitations and attendant cost. Again, the authors invite additional discussion regarding successful resolution of a troubled business’ affairs, how to define "success" and how to empirically measure its achievement.

Journal Date: 
Friday, May 1, 1998