The dramatic rise in US restructuring activity brought on by the COVID-19 pandemic in 2020 preceded a lull in US restructuring activity that has persisted in 2022. The UCLA-LoPucki Bankruptcy Research Database reported 56 large public corporation bankruptcy filings in 2020, compared to eight in 2021, and a mere five through mid-September 2022 – the lowest number of filings by large public corporations since 1981. The reduction in filings can largely be attributed to a combination of loose fiscal policy, expansionary monetary policy and the prevalence of borrower-friendly debt instruments. But as federal aid packages dry up, inflation remains high, interest rates continue to rise, and supply chain and labour shortages linger, some industry experts predict the next wave of bankruptcies is not far off.
The COVID-19 pandemic and subsequent supply chain disruptions caused a surge in inflation that the USA had not seen in decades. Fiscal stimulus programmes, designed to prop up the economy during the COVID-19 pandemic, increased the demand for goods by causing a sharp increase in disposable income for many Americans. Specifically, there was a USD1.18 trillion increase in disposable income in 2020, and about 81% of that increase resulted from fiscal stimulus. Personal income rose 21.1% in March 2021 following implementation of the American Rescue Plan. Increases in consumer spending, which accounts for more than two-thirds of US economic activity, coincided with each stimulus payment made between April 2020 and April 2021.
At the same time, supply dwindled largely due to supply chain disruptions and labour shortages. Supply chain disruptions were triggered by port and factory closures, an abrupt increase in the price of commodities, failure to predict high demand for products and prepare accordingly, a surge in shipping costs, and more.
This demand-supply imbalance has caused inflation to soar. In July 2021, the consumer price index (“CPI”) rose 5.4% from a year earlier, the largest jump since August 2008. In July 2022, the CPI rose another 3.1% from the year prior, up to 8.5%. In response to inflation, the Fed increased interest rates. In 2022 thus far, the Fed has increased interest rates five times for a total of 3 percentage points, which included three hikes in June, July and September of 75 basis points each. And the Fed has warned that it will continue to raise rates in an effort to bring down inflation to the Fed’s 2% goal. This could mean interest rates rising above 4% in 2023.
Over two years after the pandemic hit the USA, many Americans have returned to their pre-pandemic lives. But the effects of COVID-19 and the resulting fiscal and monetary responses persist, including inflation, rising interest rates, supply chain issues and labour shortages. Financially distressed companies that avoided bankruptcy in 2021 by taking advantage of cheap debt, ultra-low interest rate levels and government assistance may find themselves unable to stave off defaults in the year to come.
In the USA, business reorganisations and liquidations are undertaken under both federal and state law regimes. At the federal level, restructuring and liquidation proceedings are governed largely by Title 11 of the United States Code (the “Bankruptcy Code”). Chapters 1, 3 and 5 of the Bankruptcy Code contain general rules, definitions and eligibility requirements for bankruptcy cases and apply to federal bankruptcy cases under Chapter 7 (liquidation) and Chapter 11 (reorganisation) of the Bankruptcy Code. As federal law, the Bankruptcy Code is supreme and pre-empts conflicting state laws that may also provide for business liquidations, receiverships and similar regimes.
Under the Bankruptcy Code, with some exceptions, there are two primary types of bankruptcy cases: Chapter 7 liquidation cases and Chapter 11 reorganisation cases. Chapter 9 permits eligible municipalities to file for bankruptcy. There are also distinct Bankruptcy Code provisions that apply to railroad, family farmers, fishermen and other businesses.
Under Chapter 7, an “estate” comprising all of the debtor’s property and rights is created and then liquidated under the administration of a Chapter 7 bankruptcy trustee. Creditors are then paid based on their respective statutory payment priorities set by the Bankruptcy Code and state law.
Chapter 11 business bankruptcy cases are most often used by companies seeking to reorganise their financial affairs and operations pursuant to a Chapter 11 reorganisation plan. However, Chapter 11 may also be used to liquidate a business pursuant to a Chapter 11 plan of liquidation.
State Law Regimes
State common law and state statutory law also provide for the liquidation or restructuring of failing businesses. Unlike the Bankruptcy Code, which is uniform across jurisdictions, state common law and state statutory law vary across the 50 states.
Assignments for the Benefit of Creditors
General assignments for the benefit of creditors (“ABCs”) are available under common law or statute in all 50 states. Through an ABC, an entity assigns, by way of a deed or otherwise, all of its property to an assignee or receiver. Similar to a Chapter 7 trustee, the assignee or receiver administers the assigned assets for the benefit of the business entity’s creditors. ABCs usually implement creditor distributions following state-law priorities that are similar to the distribution priorities among creditors in Chapter 7 cases. However, an ABC generally does not impose a bankruptcy-like automatic stay of the exercise of creditor rights and remedies. Thus, creditors could still commence an involuntary bankruptcy case or pursue other remedies against the company.
State law receivers and receiverships may be authorised and ordered by a state court. Receivership laws vary among the 50 states. Typically, a receivership is commenced by petition of a creditor that requests a court to order that the debtor company be placed into receivership. In receivership, the company and its properties are administered by a court-appointed receiver for the benefit of creditors. Court-appointed receivers generally have stronger and more flexible powers than assignees in ABCs because courts can tailor receivership orders and the authority of the receiver to the circumstances of the particular case.
Under applicable state statutes, business entities (corporations, limited liability companies and limited partnerships) may have options to dissolve, wind down, liquidate or dispose of their assets, make distributions or terminate their legal existence. State-law statutes typically specify dissolution and wind-down notice requirements and procedures. Further, such statutes typically require that provision must be made for the payment of creditors before any distributions can be made to equity holders.
In the USA, there is no law that requires insolvent companies to be placed into bankruptcy or insolvency proceedings. Accordingly, there are no formal civil or criminal penalties for failure to file bankruptcy cases. Companies are typically placed in bankruptcy at the discretion of their directors and officers, who must weigh the practical, legal and financial consequences. Failure to commence bankruptcy at the appropriate time can lead to issues with contract counterparties, the loss of a company’s access to liquidity and capital markets, the loss of going-concern value, and events of default under the company’s credit facilities that may cause rapid business deterioration and losses.
In some circumstances, directors and officers with fiduciary duties may face personal liability for their failure to conduct the business and preserve its value in a manner consistent with state and federal laws.
In the USA, creditors may commence involuntary bankruptcy cases against a financially distressed company. Under Bankruptcy Code Section 303, creditors may petition a bankruptcy court to initiate a Chapter 7 or 11 bankruptcy case against a debtor company. If a debtor has 12 or more creditors who hold non-contingent and undisputed claims, an involuntary bankruptcy petition against the debtor may be filed by no fewer than three such creditors holding claims totalling at least USD16,750. If the debtor has fewer than 12 such creditors, an involuntary bankruptcy petition may be filed by one or more creditors holding at least USD16,750 of such claims.
Following the filing of an involuntary bankruptcy petition, the debtor subject to the petition may contest it. If the debtor opposes the petition, the bankruptcy court, after a trial, will grant the petition, and the case will commence, only if the petitioning creditors show that:
Outside of a bankruptcy, under applicable state laws, one or more creditors may request a state court to appoint a receiver for an insolvent entity, see 7.1 Types of Voluntary/Involuntary Proceedings.
A business entity need not be insolvent to qualify for, and commence, a case under either Chapter 7 or 11 of the Bankruptcy Code. However, some level of financial distress is generally required in order to take advantage of the federal bankruptcy laws, and a bankruptcy case may be dismissed if it is filed in bad faith.
Typically, only insolvent business entities qualify for the appointment of a state law receiver. Insolvency is not usually required for an ABC or state law dissolution. Legal “insolvency” may be defined in different ways under various state and federal laws and judicial decisions.
Banks are not eligible to be debtors under the Bankruptcy Code. Instead, federal US banking laws permit the Federal Deposit Insurance Corporation (FDIC) to close a financially troubled bank and act fairly autonomously as its receiver.
Domestic US insurance companies are also not eligible to commence bankruptcy cases under the Bankruptcy Code. However, insurance companies may be placed into trusteeship or receivership and wound down under applicable state laws.
In the USA, broker-dealers are authorised to file for bankruptcy under Chapter 7 of the Bankruptcy Code; however, their insolvencies tend to be governed by specialised federal securities laws, including the Securities Investor Protection Act (SIPA).
A company in need of financial restructuring may pursue and complete a restructuring without commencing a Chapter 11 case if it has sufficient liquidity and time to reach an agreement with its financial creditors and other primary stakeholders. Even if a company is unable to restructure entirely out of court, it can save considerable time and money by reaching agreement on restructuring terms with key stakeholders prior to commencing a Chapter 11 case.
Sophisticated creditors, debtors and restructuring professionals understand that a negotiated out-of-court financial restructuring is often preferable to potentially litigious and less certain in-court restructuring outcomes. A consensual out-of-court restructuring or “workout” may deleverage a financially distressed company and resolve risks and uncertainties for its employees, customers, suppliers and creditors if it provides the company with sufficient liquidity and a healthy balance sheet.
Out-of-court restructurings can avoid the high costs, possible reputational stigma, uncertainties and potential business disruptions that may arise during a Chapter 11 case. Even if a restructuring cannot be consummated entirely out of court, negotiations may culminate in a prepackaged (a “prepack”) or a pre-negotiated bankruptcy case, which are both generally swifter than a traditional bankruptcy case. Creditors who do not consent will be bound by the bankruptcy court process, so long as the terms of the restructuring have adequate creditor support and the plan complies with the statutory confirmation requirements.
There is no standard timeline or singular process for out-of-court restructurings. Strategies, processes, types of agreements and timelines depend heavily on the facts of each case.
Out-of-court restructuring negotiations often take many months to complete. The complexity of negotiations and the number of parties involved may extend the timeline. Timelines may shorten if an announcement is made about the restructuring process that causes suppliers to tighten trade credit. Often, a distressed company and its advisers will simultaneously pursue out-of-court negotiations and prepare for and negotiate a prepackaged or pre-negotiated bankruptcy case that will be commenced if out-of-court negotiations fail or a Chapter 11 case is needed to bind dissenters.
Typical Process and Related Agreements
At the onset of restructuring talks, debt holders and lenders will assess the company’s situation to determine whether a restructuring is feasible. Lenders, bondholders or other creditor groups may form ad hoc committees and employ their own legal and financial advisers to evaluate the company and its financial condition. Creditors will conduct business and legal due diligence, including reviewing the company’s business plans and projections, financial covenants, debt structure, liquidity and assets to determine what, if any, restructuring options are feasible.
When negotiating out-of-court restructurings, companies often seek standstill (or forbearance) agreements or waivers of credit agreement defaults from lenders, pursuant to which such parties agree that they will not exercise specified remedies otherwise available to them for a specified time period. Lenders may also agree to waive their rights to declare defaults and to exercise default remedies for expected company violations of specific financial covenants. In exchange for their agreements, creditors will often receive fees and the company’s agreement that it will pay the costs of the lenders’ advisers and counsel.
Intercreditor agreements (and subordination agreements) between two or more creditors may fix and prioritise their competing rights to receive payments of cash or other property from a company, including proceeds of a sale of shared collateral, as well as determine timelines and details with respect to such creditor groups’ respective abilities to exercise remedies. With some exceptions, intercreditor agreements are generally enforceable in bankruptcy.
Out-of-court restructuring agreements may provide for an infusion of new liquidity for a company. Outside of bankruptcy, existing creditors and new lenders are free to grant new loans to a company on terms that are valid under applicable non-bankruptcy law and the company’s existing debt documents. If a company has unencumbered collateral, it may pledge that collateral to new or existing lenders in exchange for new loans.
If substantially all of a company’s assets are already encumbered by liens, existing lenders may offer new credit to a company under new loan agreements or amended terms of existing agreements. New money lenders may agree to the “take-out” of existing debt owed to existing creditors using new loan proceeds.
A creditor’s legal obligations to a company are typically defined contractually by the terms of the agreement between the parties. Generally, creditors owe no fiduciary duties to the company or to each other, and are free to act in their own self-interest, even if doing so disadvantages the company or other creditors.
However, in rare bankruptcy cases, a creditor’s misconduct may cause its claim to be “equitably subordinated”, ie, a court orders lower-priority claims to recover ahead of a claim held by the creditor who has acted inequitably.
In certain circumstances, a creditor may lose its right to vote on a plan of reorganisation based on its conduct. Under Section 1126(e) of the Bankruptcy Code, a bankruptcy court may designate or disallow a creditor’s vote if the vote was not cast in good faith. Courts have designated votes in cases where a creditor:
Out-of-court financial restructurings are consensual and contractual in nature and, therefore, are implemented without judicial intervention or approval pursuant to the contractual terms of multi-party agreements between the company, its significant creditors and other key stakeholders.
Outside of bankruptcy, companies are generally unable to bind minority dissenting creditors or dissenting equity holders to restructuring terms. A small minority of dissenting creditors may exert outsized leverage to block an out-of-court restructuring. If a dissenting minority refuses to agree to the terms of the restructuring, the company may choose to file a prepackaged or pre-negotiated bankruptcy to effect the terms of the restructuring and bind dissenting creditors, see 6.1 Statutory Process for a Financial Restructuring/Reorganisation.
A secured creditor has a right to payment against a debtor secured by a lien on or security interest in debtor property (collateral). Such liens and security interests may be granted contractually, judicially or by operation of law.
Generally, non-bankruptcy law (and, where applicable, contractual agreements) governs the priority, extent and enforceability of such liens and security interests. The priority among secured creditors with liens on the same collateral usually depends on when each creditor perfects its liens. Unless otherwise contractually agreed, creditors who perfect their liens first typically have first priority rights with respect to any relevant proceeds of shared collateral.
Under the Bankruptcy Code, a claim is secured to the extent of the value of the secured creditor’s interest in the estate’s interest in the collateral (11 USC Section 506(a)). Generally, outside of an insolvency process, secured creditors are able to enforce payment of an obligation by foreclosing on their collateral. In bankruptcy, limits are placed on a secured creditor’s ability to enforce its liens and security interests and recover on its collateral. In the event of bankruptcy, a secured creditor who has not perfected its liens or security interests before bankruptcy will be treated as an unsecured creditor.
Generally, each state’s laws (and contractual agreements, if applicable) govern the rights and remedies of secured creditors. Secured creditors with mortgage liens on real property collateral may, upon a default by the mortgagor, obtain a judgment in court, foreclose on the real property, and force a judicial sale of the property. In some jurisdictions, secured creditors may credit bid their secured claims at judicial sales of real property collateral. Alternatively, some jurisdictions allow for strict foreclosure in which a secured creditor takes ownership of the property in complete satisfaction of its debt without a judicial sale. Likewise, applicable state laws that are generally based on the Uniform Commercial Code (the “UCC”) dictate the rights and remedies of a creditor with chattels as collateral.
Applicable state laws give secured creditors high priority rights to payment in state law receivership proceedings and ABCs. In Chapter 7 and 11 cases under the Bankruptcy Code, secured creditors have the following rights, among others.
Adequate Protection Rights
Secured creditors are entitled to seek “adequate protection” of their liens and security interests in debtor property to protect against any diminution in the value of their interests in collateral that might occur during a Chapter 11 case with the passage of time or as a result of use of the collateral property or the imposition of post-petition financing liens on the property. Adequate protection includes periodic cash payments to the secured creditor (usually in the amount of post-petition interest that would otherwise be payable contractually) and/or granting the secured creditor replacement liens on other debtor property.
Relief From Automatic Stay
Section 362(d) of the Bankruptcy Code gives secured creditors the right to seek a bankruptcy court order granting the secured creditor relief from the Section 362(a) automatic stay to exercise remedies against the secured creditor’s collateral. A bankruptcy court may lift or modify the automatic stay in the following circumstances:
Cram-Down Treatment Rights
If a debtor proposes in a plan of reorganisation to not pay a secured creditor in full, and the secured creditor does not vote to accept the plan, the debtor must show that the proposed plan either:
The “indubitable equivalent” standard requires that the secured creditor receives the equivalent of the secured amount of its claim or the value of its collateral by, for example, cash payments being made to the secured creditor equal to the allowed amount of its claim, abandoning the collateral back to the secured creditor, or granting the secured creditor a substitute lien on collateral of the same or greater value.
If the transactions contemplated by the plan involve a sale of the secured creditor’s collateral, then to cram down the secured creditor the creditor must be provided with an opportunity to credit bid.
Applicable state laws control the priority of payment rights of creditors and may vary across jurisdictions.
The Bankruptcy Code’s hierarchical creditor priority scheme is as follows:
Secured creditors have first priority payment rights in bankruptcy to the extent of the value of their collateral. A creditor’s claim may be partially secured and partially unsecured. If a secured creditor’s claim is greater than the value of its collateral, then the creditor will have two separate claims: a secured claim equal to the value of the collateral, and an unsecured claim for the “deficiency” in collateral value (11 USC Section 506(a)). A secured creditor has no priority rights to payment of proceeds of assets of the debtor’s estate that are not subject to the secured creditor’s lien.
An administrative expense claim has a payment priority junior to secured claims and senior to other unsecured claims, see 5.5 Priority Claims in Restructuring and Insolvency Proceedings.
A general unsecured claim is a debt or other obligation owed by the debtor that is not secured by a lien or security interest. The general rule is that all pre-petition general unsecured claims are generally entitled to equivalent bankruptcy treatment and the same payment priority, but there are statutory exceptions to the rule.
Section 507 of the Bankruptcy Code provides enhanced statutory priority for certain types of pre-petition unsecured claims that are entitled to payment in full before lower-ranked general unsecured claims receive a distribution.
Section 510 of the Bankruptcy Code provides that particular claims may be subordinated to general unsecured claims. For instance, a contractual subordination agreement entered into between creditors before the bankruptcy case will generally continue to be enforceable during the bankruptcy case as between the parties to the agreement. Section 510 also provides that claims for damages arising from the purchase or sale of securities are subordinated to all claims that are senior to or equal to the claim or interest represented by the security. Also, claims of creditors that engage in “inequitable” conduct may be subordinated to other claims by order of the bankruptcy court.
Unsecured pre-petition trade claims are generally entitled to no higher priority or better treatment than other general unsecured claims. However, Section 503(b)(9) of the Bankruptcy Code grants administrative expense priority to claims of pre-petition unsecured trade creditors arising out of their delivery of goods to the debtor within 20 days of a bankruptcy filing, up to the value of the goods delivered during that time period.
Trade creditors may also receive full or substantially full payment on their pre-petition unsecured claims in bankruptcy if such trade creditors are determined by court order to be “critical vendors” of the debtor. Generally, critical vendors are those who provide unique goods or essential services to the debtor, and are irreplaceable vendors. Before a debtor can pay the pre-petition claims of critical vendors, the debtor must obtain a bankruptcy court order authorising such payments.
Unsecured trade creditors may receive full or substantially full payment of their claims under a Chapter 11 plan if their claims qualify as “convenience class” claims under the plan. Typically, convenience class claims are a separately classified class of smaller unsecured claims that receive payment in full under a Chapter 11 plan for ease of administration of the plan.
Upon the commencement of a bankruptcy case, the automatic stay of Section 362 of the Bankruptcy Code takes effect, preventing creditors from asserting their non-bankruptcy rights and remedies, see 6.2 Position of the Company.
Unsecured creditors and other parties-in-interest in a bankruptcy case may, in limited circumstances, move the bankruptcy court to dismiss a voluntary bankruptcy petition “for cause”, which may include unreasonable delays by the debtor. In some jurisdictions, creditors may seek dismissal of a bankruptcy case if it was filed in “bad faith” (relevant factors include a debtor’s lack of truthfulness with the court and improper management of the estate). In some circumstances, unsecured creditors may seek to convert a Chapter 11 case to a Chapter 7 liquidation case, pursuant to Section 1112(b) of the Bankruptcy Code.
After a bankruptcy case has been properly commenced, unsecured creditors have rights to assert their claims by filing proofs of claim in the manner and before the deadlines set by the bankruptcy court and applicable provisions of the Bankruptcy Code and related rules. Individually, unsecured creditors are parties-in-interest in a bankruptcy case with standing to participate and be heard in the proceedings. Unsecured creditors may, among other things, file motions seeking judicial relief, object to motions filed by other parties, and object to the confirmation of a proposed Chapter 11 plan. Unless a Chapter 11 plan provides for payment in full of unsecured claims or provides for no distribution to such creditors, unsecured creditors have the right to vote to accept or reject the plan.
Prior to a bankruptcy filing, an unpaid unsecured creditor may proceed in state court to seek a pre-judgment attachment of debtor property. Pre-judgment attachments allow an unsecured creditor to simultaneously preserve its rights against debtor property at the same time the creditor proceeds with a civil action to obtain a monetary judgment against the debtor, so that the creditor can collect against the debtor’s property if successful in the litigation.
Under the Bankruptcy Code, administrative expense claims are entitled to first priority in payment after secured creditor claims are paid out of the proceeds of their secured creditor collateral, for which a confirmed Chapter 11 plan must provide payment in full unless the holders of such claims agree to different treatment. Administrative expense claims are claims for “the actual, necessary costs of preserving the estate”. Administrative priority expenses include post-petition operating expenses such as post-petition wages, taxes and amounts payable to trade creditors who have supplied goods and services during the bankruptcy case, bankruptcy court-approved professional fees and, generally, amounts owing to lenders and other creditors who have extended new money financings or trade credit to a debtor during a bankruptcy case.
Other priority unsecured claims receive payment after administrative expense claims, but before general unsecured claims. Common priority claims under the Bankruptcy Code are certain employee unpaid wage claims up to certain dollar amounts (USD15,150 as of 1 April 2022) incurred during the 180 days prior to the bankruptcy filing, certain employee benefit programme contribution claims up to a capped dollar amount, and certain tax claims.
A rehabilitative financial restructuring in the USA is achieved by a US bankruptcy court’s confirmation of a Chapter 11 plan of reorganisation in a Chapter 11 case under the Bankruptcy Code. A Chapter 11 case gives a financially distressed company the opportunity to continue operating as a going concern while restructuring its balance sheet, its operations, or both.
When there are minority dissenting creditors objecting to a consensual restructuring, a company may commence a prepackaged or a pre-negotiated Chapter 11 bankruptcy case in order to bind dissenting creditors to otherwise agreed terms of a restructuring. Before commencing a prepackaged or pre-negotiated bankruptcy case, the debtor and its supporting creditors will typically execute a restructuring support agreement (“RSA”), which is generally enforceable in bankruptcy and binds the debtor and supporting creditors to the agreed terms of a bankruptcy restructuring.
In a prepackaged bankruptcy case, the debtor company negotiates and documents a plan of reorganisation and solicits votes on the plan prior to filing for Chapter 11. A debtor does not need creditors to unanimously accept the plan – only a majority in number of voting creditors that hold at least two-thirds of the dollar amount of debt voted in a class are needed to confirm a plan. Once the requisite votes are obtained, the company files its Chapter 11 case and submits its prepackaged plan for confirmation. A court date is obtained for a hearing on confirmation of the prepackaged plan, often within weeks of the bankruptcy filing.
A pre-negotiated bankruptcy is similar to a prepack, except that, by definition, creditors will not have voted on the Chapter 11 plan of reorganisation prior to commencement of the debtor’s Chapter 11 case. An RSA may be signed before or after a company files for bankruptcy, but votes on the plan of reorganisation are not solicited until after the company has sought bankruptcy protection and the solicitation and disclosure documents are approved.
If pre-bankruptcy restructuring negotiations fail and significant creditors begin to exercise remedies against the company, or if the financially distressed company lacks the liquidity needed to operate its business and continue negotiations outside of bankruptcy, it may commence a “traditional” Chapter 11 reorganisation case. In the Chapter 11 case, the company may:
A traditional Chapter 11 reorganisation process may take several months or even years.
Chapter 11 plan
A Chapter 11 plan is a multi-party contract that resolves claims against and liabilities of the debtor entity in a manner consistent with the requirements of the Bankruptcy Code. The terms of a confirmed Chapter 11 plan are binding on all creditors, equity interest holders and other parties-in-interest.
Under Section 1123 of the Bankruptcy Code, a plan must include, among other provisions, terms that:
Plan terms may:
The Chapter 11 plan process is very flexible. While the form of most Chapter 11 reorganisation plans is similar, the terms of a particular plan are unique and highly negotiated. The terms of a confirmed Chapter 11 plan, to the extent they are accepted by voting creditor classes, may provide for distributions of value and payments to classes of creditors and equity holders that vary from their respective rights and priorities under the statutory priority scheme under Section 726 of the Bankruptcy Code, see 7.1 Types of Voluntary/Involuntary Proceedings.
Plan formulation and solicitation
A Chapter 11 plan may be confirmed consensually with votes of acceptance by all classes entitled to vote. If not all classes vote to accept the plan, the confirmation of the plan requires that it be accepted by the requisite majorities of creditors voting in at least one impaired creditor class without counting the votes of insiders. A class of creditors accepts a plan if holders of at least two-thirds in amount and more than one-half in number of those actually voting vote to accept the plan.
If at least one impaired creditor class votes to accept the plan and the plan otherwise satisfies all other requirements of the Bankruptcy Code, the plan will be binding on all creditors and equity interest holders, regardless of whether or not they voted to accept the plan, ie, the plan can be “crammed down” on dissenting creditor and equity classes if the Bankruptcy Code’s Section 1129(b) requirements are met, see 4.3 Special Procedural Protections and Rights.
A company may file a Chapter 11 plan at any time during its Chapter 11 case. Typically, a plan confirmation process will take at least 60 days or longer after a proposed plan has been negotiated, documented and filed. A Chapter 11 debtor has the exclusive right to propose a Chapter 11 plan for the first 120 days of its Chapter 11 case, which may be extended for up to a maximum of 18 months after the commencement of the Chapter 11 case. Before the debtor may solicit votes on the plan, it must obtain bankruptcy court approval of a disclosure statement that provides “adequate information” to those entitled to vote on the plan about the Chapter 11 case, the plan and their treatment under the plan (11 USC Section 1125).
After votes have been solicited and obtained from classes entitled to vote on a plan, and after the deadline for filing objections to the confirmation of a Chapter 11 plan has passed, the bankruptcy court holds an evidentiary hearing on the confirmation of the plan. At the confirmation hearing, the plan proponent must show that required acceptances of the plan have been received and that the plan satisfies all of the requirements of the Bankruptcy Code, including that the plan contains all plan provisions required by Section 1123(a) and meets the numerous Section 1129 confirmation requirements, including cram-down requirements under Section 1129(b), if relevant, see 6.12 Restructuring or Reorganisation Agreement.
Confirmation order and effective date
If the court decides to confirm a plan, it will enter an order with findings of fact and conclusions of law that all Bankruptcy Code confirmation requirements have been satisfied.
Following the confirmation and consummation of a Chapter 11 plan, the reorganised company must perform its obligations and effectuate the transactions contemplated by the plan, including implementing the plan’s treatment of various classes of creditors and equity interests (11 USC Section 1142(a)). A confirmation order typically discharges the pre-petition claims and liabilities of a debtor, and includes plan-based injunctions against post-confirmation actions by creditors and other parties-in-interest that are inconsistent with the confirmed plan.
Upon the filing of a voluntary Chapter 11 petition by a debtor, the company is automatically authorised (without need for court approval) to proceed in bankruptcy as a “debtor-in-possession”, and may continue to operate its business (11 USC Section 1108). The Chapter 11 company’s internal governance and management continue under the applicable non-bankruptcy law. The debtor company’s incumbent directors and officers continue to manage the company’s business and properties, and perform the debtor’s duties under the Bankruptcy Code.
No bankruptcy court approvals are required for ordinary course business transactions, including ordinary course property uses and sales, and the incurrence of ordinary course unsecured debt (such as trade credit).
In circumstances involving fraud, dishonesty or gross mismanagement of the affairs of the debtor by its current management before or during the Chapter 11 case, the bankruptcy court may appoint a Chapter 11 trustee to displace the debtor and incumbent management, and to take control of the debtor’s property and business (11 USC Section 1104(a)). In other cases, the court may appoint an “examiner” to investigate the debtor, its management and its affairs as appropriate, and may grant an examiner expanded powers to perform Chapter 11 duties that the court orders a debtor not to perform (11 USC Sections 1104(c), 1106(b)).
During a Chapter 11 case, the debtor company is protected by the automatic stay of Section 362 of the Bankruptcy Code, which applies very broadly in any Chapter 11 or 7 bankruptcy case to protect a debtor and its properties against unilateral creditor actions and other interferences with estate property. Subject to certain statutory exceptions, the Section 362 stay applies globally, automatically and generally to all persons and entities. The stay gives a Chapter 11 debtor company an opportunity to stabilise its business and affairs, negotiate with creditors and other stakeholders, and formulate and propose a Chapter 11 plan of reorganisation.
However, relief from the automatic stay may be granted in certain circumstances (11 USC Section 362(d)), see 4.3 Special Procedural Protections and Rights and 6.3 Roles of Creditors.
Individual creditors and ad hoc or other creditor groups have standing to appear and be heard in a bankruptcy case, and a bankruptcy court may permit them to intervene generally or in any specific Chapter 11 matter or proceeding. Creditors may file motions seeking bankruptcy court relief (including relief from the automatic stay), file objections to motions filed by the debtor or others, and object to confirmation of a Chapter 11 plan. However, many individual creditors do not organise and do not play an active role in a Chapter 11 case.
Official Committee of Unsecured Creditors
The rights of unsecured creditors in a Chapter 11 case are usually represented by an official committee of unsecured creditors. The Bankruptcy Code requires the United States Trustee (the “US Trustee”) to appoint an official committee of creditors holding unsecured claims “as soon as practicable” after the commencement of a Chapter 11 case. The US Trustee may appoint additional committees of creditors or equity security holders as he or she deems appropriate (11 USC Section 1102(a)).
Ordinarily, the members of an official committee of unsecured creditors appointed by the US Trustee are those willing to serve who hold the seven largest unsecured claims against the debtor (11 USC Section 1102(b)). In practice, the US Trustee exercises discretion, will interview those who express interest in serving, and will take into account the views of the Chapter 11 debtor about whether particular creditors should be appointed.
An official committee in a Chapter 11 case monitors developments in the case and acts as it deems appropriate to advance the interests of the parties it represents. An official committee owes fiduciary duties to the parties it represents, and may be expected to provide information requested by class members and to recommend to them whether to accept or reject a proposed plan. An official committee may employ attorneys, financial advisers and other professionals to assist the committee in its role, and the fees, costs and expenses incurred by an official committee and its professionals are paid by the debtor’s estate to the extent approved by the bankruptcy court.
The official committee has standing to be heard on all matters, and may take positions adverse to the debtor and/or object to the confirmation of the Chapter 11 plan. A bankruptcy court may give standing to an official committee to commence estate causes of action against third parties in certain circumstances.
Creditors whose claims are impaired under a proposed Chapter 11 plan may vote to reject the plan. However, unanimous creditor acceptance is not required.
Individual dissenting creditors can thwart confirmation of a plan if they can show that the plan does not satisfy the best interest of creditors test. This test requires that the plan provide them with at least as much value on account of their claims as they would receive in a hypothetical liquidation of the debtor under Chapter 7 (11 USC Section 1129(a)(7)(A)(ii)).
When a class of creditors has voted as a class to accept a plan, the terms of the confirmed plan will be binding on all creditors within the class, including individual creditors who voted against the plan.
In addition, a Chapter 11 plan may be confirmed over the dissent of entire non-accepting creditor classes. If one or more impaired creditor classes vote as a class to accept the plan, non-accepting creditor classes can be “crammed down” on such classes if the plan provides that each creditor in a non-accepting class receives at least as much value as it would receive in a hypothetical Chapter 7 liquidation of the company and the plan:
The cram-down requirements for non-accepting unsecured creditor classes include that no class junior to a non-accepting unsecured creditor class will receive any payment until the non-accepting class is paid in full, and that no class senior to the non-accepting unsecured creditor class will receive more than the allowed amount of their claims (11 USC Section 1129(b)(2)(B)). Likewise, a plan may be confirmed and crammed down over the dissent of a non-accepting secured creditor class if it satisfies the requirements of Section 1129(b)(2)(A), as discussed above, see 4.3 Special Procedural Protections and Rights.
The Bankruptcy Code also provides for the cram-down of non-accepting classes of equity interests (11 USC Section 1129(b)(2)(C)).
Generally, claims of creditors may be freely traded and transferred during a Chapter 11 case. However, various contractual and legal restrictions may limit trading in a Chapter 11 company’s debt and debt securities.
It is common for bankruptcy cases of affiliated business entities to be “jointly administered” before a single bankruptcy court and judge.
On commencement of a Chapter 11 case, a debtor’s legal and equitable interests in property become property of the debtor’s estate (11 USC Section 541). Any use, sale or lease of estate property outside the ordinary course of business requires bankruptcy court approval (11 USC Section 363(b)).
A Chapter 11 debtor may sell estate property in the ordinary course of business without bankruptcy court approval, but otherwise bankruptcy court approval of a sale is required (11 USC Section 363(b)). A court will generally defer to a debtor’s business judgement and approve a sale of property if the sale process and procedures are reasonable, fair and used to maximise value for the estate, see 7.2 Distressed Disposals.
In a Chapter 11 case, a secured creditor may agree to release its liens on property of the estate that is sold in a Chapter 11 case, in return for “adequate protection” of its lien interest by having the lien attach to the proceeds of the sale or other property. Section 363(f) of the Bankruptcy Code permits property to be sold free and clear of all liens, claims or interests, see 4.3 Special Procedural Protections and Rights and 7.2 Distressed Disposals.
In Chapter 11, an operating company usually needs ordinary course trade credit from its vendors and suppliers. The Bankruptcy Code permits a debtor company to obtain unsecured credit and incur unsecured debt in the ordinary course of business without bankruptcy court approval, and those who extend such credit are entitled to administrative expense priority rights of repayment (11 USC Section 364(a)).
A debtor may need significant additional borrowings of new money financings during the Chapter 11 case. The Bankruptcy Code authorises the debtor to obtain unsecured or secured post-petition financing outside of the ordinary course of business (“DIP Financing”), with bankruptcy court approval after notice and a hearing. DIP Financing may be secured by a lien on unencumbered property, a junior lien on already-encumbered property, or a “priming” lien that is senior or equal to existing liens on the property. The bankruptcy court and debtor must provide “adequate protection” to pre-existing secured lenders whose collateral and liens are subjected or subordinated to (primed by) new DIP Financing liens (11 USC Section 364(b)-(d)).
The Bankruptcy Code permits a Chapter 11 debtor to use “cash collateral” (ie, cash, cash equivalents and cash proceeds of debtor accounts receivable and other collateral property that is subject to pre-existing liens and security interests) with the consent of all holders of liens on or security interests in the cash collateral, or if there is no consent, by order of the bankruptcy court if the order provides “adequate protection” of such liens and security interests (11 USC Section 363 (c), (e)).
The Chapter 11 process may establish and determine the allowed amount of creditor claims, and whether they are secured or unsecured. Substantive non-bankruptcy law usually determines whether asserted claims are valid and allowable, and in what amounts. In Chapter 11 cases, the allowed amount of most claims, as well as whether such claims are secured or unsecured, is determined in an allowance/disallowance process (or “claims reconciliation process”), often occurring after a Chapter 11 plan is confirmed and consummated, see 6.1 Statutory Process for a Financial Restructuring/Reorganisation.
Section 1129(a) of the Bankruptcy Code enumerates mandatory requirements that apply to confirmation of a Chapter 11 plan for a business entity. The Section 1129(a) confirmation requirements incorporate other provisions of the Bankruptcy Code (for instance, Section 1123(a)’s requirement for inclusion of certain mandatory provisions in a Chapter 11 plan). The burden is generally on a Chapter 11 plan proponent to show that the following Section 1129(a) requirements are satisfied:
The terms of a confirmed Chapter 11 plan may release non-debtor parties from actual or potential claims held by the debtor against such parties. Bankruptcy courts typically require showings that some consideration was provided for the releases received. Such consideration may be monetary or other contributions to the debtor during the Chapter 11 case or pursuant to the plan. Chapter 11 plans routinely provide for general releases of possible estate claims and causes of action against officers and directors of a Chapter 11 debtor in consideration of their services to the company during the Chapter 11 case, although such releases have been subject to increased scrutiny.
Chapter 11 plans may also propose and effectuate “non-consensual third-party releases” on creditors in consideration of the value they will receive under a plan, whereby creditors are deemed to release, upon consummation of the plan, any direct or derivative claims and causes of action that individual creditors might have or assert against non-debtor “released parties” (including current and former officers, directors and employees of the debtor, official committee members, lenders to the Chapter 11 company, plan funders, purchasers and other parties who have made it possible for the plan to be confirmed). Such non-consensual third-party releases are often highly contentious and their validity has recently been called into question by some courts.
In Chapter 11 cases, creditors may have rights to offset and reduce a pre-petition obligation they owe to the debtor by the amount of a pre-petition obligation owed by the debtor to the creditor. Such “set-off” rights and “recoupment” rights may be enforced to the extent permitted by non-bankruptcy law and the Bankruptcy Code. Generally, the Section 362 automatic stay prevents a creditor from exercising any set-off rights unless the creditor obtains a bankruptcy court order modifying the automatic stay, but does not preclude exercise of recoupment rights.
Chapter 11 plans and confirmation orders usually include injunctions that prohibit creditors and other parties from taking actions that are inconsistent with plan terms. If a debtor or other party fails to perform according to the confirmed plan, the bankruptcy court may direct the performance of such acts (11 USC Section 1142(b)).
Existing equity owners of a Chapter 11 company may, pursuant to a Chapter 11 plan (and depending on the facts and circumstances):
Generally, equity holders do not retain ownership of the reorganised company if the company is insolvent. Typically in that circumstance, the Chapter 11 plan provides that old equity interests are cancelled without any distribution on account of such interests, but the facts and circumstances may permit better plan treatment.
In some cases, existing equity holders may retain their ownership interests in exchange for making contributions of substantial “new value” to the debtor’s estate. Any new equity to be received by an existing equity holder on account of such new value must be subject to a market test, ie, be subject to higher and better third-party offers.
Insolvent companies may be liquidated voluntarily or involuntarily under federal law, pursuant to Chapter 7 or Chapter 11 of the Bankruptcy Code, see 2. Statutory Regimes Governing Restructurings, Reorganisations, Insolvencies and Liquidations.
Alternatively, an insolvent company may also be liquidated pursuant to varying laws of the 50 states that provide for:
See 2.2 Types of Voluntary and Involuntary Restructurings, Reorganisations, Insolvencies and Receivership.
In the USA, the point at which a liquidation proceeding may be commenced by a company is generally in the company’s discretion. Exceptions include the commencement by creditors of an involuntary Chapter 11 or Chapter 7 case, when a state court orders the appointment of a receiver, or the dissolution of the insolvent entity.
Chapter 11 Liquidations
A key advantage of a Chapter 11 liquidation is that the company’s existing managers and directors usually remain in control to oversee continued operations and the liquidation of the business as a going concern. Management continuity and knowledge may preserve and maximise going-concern values when business assets are sold.
The timelines and duration of Chapter 11 liquidations vary from case to case. Chapter 11 provides maximum flexibility for a liquidation, but it is the most expensive and time-consuming type of liquidation proceeding.
Confirmation of a liquidating Chapter 11 plan requires satisfaction of the same legal standards for confirmation of a Chapter 11 plan of reorganisation, see 6.1 Statutory Process for a Financial Restructuring/Reorganisation. The “feasibility” requirement requires a showing of sufficient funding to consummate the liquidating plan. Unless there is sufficient net sale proceeds or other funding required to pay secured and administrative expense claims in full and to fund the plan, the legal standards for confirming a liquidating Chapter 11 plan cannot be satisfied.
A Chapter 11 case may be converted to a Chapter 7 liquidation case if a Chapter 11 plan cannot be confirmed. The Chapter 11 debtor may request such conversion voluntarily as a matter of right, or another party-in-interest may request conversion for “cause”, pursuant to Section 1112(b) of the Bankruptcy Code. “Cause” is defined under Section 1112(b)(4) of the Bankruptcy Code to include, among other things:
Instead of converting its Chapter 11 case to Chapter 7 when a liquidating plan cannot be confirmed or consummated, a Chapter 11 debtor may seek a “structured dismissal” of its bankruptcy case, ie, a court-ordered dismissal of the bankruptcy case combined with certain additional relief, such as court-approved distributions to certain creditors and releases for various parties. However, bankruptcy courts cannot approve structured dismissals that do not strictly adhere to the Bankruptcy Code’s payment priority scheme absent consent of affected parties (Czyzewski v Jevic Holding Corp., 137 S. Ct. 973 (2017)).
Chapter 7 Liquidations
A Chapter 7 case may be a viable alternative to Chapter 11 when the going-concern value of a debtor’s business and properties has been lost. Chapter 7 may be preferable if the liquidity needed to administer the high costs of Chapter 11 or to continue or restart business operations is unavailable, or if incumbent management is untrustworthy, unreliable or uncooperative. Administrative expenses are generally lower in Chapter 7 than in Chapter 11.
Upon the commencement of a Chapter 7 case, the incumbent management and directors of the debtor are immediately replaced by an interim Chapter 7 trustee who is appointed by the US Trustee (11 USC Section 701(a)). The interim trustee exercises complete control over the debtor’s estate and properties in accordance with the Bankruptcy Code and will continue as trustee unless creditors holding undisputed, non-contingent unsecured claims elect a different permanent Chapter 7 trustee of their own choosing (11 USC Section 702).
A Chapter 7 trustee must “investigate the financial affairs of the debtor” and liquidate and distribute the debtor’s property “as expeditiously as possible” (11 USC Section 704). The Chapter 7 trustee collects and sells the debtor’s assets in one or more 363 sales, and uses net proceeds (if any) to pay creditors in accordance with statutory priorities set by Section 726 of the Bankruptcy Code. The statutory distribution priorities among various classes of creditors and equity interest holders is mandatory in Chapter 7 liquidation cases. A Chapter 7 trustee may make distributions to creditors without court approval of any formal distribution plan.
State Law Receiverships
An insolvent business may be liquidated in state law receivership proceedings under the supervision of a state court. For companies with significant or complicated assets across multiple jurisdictions, a Chapter 7 or 11 case under federal law may be more practical. Commencement of a state law receivership proceeding does not preclude the subsequent commencement of a bankruptcy case that may supersede and stay the receivership.
Generally, state courts have authority to appoint receivers under applicable state law, either by statute or under their general equitable authority. The authority of state law receivers is typically limited to liquidating a company’s assets and distributing the proceeds, but receivers may sometimes be empowered to operate a business.
State law receivership proceedings may be commenced when a creditor or shareholder requests a state court to appoint a receiver. After the receiver is appointed, it has jurisdiction over all property of the insolvent entity, except for real property located outside of the state.
Assignments for the Benefit of Creditors (ABCs)
In an ABC, a debtor company (as “assignor”) executes an agreement with an experienced individual or entity fiduciary (the “assignee”), providing for the general assignment of all of the debtor’s assets to the assignee as a trustee for the benefit of the debtor’s creditors. An ABC functions much like a Chapter 7 liquidation under the Bankruptcy Code, but is subject to the laws of the state in which the assignment is made. ABCs may either be court-supervised or proceed without judicial supervision, depending on the law of the applicable state.
The assignment of all of a debtor’s assets creates an estate. The transfer of assets is subject to any and all creditor claims and pre-existing valid liens and security interests encumbering such assets. The assignee as a fiduciary for creditors acquires all right, title and interest in the assigned assets for the purposes of liquidating the assets and making distributions to creditors in order of their respective state law priorities.
An ABC does not result in an automatic stay of creditor actions.
State law dissolutions permit a business entity to wind up its affairs, liquidate or dispose of its assets, pay its liabilities and claims, and conclude its existence. Dissolution and wind-up procedures vary from state to state and for differing forms of business entities. There is no stay of legal proceedings or creditor enforcement actions upon the commencement of a dissolution under state law.
Corporate dissolutions are typically commenced voluntarily by shareholder vote. In some circumstances, a corporation may also be dissolved involuntarily by court order. A corporation need not be insolvent to be dissolved.
The winding-down process typically includes:
Although some states do not permit a shareholder to file a lawsuit to involuntarily dissolve a corporation, a state’s attorney general is generally able to file a lawsuit to request the revocation or forfeiture of the corporation’s charter if there has been an abuse of corporate power. If a corporation is dissolved as a result of such a court order, the liquidation plan will be prepared by a court-ordered trustee or receiver and may be subject to court approval.
The manner in which business assets are sold, or otherwise disposed of, in a liquidation – and who has authority to make such dispositions – depends on the type of liquidation proceeding.
Dispositions in Receiverships
In a receivership under state law, the court-appointed receiver generally has exclusive authority to negotiate and execute any sale of the company’s assets, which must then be reported to the court. State law receiverships may allow for certain “free and clear” sale transactions.
Dispositions in an ABC
In an ABC, the designated assignee takes title to all of the assignor company’s assets for the benefit of its creditors. The assignee exercises its discretion about how best to liquidate assets and maximise their value. Asset sales by an ABC assignee must comply with applicable laws, and will be subject to the liens of secured creditors. Usually, applicable state law does not permit an assignee to sell “free and clear” of liens, so secured creditor consent to such free and clear sales must be obtained. If the ABC is court-supervised, a sale – especially of assets subject to liens – may require court approval.
Dispositions in Dissolutions
In state law dissolutions, the persons authorised by the company’s directors to administer the dissolution and wind-up of the company’s affairs will negotiate and consummate asset sales and dispositions in accordance with the company’s plan of dissolution. No judicial approval is required, unless the dissolution has been ordered by a court or is subject to judicial supervision. No “free and clear” asset sales are available in a corporate dissolution, and no special credit bidding rules apply.
363 Sales in Bankruptcy Cases
In Chapter 11 and Chapter 7 cases, the debtor or trustee, as applicable, is authorised to sell assets outside the ordinary course of business with bankruptcy court approval, pursuant to Section 363 of the Bankruptcy Code. Section 363 sales often include the assumption and assignment to a purchaser of particular executory contracts and unexpired leases if the purchaser wants to assume the debtor’s rights and obligations under such agreements.
A bankruptcy court will approve the use or sale of debtor property outside the ordinary course of business as long as it is a sound exercise of the debtor’s business judgement and is in the best interests of the debtor’s estate. In deciding whether to approve a sale or use of debtor property, a court may consider numerous factors, such as:
Section 363 of the Bankruptcy Code permits both public and private sale transactions. Bankruptcy courts generally favour a public auction process, to ensure that a sale transaction is fair and market-tested. A bankruptcy court-approved 363 sale process is flexible and tailored to maximise value in light of the particular facts and circumstances of the case.
Debtors and bankruptcy trustees often seek advance bankruptcy court approval of bidding procedures that will apply to a particular 363 sale. Bidding procedures may include the following:
Stalking horse bidders
In many 363 sales, a potential purchaser is selected as the “stalking horse” bidder, setting a floor value for the sale and assuring that the debtor has a sale transaction to consummate before further efforts are undertaken to seek a higher bid. Section 363(k) of the Bankruptcy Code specifically permits a secured creditor that is a prospective asset buyer to credit as purchase price (or “credit bid”) the amount of any claims it may have that are secured by the property being sold. Credit bidding rights give a secured creditor some control over a sale of collateral property to ensure the collateral is being sold for the highest price. The right to credit bid, however, is not absolute, and the Bankruptcy Code permits the bankruptcy court to deny a purchaser the right to credit bid “for cause”. If the secured creditor is the successful bidder, the creditor’s claim is reduced by the amount of its credit bid.
A stalking horse bidder usually receives bidder protections in exchange for its agreement to make an initial firm bid, and to compensate it for its due diligence costs and accepting the risk of being outbid. Common bidder protections include a break-up fee, which typically ranges from 1% to 3.5% of the value of the stalking horse bid, plus an expense reimbursement, both of which are payable in accordance with the negotiated terms of the bidder protections, usually if a transaction is consummated with an alternative buyer. A limited “no shop” period may protect a stalking horse bidder during the time between the execution of its purchase agreement and when the bankruptcy court approves the bidder protections. Bidder protections are not immediately enforceable and must be approved by the bankruptcy court.
An expeditious 363 sale may be accomplished by negotiating and executing a purchase agreement with a stalking horse bidder prior to commencement of a Chapter 11 case, and then seeking bankruptcy court approval of the transaction promptly after the Chapter 11 case is commenced.
363 sale benefits and protections
Parties-in-interest in a bankruptcy case may object to a proposed 363 sale, so there is a risk that a proposed sale may not be approved by the bankruptcy court. Under Section 363(m) of the Bankruptcy Code, a sale of debtor property to a good faith purchaser generally cannot be unwound after the sale closes, even if the bankruptcy court order approving the sale is overturned on appeal.
Section 363 sales are often viewed favourably by potential purchasers for the following reasons:
In a 363 sale, a purchaser may acquire assets “free and clear” of all liens, claims, interests and other encumbrances on the assets. A “free and clear” sale is permitted as long as one of five conditions in Section 363(f) of the Bankruptcy Code is satisfied:
Whether one or more of the Section 363(f) conditions is satisfied with respect to particular interests may often be disputed. Whether Section 363(f) permits a 363 sale free and clear of all successor liability claims is not clear.
Undisclosed and unauthorised agreements among potential bidders and collusive bidding arrangements may be illegal or even criminal. Under Section 363(n) of the Bankruptcy Code, such agreements are grounds to avoid a 363 sale or to recover additional consideration from the purchaser.
In a Chapter 11 case, an official committee of unsecured creditors is typically appointed by the US Trustee, see 6.3 Roles of Creditors.
Foreign, non-US companies that meet the eligibility requirements set forth in the Bankruptcy Code may commence plenary Chapter 11 or Chapter 7 bankruptcy cases in US bankruptcy courts. Many foreign business entities commence Chapter 11 proceedings in the USA by showing that they conduct business or hold property located in the USA. If a company commences a plenary insolvency proceeding outside the USA, the Bankruptcy Code also provides procedures for the foreign proceeding to be recognised in US bankruptcy courts and, in that case, affords the non-US debtor certain rights and protections.
Eligible non-US insolvency proceedings are recognised in the USA through Chapter 15 of the Bankruptcy Code, which provides for the commencement of an ancillary US bankruptcy case to assist a foreign court in a foreign insolvency proceeding. Chapter 15 is based on the United Nations Commission on International Trade Law’s Model Law on Cross-Border Insolvency. More than 50 nations or territories have adopted legislation based on this Model Law, which is premised on international comity. A Chapter 15 bankruptcy case serves both protective and facilitative functions, protecting the non-US debtor by allowing it to stay both actions against its assets in the USA and litigation pending against it in US courts. It also facilitates a foreign debtor’s restructuring efforts by allowing it to administer, sell or transfer property within the jurisdiction of the USA, and to take other actions in furtherance of its restructuring.
Foreign Representatives and Proceedings
By filing a petition under Chapter 15 of the Bankruptcy Code, a “foreign representative” petitions a US bankruptcy court for recognition of a “foreign proceeding”. A “foreign representative” is authorised in a foreign proceeding to administer the reorganisation or liquidation of the foreign debtor’s assets or affairs, or to act in a Chapter 15 case as a representative of such foreign proceeding (11 USC Section 101 (24)). A “foreign proceeding” is a “collective” judicial or administrative proceeding in a foreign country under the supervision of a non-US court and the laws of that jurisdiction relating to reorganisation, insolvency or liquidation of the debtor. In order to be eligible to seek recognition under Chapter 15, a non-US entity must either be domiciled, conduct business or hold property in the USA.
Upon the filing, the bankruptcy court will hold a hearing to consider entering an order of recognition of the foreign proceeding, either as a foreign “main” proceeding or as a foreign “non-main” proceeding. The distinction between “main” and “non-main” is crucial. If the foreign proceeding is recognised as a main proceeding, because the foreign proceeding is in the country where the debtor’s centre of main interests is located, the US automatic stay goes into effect and much of the core relief available to a Chapter 15 debtor is granted automatically. On the other hand, if a Chapter 15 proceeding is recognised as a foreign non-main proceeding (ie, the centre of main interests of the foreign debtor is located in a third country), all relief requested in the Chapter 15 case is left to the discretion of the US bankruptcy court.
For a foreign proceeding to be recognised as a main proceeding, the debtor’s “establishment” (ie, a place of operation from which the debtor conducts non-transitory economic activity) in the country of the foreign proceeding must be the debtor’s centre of main interest. It is a rebuttable presumption that the debtor’s centre of main interest is the country of the debtor’s registered office. The presumption may be rebutted using evidence of the location of the debtor’s headquarters, its management, its primary assets, or the creditors most likely to be affected by the case. In making the centre of main interest determination, a US bankruptcy court may also consider which foreign jurisdiction’s laws will apply to most disputes between the debtor and its creditors.
One of the policies underlying Chapter 15 is to encourage co-operation between US courts and their non-US counterparts. To effectuate this policy, and to facilitate co-ordination and communication between courts, US courts have employed a number of procedures with varying degrees of formality. A bankruptcy court may appoint a person or entity to act at the direction of the court, or may enter into a cross-border protocol or cross-border agreement with a non-US court. Protocols and agreements clarify and allocate the responsibilities of the relevant US and foreign courts over certain issues, and establish methods by which the courts will communicate. Less formal arrangements include communication of information and developments by methods considered appropriate by the bankruptcy court, including statements made on the record at the relevant proceedings by the parties-in-interest.
Debtors in Chapter 15 cases will often seek to allocate and clarify the scope of authority of the various courts in Chapter 15 and plenary cases, sometimes through a cross-border protocol. Generally, US courts will respect the decisions and procedures of foreign jurisdictions and tribunals so long as they are not “manifestly contrary to the public policy of the United States” (11 USC Section 1506). This public policy exception to the recognition of foreign decisions has been interpreted narrowly and will generally only apply in exceptional circumstances.
Foreign creditors are treated no differently from domestic creditors under the Bankruptcy Code.
The recognition of foreign judgments is generally a matter of state law because the USA is not a signatory to any treaties that address the recognition of foreign judgments, and the federal government has not passed a statute to govern this matter.
Federal laws and various state statutes provide for and require the appointment of individuals or entities to function in executive, supervisory, fiduciary or representative roles in connection with bankruptcy, insolvency and similar proceedings governed by federal or state laws.
Under federal bankruptcy law, these individuals and entities include, among others, bankruptcy court judges, the US Trustee, official committees of unsecured creditors or equity holders, Chapter 7 and 11 trustees, and examiners.
Bankruptcy Court Judges
Federal bankruptcy court judges preside over business reorganisation and liquidation cases under the Bankruptcy Code.
United States Trustee
The US Trustee is an official in the US Department of Justice who acts as a governmental “watchdog” in Chapter 7 and 11 cases.
An official committee of unsecured creditors in a Chapter 11 case monitors developments in the Chapter 11 case and acts as it deems appropriate to advance the interests of unsecured creditors, see 6.3 Roles of Creditors. An official creditors’ committee in a Chapter 7 case functions differently, see 7.3 Organisation of Creditors or Committees.
In Chapter 7 liquidation cases, a trustee displaces the debtor’s existing management, and liquidates the assets of the estate and distributes the proceeds to creditors. A Chapter 7 trustee has the right to employ attorneys and other professionals, with bankruptcy court approval.
Similarly, in the rare instance where a Chapter 11 trustee is appointed, the trustee takes on the roles and responsibilities of the debtor, displaces incumbent management, controls the debtor’s properties and estate, is responsible for managing and operating the debtor’s business, and files all reports and other pleadings, including a plan of reorganisation or liquidation. A Chapter 11 trustee has the right to employ attorneys and other professionals, with bankruptcy court approval.
An examiner may be appointed in a Chapter 11 case to investigate specific matters related to the debtor as ordered by the bankruptcy court. For instance, an examiner may investigate questionable pre-bankruptcy transactions, possible litigation claims against third parties, and allegations of fraud, dishonesty, incompetence, misconduct or mismanagement by current or former management. An examiner reports its findings to the bankruptcy court, and may employ professionals to assist in its duties.
In a state law ABC, the assignee is the person appointed to act as a fiduciary for creditors. The assignee liquidates the debtor’s assets and distributes the proceeds to creditors in accordance with their respective priorities under applicable state law.
In a state law receivership, a receiver is appointed by a state court, most often to liquidate an insolvent business when a creditor or shareholder successfully requests a receivership. The receiver’s authority is governed by the applicable state law and orders of the court.
United States Trustee
The US Trustee is a federal official appointed by the President as an official in the US Department of Justice.
Bankruptcy Code Section 1102 gives the US Trustee authority to appoint members of an unsecured creditors’ committee in Chapter 11 cases. Members of an official creditors’ committee in a Chapter 7 case are selected differently, see 6.3 Roles of Creditors and 7.3 Organisation of Creditors or Committees.
In Chapter 7 liquidation cases, an initial interim Chapter 7 trustee is appointed by the US Trustee at the outset of the case. The interim trustee is selected from a panel of pre-qualified trustees in the district where the case is filed, and often remains the Chapter 7 trustee for the entirety of the case. However, the Bankruptcy Code allows creditors to elect a different trustee at the Section 341 meeting of creditors required by the Bankruptcy Code.
In Chapter 11 cases, the appointment of an examiner may be ordered by the bankruptcy court upon the request of a party-in-interest or the US Trustee, in which case the US Trustee selects and appoints the examiner in consultation with key parties-in-interest, subject to final court approval.
US state and federal laws, governing documents and judicial decisions impose duties on officers, directors and managers of business entities. Such duties generally apply regardless of whether or not a company is financially troubled. Failure to satisfy such duties may result in personal liability.
At the federal level, non-bankruptcy statutes (such as Sarbanes-Oxley and the Dodd-Frank Act) impose duties that may be implicated when a company, especially a publicly traded company, experiences financial distress or bankruptcy. Federal court decisions applying the federal statutes inform the potential duties and liabilities that may apply in particular circumstances. Such non-bankruptcy federal statutory duties and liabilities are outside the scope of this commentary.
Federal court decisions indicate that trustee-like duties apply to officers, directors and managers when a business entity is in bankruptcy. State laws generally provide for potential duties, including fiduciary duties, of officers, directors and managers of corporations and other business entities, that apply regardless of whether or not a company is financially troubled or in bankruptcy.
The full range of state law legal standards and judicial decisions addressing fiduciary duties is outside the scope of this commentary, but the law of the state of Delaware is informative generally because a majority of publicly traded corporations in the USA are formed under Delaware law.
Fiduciary Duties of Directors and Officers of Delaware Corporations
The Delaware General Corporation Law states that, unless otherwise provided by law or in the company’s Certificate of Incorporation, “[t]he business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors.” In carrying out their managerial roles, directors are charged with an unyielding fiduciary duty to the corporation and its shareholders. Directors owe both a duty of loyalty and a duty of care.
Officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty.
Fiduciary Duties of Managers of a Delaware Limited Liability Company
By default, managers of a Delaware limited liability company (an “LLC”) have traditional fiduciary duties, but those duties may be modified or limited by the LLC agreement.
Section 18-1101(c) of the Delaware Limited Liability Company Act (the “Act”) provides that “to the extent that, at law or in equity, a member or manager has duties (including fiduciary duties)”, such duties may be “expanded, restricted or eliminated” by provisions in the LLC agreement, provided that the LLC agreement may not eliminate the implied contractual covenant of good faith and fair dealing.
If an LLC agreement is silent regarding these matters, traditional fiduciary duties will be implied as a matter of Delaware law. Delaware courts have required that any provisions eliminating or restricting duties (including fiduciary duties) must be “clear and unambiguous”.
Outside bankruptcy, the general rule is that directors do not owe creditors duties beyond the relevant contractual terms. As a result, even when a corporation is insolvent or in the “zone of insolvency”, creditors do not have standing to bring direct claims for breach of fiduciary duty. However, creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties because the corporation’s insolvency makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value. The fiduciary duties that creditors gain derivative standing to enforce are not special duties to creditors, but rather the fiduciary duties that directors owe to the corporation for the benefit of all residual claimants.
With respect to the rights of creditors outside bankruptcy, Delaware law is clear that, unless the LLC agreement provides otherwise, managers of an LLC do not owe fiduciary duties to creditors of the LLC, even when the LLC is insolvent.
Federal bankruptcy law provides statutory causes of action to avoid (ie, set aside or unwind) certain transfers made to or for the benefit of third parties, primarily fraudulent transfer avoidance actions under Bankruptcy Code Section 548, and preferential transfer avoidance actions under Bankruptcy Code Section 547.
Fraudulent Transfers/Fraudulent Conveyances
There are two types of transfers of debtor property that constitute a fraudulent transfer under Bankruptcy Code Section 548. The first is a transfer made with actual intent to hinder, delay or defraud creditors. The second is a constructively fraudulent transfer, which is a transfer made in exchange for less than “reasonably equivalent value”, at a time when the transferor was either insolvent, undercapitalised or generally unable to pay its debts as they came due. Under the Bankruptcy Code, fraudulent conveyances may be avoided if they were made or incurred on or within two years before the commencement of a bankruptcy case. However, Section 544 of the Bankruptcy Code permits a trustee or Chapter 11 debtor-in-possession to rely on any applicable longer state law fraudulent transfer look-back (or “reach-back”) periods. State law reach-back periods may be up to four or six years after the transfer was consummated.
The Bankruptcy Code provides some defences and limitations to fraudulent transfer liability. Transferees who “take for value” and in “good faith” may have a defence to fraudulent transfer actions. The word “value” in this context is defined as “property, or satisfaction or securing of a present or antecedent debt of the debtor”. The Bankruptcy Code also provides certain statutory safe harbours against fraudulent transfer liability with respect to certain otherwise-avoidable transfers.
Preferential transfers may be avoided under Bankruptcy Code Section 547, which provides that a debtor or trustee may avoid:
Affirmative defences may be asserted against voidable preference liability. The most common affirmative defences, each of which is fact-intensive, include the following:
The burden is on the transferee to prove all elements of a claimed defence by a preponderance of the evidence.
Preference liability is imposed under Section 547 of the Bankruptcy Code for any transfer of an interest of the debtor in property that was made on or within 90 days before the bankruptcy case, if the elements of Section 547 are satisfied and the creditor-transferee has no defences. The 90-day preference “reach-back” period is extended to one year prior to the bankruptcy case if the transferee was an insider of the debtor at the time of the transfer.
Please refer to 11.1 Historical Transactions.
A bankruptcy trustee (or a Chapter 11 debtor) has standing to assert fraudulent conveyance and preference avoidance actions. A bankruptcy trustee’s (or Chapter 11 debtor’s) avoidance powers are exclusive during the bankruptcy case.
Creditors’ committees and individual creditors may seek derivative standing to assert avoidance actions on behalf of the debtor’s estate, especially in cases where the debtor may have a conflict. The bankruptcy court must order and authorise such derivative standing. The terms of a Chapter 11 plan of reorganisation or liquidation may provide that the reorganised debtor or some other estate representative, such as a litigation trustee, may retain and assert avoidance actions following consummation of the plan.
Current State of the Restructuring Market
As of June 2022, there has been a noticeable decrease in US Chapter 11 commercial bankruptcy filings in 2022 versus the same time period in 2021. Personal and business bankruptcy filings took a sharp drop in the twelve-month period ending 30 June 2022, falling 17.7% compared with the previous year.
According to statistics released by the Administrative Office of the U.S. Courts, annual bankruptcy filings totalled 380,634 in the year ending June 2022, compared with 462,309 cases in the previous year.
Business filings fell 31.1%, from 18,511 to 12,748 in the year ending 30 June 2022. Non-business bankruptcy filings fell 17.1% to 367,886, compared with 443,798 in the previous year.
Bankruptcy filings have fallen almost steadily since peaking in 2010. That trend has accelerated since the pandemic began in early 2020, despite some early COVID-related disruptions to the economy.
Bankruptcy filings decreased across most industries in 2021, including those industries with the most filings following the pandemic: mining, oil and gas; retail trade; manufacturing; and services.
As of June 2022, bankruptcy filings across most industries continued to decline from mid-2020 pandemic highs.
Forecasts of a continued trend of increased bankruptcies in 2021 were disrupted by government stimulus programmes, low borrowing rates and high debt forbearance. Oil prices also rose by 55.8% in 2021 and surged another 43.1% in the first half of 2022. Consumers spent USD163 trillion in 2021, 7.9% and 3.8% higher than in 2020 and 2019, respectively.
Nevertheless, there appears to be a recent change in these trends. Bankruptcy filings in August 2022 across all chapters totalled 35,355, a 10% increase from the August 2021 total of 32,276, according to Epiq’s Bankruptcy Analytics platform.
Overall commercial filings increased 6% in August 2022, as the 1,861 filings were up over the 1,753 commercial filings registered in August 2021. Individual filings increased 10%, totalling 33,494 in August 2022 compared to the 30,523 filed in August of 2021.
Total filings, both commercial and individual, show a 15% increase month-over-month compared to the July 2021 total of 30,854 filings. August’s commercial filings represent a 16% increase compared to July’s commercial filing total of 1,607, while August’s individual filings represent a 15% increase compared to July’s individual filing total of 29,247.
Notably, for the first time in months, all chapters registered a month-over-month increase. Chapter 11 filings increased 81%, totalling 466 filings in August 2022 compared to 257 registered in July. Chapter 13 filings increased 15%, totalling 14,981 filings compared to 12,992 registered in July. Chapter 7 filings increased 13%, totalling 19,884 compared to the 17,593 registered last month.
From a commercial Chapter 11 perspective, filings continue to trend up. August’s Chapter 11 filings, totalling 466, increased 81% from the 257 registered in July 2022. Small business filings, captured as subchapter V elections within Chapter 11, increased 41% to 140 in August 2022 from 99 in August 2021. Similarly, August’s commercial Chapter 11 filings were up 91% over the 212 filings in July 2022. The commercial filing total represented a 16% increase from the July 2022 commercial filing total of 1,607. Subchapter V elections within Chapter 11 increased 42% from the 85 filed in July 2022.
As of September 2022, the industries with the most bankruptcy filings included finance, insurance and real estate.
The ten largest (by asset size) bankruptcy filings in the first half of 2022 are as follows:
Finance, Insurance and Real Estate Filings
Looking at data from Chapter 7 and Chapter 11 bankruptcy filings by companies with assets of USD100 million or higher, as of September 2022, there have been six bankruptcy cases filed by finance, insurance and real estate companies. The filings in this sector increased from ten bankruptcies in 2020 to 15 in 2021, and remained elevated with six in the first half of 2022 – the most by any industry in the first half of 2022.
Real estate filings by companies with more than USD100 million in liabilities rose dramatically in 2020 and continued their increase in 2021. In the first half of 2022, larger real estate cases remain elevated from historical levels.
Looking at data from Chapter 7 and Chapter 11 bankruptcy filings by companies with assets of USD100 million or higher, consistent with prior years, the most common venue for bankruptcy filings was Delaware, which accounted for 34% in 2021 and 50% in the first half of 2022.
The second largest venue was the Southern District of Texas, which accounted for 24% of filings in 2021 and 20% in the first half of 2022.
Coming in at number three was the Southern District of New York, which accounted for 16% of the filings in 2021 and 10% of the filings in the first half of 2022.
Together, these three districts accounted for 74% of the bankruptcies in 2021 and 80% in the first half of 2022.
In 2021, there were 20 “mega bankruptcies” – bankruptcy filings among companies with over USD1 billion in reported assets – a substantial decline from the 60 mega bankruptcy filings in 2020. The first half of 2022 saw four Chapter 11 mega bankruptcy filings, compared to nine in the first half of 2021 and at a pace significantly lower than the annual average of 22 filings in 2005–2021.
Debtor-in-Possession (DIP) Financing
Chapter 11 cases involving requests for DIP financing increased significantly in the second quarter of 2022, especially with respect to the middle-market-and-up liability thresholds. In the first quarter of 2022, just 11 companies sought DIP financing on a first day basis. This number more than doubled, to 24, in the second quarter of 2022.
The amounts financed by DIP financing rose as well from quarter one to quarter two. In the first quarter, seven of the 11 DIP facilities were between USD1 million and USD10 million and the remaining four were between USD10 million and USD100 million. In the second quarter, while there was one DIP facility valued at less than USD1 million and the number between USD1 million and USD10 million remained roughly the same, facilities valued between USD10 million and USD100 million increased to ten. Moreover, there were four facilities valued between USD100 million and USD1 billion and two facilities over USD1 billion.
Several of the DIPs provided in the first half of 2022 – five in total – were done by parties who provided bridge financing to the company shortly before the petition date. These DIPs sought to “roll up” the pre-petition financing into the DIP obligation. The five requests for such DIPs in the first half of 2022 alone represents an uptick over 2021, which saw a total of seven such DIPs requested during the entire calendar year. This may suggest an emphasis on urgency with respect to the debtors’ need for funding operations to make it through Chapter 11 in the current environment.
The majority of DIP lenders over the first half of 2022 were pre-petition creditors. The second highest number of DIP lenders in the first half of 2022 were third party lenders, followed by equity holder/affiliate DIPs, and stalking horse bidder DIPs.
Legal Developments in the Restructuring and Insolvency Market
The October 2021 term of the Supreme Court of the United States saw the Court address just one bankruptcy case.
Supreme Court Unanimously Strikes Down 2017 U.S. Trustee Fee Hike as Unconstitutional
On 6 June 2022, the Supreme Court issued a unanimous ruling in Siegel v Fitzgerald, 142 S. Ct. 1770 (U.S. 2022), holding that the increase in fees payable to the Office of the United States Trustee (“U.S. Trustee”) system in 2018 violated the uniformity aspect of the Bankruptcy Clause of the Constitution because it was not immediately applicable in the two states with Bankruptcy Administrators rather than U.S. Trustees. Id. at 1780. The Supreme Court, however, did not decide whether Chapter 11 debtors are entitled to refunds for overpayments of quarterly fees paid to the U.S. Trustee system. Instead, it remanded the case back to the Fourth Circuit to consider the appropriate remedy.
In a 9–0 decision written by Justice Sotomayor, the Supreme Court determined that the 2017 Amendment violates Congress’s constitutional authority under the “Bankruptcy Clause … to establish 'uniform Laws on the subject of Bankruptcies throughout the United States.' U.S. Const., Art. I, § 8, cl. 4” because while “[t]he Bankruptcy Clause affords Congress flexibility to 'fashion legislation to resolve geographically isolated problems,' … the Clause does not permit Congress to treat identical debtors differently based on an artificial funding distinction that Congress itself created.” Id. (citation omitted).
Bankruptcy Cases Before the Supreme Court During the October 2022 Term
With the 2022 October term just commencing, the number of bankruptcy cases this year is again small, with, as yet, only two cases directly addressing the Bankruptcy Code:
(1) MOAC Mall Holdings LLC v Transform Holdco LLC, No. 21-1270. In MOAC Mall Holdings, the Court will address the following question: whether Bankruptcy Code Section 363(m) limits the appellate courts’ jurisdiction over any sale order or order deemed “integral” to a sale order, such that it is not subject to waiver, and even when a remedy could be fashioned that does not affect the validity of the sale.
(2) Bartenwerfer v Buckley, No. 21-908. In Bartenwerfer, the Court will address the following question: whether an individual may be subject to liability for the fraud of another that is barred from discharge in bankruptcy under 11 U.S.C. § 523(a)(2)(A), by imputation, without any act, omission, intent or knowledge of her own.