In the commercial arena, bankruptcy has become a tool not infrequently used by business people. Be it an asset sale, a device to negotiate with the taxing authorities or a precursor to a recapitalization, the financial professional should be familiar with the options available under the Bankruptcy Code. Also, being aware of what may occur in a bankruptcy can prove invaluable in restructuring a business without a business filing. The purpose of this article is to review certain options made available by the law.
1. THE SALE “FREE AND CLEAR.”
Occasionally, the sale of a business or a piece of real estate is stopped dead in the tracks by a seemingly insoluble problem. Perhaps a disputed lien encumbers the property or the assets. The specter of a tax liability may dissuade a possible purchaser. Issues involving environmental or successor liability, outstanding litigation claims against the business assets or the property can pose an insurmountable obstacle to a sale.
The Bankruptcy Code permits a sale of estate assets free and clear of liens, claims, and interest. A bankruptcy sale frequently “sanitizes” the assets being transferred. The free and clear sale is a title examiner’s dream: the bankruptcy judge’s order can resolve thorny issues of title, litigation claims or successor liability.
2. THE LIQUIDATION SALE.
More and more Chapter 11 “Reorganizations” are filed with the sole purpose of promptly selling an over-leveraged company’s assets to a new entity. At times, principals of the over-leveraged debtor even participate in the new acquiring entity, although such participation is closely scrutinized. Such liquidation sales are subject to notice and the opportunity for others to make a higher bid. However, a liquidation sale conducted within a Chapter 11 Reorganization case may be the solution to the transfer of valuable, but over encumbered assets.
3. DISCHARGE OR DAMAGE CONTROL OF TAX LIABILITY.
As a general rule, the government has enacted the bankruptcy laws and largely exempted itself from their effect. Nevertheless, certain older taxes may be discharged, i.e., income taxes more than three years old. Just as importantly, a bankruptcy reorganization plan can eliminate the continued accrual of penalties and exorbitant interest. A “priority” tax claim must in fact be repaid with interest, however the interest rate can be reduced to a market rate to avoid the rates and penalties that the Internal Revenue Service or the Department of Revenue would require outside of bankruptcy.
Additionally the Bankruptcy Code provides an expedited procedure for the termination of a tax liability. Oftentimes, the dealing with the labyrinth known as the Internal Revenue Service does not result in a definitive and prompt determination of tax liability. The Bankruptcy Code includes a provision that may result in a liquidation of tax claims within a matter of months.
4. CONVERTING SHORT-TERM TO LONG-TERM DEBT.
One of the most significant features in most Chapter 11 Plans is the conversion of trade debt due in thirty days to an obligation to be paid out over an extended time, often from future profits of the business. Bankruptcy’s automatic stay prohibits the repayment of pre-petition unsecured debt until a reorganization plan is confirmed. Such pre-petition unsecured debt is very typically paid post-confirmation over a period of years after the individual or company’s current debts are paid.
5. RESTRUCTURING THE BALANCE SHEET PRIOR TO AN EQUITY INJECTION.
Business owners frequently make the mistake of injecting new capital into a troubled business only to have the money consumed by old obligations. New capital can be effectively leveraged if it is injected into the company only upon confirmation of a plan which converts pre-petition trade debt to a long term payout, thereby allowing the new money to be used as working capital to address the fundamental problems in that business or its industry.
Whenever a business professional is consulted about the recapitalization of a business, a reorganization professional should be consulted. The promise of recapitalization may also be an incentive to convince secured lenders to make concessions in the repayment of their obligations, interest rates, amortization terms, and the like.
6. STAYING LITIGATION OR PERMITTING AN APPEAL.
Upon the filing of a bankruptcy case, the automatic stay prevents the continuation of – or initiation of litigation against – the debtor. While bankruptcy judges take a dim view of a bankruptcy filing on the eve of a trial, the automatic stay can be used to slow litigation, or move the dispute to the bankruptcy court by resolution of the judge rather than a jury. A bankruptcy filing may also be a consideration for a party who has had a contested judgment taken against it. Rather than posting a supersedes bond in order to stay execution of the adverse judgment, a bankruptcy filing can prevent execution, while permitting the trial court loser to take the matter to appellate review. In addition to substantive benefits in litigation, a bankruptcy filing, or the threat thereof, may provide the leverage needed to settle potentially disastrous litigation.
7. INTEREST RATE RELIEF.
The Bankruptcy Code permits the repayment of indebtedness over time. Extending repayment of debts can include secured claims so long as the payment over time is accompanied by market rate interest. The market rate at the time of the repayment proposal may be substantially different than the contract rate. A business financed at high interest rates may obtain relief in a bankruptcy proceeding from above-market rates. Alternatively, an unsecured creditor will not be entitled to interest as its debt is repaid over time, pursuant to a bankruptcy plan. A secured creditor, whose collateral is worth less than its debt, will have its claim bifurcated into a secured portion (which would accrue interest at a market rate) and an unsecured portion (which would not accrue interest post-bankruptcy filing).
8. AN OPPORTUNITY TO ACCUMULATE WORKING CAPITAL.
Upon filing of a reorganization case, pre-petition, unsecured debt may not be paid prior to approval of a reorganization plan. This relief from trade payables may allow a reorganizing business a period of time within which to accumulate capital needed for operations. Most successful reorganizations require the injection of new capital pursuant to a plan, a refinancing, sale or other extraordinary event. However, a business beset by a paucity of working capital can, in the initial stages of a bankruptcy proceeding, enjoy a respite from the demands of servicing trade debt and accumulate cash.
9. THE REJECTION OF BURDENSOME LEASES OR EXECUTORY CONTRACTS.
One of the more well known remedies offered by the Bankruptcy Code is the opportunity for a debtor to extricate itself from leases or continuing contractual obligations. More often than not the rejection of contracts or leases is an ancillary benefit to a corporate reorganization, rather than the raison d’etre for the filing. Restrictions apply to the rejection of certain leases, union contracts, and personal service contracts, and the non-debtor party to a rejected agreement is compensated with a pre-petition unsecured claim for its damages. Many reorganizing businesses use the opportunity to reject leases and contracts as the leverage needed to renegotiate the terms of the lease or contract, where the non-debtor party would prefer to maintain the lease or contract. Moreover, rejection or a threat to reject is a key component to the law’s purpose of reorganizing businesses.
10. SANITIZING TORTIOUS OR CRIMINAL BEHAVIOR.
The Bankruptcy Code’s automatic stay does not prevent state authorities from prosecuting crimes or acting in the state’s interest concerning health and welfare. A Chapter 11 repayment plan, however, has been used by perpetrators of fraud or worse, to address the complaints of investors or customers prior to the businesses’ conduct boiling-over into the criminal justice system. Again, the Bankruptcy Code is not a panacea for criminal prosecution. However, criminal authorities who are reluctant to become involved in complex business and white collar crimes, are further dissuaded where victims have been provided “restitution” via payments under a reorganization plan. Bankruptcies of this type are often filed with the principals of the scrutinized business turning over its assets to a trustee who operates the assets as a fiduciary for the creditors. A plan is then promulgated which results in a repayment of investors’ or customers’ claims over time, so that the damages are mitigated or eliminated.
11. THE INVOLUNTARY BANKRUPTCY.
Three or more creditors can petition to put an individual or business into bankruptcy, where the business is not paying its obligations as they become due. An involuntary petition may be an effective remedy against a dishonest operator who is sucking money out of a company or transferring assets to friends, families or affiliates instead of repaying creditors. An involuntary bankruptcy may promptly be followed by the appointment of an interim trustee who will take charge of the business where the affairs of the business have been corrupted.
The Bankruptcy Code provides for the recovery by an estate of preferential or fraudulent transfers. While these sections apply and are used in all types of bankruptcy cases, they may be particularly effective in an involuntary case so as to allow the estate of creditors to recover transfers that a dishonest business person has made to friends, family or himself.
12. REPLACEMENT OF MANAGEMENT AND THE RESTRUCTURE OF EQUITY.
Real estate syndication, start up technology business, and other ventures are at times plagued by ineffective management and/or governance. Limited partnership agreements and operating agreements for LLCs often times impose insurmountable hurdles on replacement of the ineffective manager or management team. Corporate organizational documents which may require unanimity or super-majorities for amendment, may effectively be modified in the course of a bankruptcy reorganization case through plan confirmation.
A deadlocked company, or one beset by entrenched yet ineffective management, may use the bankruptcy laws to bring in substitute general partners, turnaround professionals, or a new management team acceptable to the equity sources.
After the filing of the bankruptcy petition, but before confirmation of a plan replacing management, the Bankruptcy Code provides a device of having a trustee take over the operation of a business. A trustee can control the business, pending confirmation of a plan, “for cause,” including fraud, dishonesty, incompetence or gross mismanagement. The bankruptcy laws provide for both an immediate and a permanent remedy for an operation beleaguered by ineffective management.
The Code’s reorganization chapter also permits the restructure of equity, drumming out those who refuse to commit money to the debtor’s operation or recapitalization. Non-contributors can be “thinned down,” while those injecting new money can be rewarded with priority returns or expanded equity interests.
CONCLUSION
Business professionals recognize that knowledge is power. The business professional’s quiver should include a familiarity with the business tools offered by the bankruptcy laws. While the expense, the stigma and the trauma of a bankruptcy case may limit its application, the remedies of the Bankruptcy Code are sufficiently powerful such that all business professionals should have its considerations as a part of their repertoire.
