Corporate Update – Summer 2006
Even in today’s relatively robust economy, boards of directors are, on occasion, called upon to oversee the winding-down of a corporation’s business operations. Although the decision to cease business operations may be an easy one, achieving that goal requires a thorough understanding of the various bankruptcy and non-bankruptcy alternatives available to the corporation. This article will briefly examine some of the bankruptcy and non-bankruptcy alternatives available to financially-distressed companies and consider some of the advantages and disadvantages of each of these alternatives.
Chapter 11 Bankruptcy
A Chapter 11 refers to the filing of a petition for relief pursuant to Chapter 11 of the United States Bankruptcy Code. Although the vast majority of Chapter 11 cases are filedvoluntarily by the debtor corporation, the Bankruptcy Code does permit three or more creditors to file an involuntary Chapter 11 petition against a corporation that is generally not paying its debts as they become due. Historically, the purpose of a Chapter 11 was to give a corporate debtor some “breathing room” during which time it could formulate a plan of reorganization in an attempt to reorganize its business operations. More recently, corporations have sought Chapter 11 protection solely as an orderly means to liquidate their assets. The hallmark of this alternative is that Chapter 11, unlike most of the other bankruptcy alternatives which will be discussed in this article, the board of directors and management continue to govern the corporation during the wind-down process. Even in a liquidation scenario, this ability to control the wind-down process often times results ina maximization of value to the corporation’s creditors and shareholders for several reasons. First, the filing of the Chapter 11 automatically causes a stay of creditor actions against the corporation and its assets. Secondly, a Chapter 11 filing provides a mechanism which allows a corporation to retain critical employeesthat are often necessary to support an orderly transfer of the corporation’s assets. Third,Chapter 11 permits either the rejection or the assumption and assignment of certain leases and contracts, regardless of provisions in those leasesand contracts prohibiting an assignment. And finally, a Chapter 11 debtor can obtain a court order selling the corporation’s assets free and clear of any existing liens and encumbrances,thereby giving clean title to any prospective purchaser.
As might be expected, the Chapter 11 alternativeis not always viable. Perhaps the biggest negative associated with Chapter 11 is its relatively highcost. Not only will a bankruptcy attorney demand a substantial retainer prior to filing Chapter 11,but once the petition is filed, the debtor must continue to satisfy all of its post-filing liabilities as they become due. As a result, although many corporations would greatly benefit from aChapter 11 filing, oftentimes financial burdens will dictate that the corporation seek another alternative. Finally, given the notice requirements of the Bankruptcy Code, a Chapter 11 case can be time consuming and rarely is completed in less than 90 days.
Chapter 7 Bankruptcy
Like a Chapter 11, a Chapter 7 is commenced by the filing of a voluntary or involuntary petition for relief pursuant to Chapter 7 of the United States Bankruptcy Code. Unlike a Chapter 11 however,the sole purpose of a Chapter 7 is to liquidate the corporation’s assets. In a Chapter 7, a court appointed trustee is immediately assigned to take possession of all the debtor’s assets and liquidate them for the benefit of the corporation’screditors and shareholders. In a Chapter 7,the corporation immediately ceases business operations, and all remaining employees are terminated. Although a Chapter 7 debtor enjoys the same protection of the automatic stay of any creditor actions and the ability to assume and assign leases and contracts to third parties, as a practical matter, it is very difficult for a court appointed trustee to maximize the value of a corporation’s assets. This is especially true with technology companies, where both technical expertise and the ability to retain critical employees are often times necessary to maintainvalue. Although a Chapter 7 filing might notbe the best way to maximize value, it does provideboth a structured process and finality. Once a bankruptcy lawyer is retained and the necessary paperwork is finalized and filed with the court, there is very little left for the corporation or its board of directors to do. The responsibility to contact creditors and to oversee the claims review process belongs to the Chapter 7 trustee,and the board of directors ceases to have anyrole with respect to further corporate governance. As was true with the Chapter 11, a bankruptcy attorney will require a retainer to file a Chapter 7. However, given the fact that much of the legal work in a Chapter 7 is actually performedby the trustee, such retainers are typically less then those required for a Chapter 11. Both Chapter 11 and Chapter 7 filings allow a bankruptcy trustee or creditors’ committee to attempt recovery of the corporation’s pre-filing transfers that appear to be either preferential or a fraudulent conveyance. Generally speaking,a “preference” is any transfer to a creditor made outside of the ordinary course of business that enables the creditor to receive more than it would in a Chapter 7 liquidation case. Payments made to non-insiders up to 90 days prior to the bankruptcy may constitute a preference. With respect to insiders, the court applies a “reachback”period of one year. Under federal bankruptcy law, the reach-back period with respect to fraudulent conveyances is also one year, but the trustee may also rely on applicable state fraudulent conveyance statutes, which typically have reach-back periods extending up to four years. Finally, directors should also be aware that Regulation S-K of the federal securities laws stipulates that, under certain circumstances, a director or executive officer of a registrant must disclose involvement with a corporation that has filed a petition under federal bankruptcy law or a similar state proceeding within the preceding five years.
Dissolution Under State Law
In certain situations, it may be possible simply to liquidate the assets and file for dissolution under state law. Under this scenario, the board ofdirectors orders the liquidation of the corporation’s assets and the distribution of the proceeds to the creditors according to their legal priority. Some corporations will have secured creditors–those who have been granted or otherwise obtained a lien on some or all of the corporation’s assets to secure the repayment of amounts owing to that creditor. If the secured creditor’s claim exceeds the likely value of the corporation’s assets, the board of directors might agree to a “friendly foreclosure,” surrendering the collateral to the secured creditor in full or partial satisfaction of its claim. In situations where there are no secured creditors, the assets are typically liquidated, and the unsecured creditors are paid on a pro rata basis. After an appropriate reserve is established for contingent claims, stockholders may receive a pro rata distribution of any remaining assets.The advantages of such a wind-down and dissolution are that they can be done quickly and are relatively inexpensive. The main disadvantage of pursuing a dissolution under state law is that it is often times difficult to maximize the value of the assets since there is no ability to transfer assets free and clear of liens and encumbrances, not an ability to assign leases and contracts to a purchaser. Furthermore, because the wind-down and dissolution is done outside of any court proceeding,the corporation has no protection from creditor interference, such as litigation, attachments,or an involuntary bankruptcy filing. In addition, unlike the case with a bankruptcy filing, fraudulent conveyance and preference actions are much less likely to be pursued under this scenario, since most states do not have preferences statutes and any fraudulent conveyance lawsuit would require that the creditors fund the cost of litigation.
Assignment for the Benefit of Creditors
Recently, another non-bankruptcy alternative that has become quite popular in some jurisdictions is an assignment for the benefit of creditors,a state law liquidation statute that is somewhat analogous to a Chapter 7. Under an“assignment,” the corporation (or in some states, its creditors) typically appoints an individual to serve as assignee. The assignee takes title to the assets of the corporation and liquidates them for the benefit of the corporation’s creditors. The advantages to the corporation are several: (i) it is relatively inexpensive when compared to the cost of a Chapter 11; (ii) it is relatively quick, since an assignee is not bound by the sometimes burdensome notice requirement mandated by the Bankruptcy Code; (iii)there is no independent third-party interventionor supervision to interfere with the liquidation process; and (iv) often there is less stigma associated with an assignment than with a bankruptcy case since disclosure under the federal securities laws is in some cases unnecessary.
Generally speaking, assignments work best when a corporation has a cohesive and understanding creditor body. Because an assignment does not typically provide for a stay of creditor actions, litigation, attachments or involuntary bankruptcy filing are always possibilities. In addition, absent the dedication of management to the process, it is difficult for the assignee to maximize the value of the corporation’s assets. Finally, as was the case with state law dissolutions, fraudulent conveyance and preference actions are much less likely to be pursued in connection with an assignment.
Receiverships
The federal government and a number of states have statutes authorizing the appointment of a receiver for the purpose of administering and liquidating the assets of a corporation. Although state court receiverships are widely used in a handful of jurisdictions, they are viewed by many insolvency practitioners as perhaps the most uncertain of all the liquidation alternatives.Although receiverships are relatively inexpensive and are often times quicker than bankruptcy,they may hinder the maximization of a corporation’s value since a court-appointed receiver (typically, a lawyer) will control the disposition of the corporate assets. In addition, areceiver generally cannot assign leases and contracts to third parties or authorize the sale of a creditor’s collateral absent its consent.
Kevin T. Lamb (WPB)(561) 650-0657 [email protected]
