Many of us learned about chapter 11 the first time by hearing that the debtor gathers its creditors together, and reaches a deal with them (or not). If that is all there is to it, why does anyone go to court? Why not just reach the deal?
Often, that is exactly what happens. Debtors have always worked out deals with their creditors outside of court. “Workouts” happen all the time. A better measure of success is keeping a business out of bankruptcy court than getting it in. There are obvious benefits to a workout: it is usually faster and less expensive, and there is less of the grueling paperwork involved. There is less attention on the business as well.
Holdout Creditors
The challenge is that with more than a handful of creditors, it can be virtually impossible to coordinate everyone. Even if most creditors agree, nothing compels the others to do so. Once in a while, these holdout creditors will try to extract a better deal. They may try to derail the deal by rushing to levy on the assets. Or they may just plain refuse. A single holdout — someone who is not cooperating — can ruin a workout. By contrast, a chapter 11 proceeding allows a reorganization plan to be imposed on the holdouts.
That is only one of the tools. In chapter 11, all the creditors are stopped — the automatic stay — so the debtor has time to work on a plan. The plan can then be confirmed over the heads of those dissenting creditors, ugly contracts can be rejected, and certain prepetition payments can be clawed back. Taxes matter too. Generally, debt cancelled in a chapter 11 case is not included in the debtor’s taxable income (although it does reduce the debtor’s tax attributes). The same transaction done outside of bankruptcy may trigger a substantial tax liability. An owner who needs those protections may be better off filing.
If the debtor simply has a balance-sheet problem, the mere risk of filing chapter 11 can be enough to get creditors to go along with an out-of-court restructuring. Today’s creditors are more sophisticated, know the cost of chapter 11, and are more likely to settle.
Not every creditor sees it that way, though. When a creditor is distrusting of the debtor, it will want the judge to be its eyes and ears. In bankruptcy, the creditor also need not fear that a rival creditor will make a better deal outside. The Bankruptcy Code guarantees that similarly-situated creditors will be treated equally.
A Prepackaged Bankruptcy Plan
There is also a middle path, where the negotiating happens before the filing. A prepackaged bankruptcy plan (more commonly called a prepack) is one that is negotiated and accepted by creditors prior to the case being filed. It has the speed, lower costs and flexibility of a workout and the finality of chapter 11. A prepack can be as short as 30 to 45 days in court. This option is particularly appropriate for companies that are image sensitive such as retailers. A protracted bankruptcy case can be disastrous to their reputation.
In a prepack, the debtor drafts a reorganization plan and negotiates its terms with creditors. The debtor then provides creditors with the plan, disclosure statement and ballot. Creditors are given an opportunity to review the plan, disclosure statement and vote. Once the debtor has received a sufficient number of votes to confirm the plan, the debtor files the petition, plan, disclosure statement and ballots all at the same time. All the court must do is confirm the plan and approve the disclosure statement thereafter. The Bankruptcy Code at Section 1126(b) allows the court to count pre-filed votes as long as creditors were given the same information that creditors would receive in a chapter 11 filing.
All of that means that a prepack is only feasible when you can reach an agreement with a large majority of the creditors. A small number of creditors makes a prepack feasible. Hundreds of widely dispersed bond holders and trade creditors make a prepack unlikely. A prepack can be no safer than its disclosure statement. The court does not approve the disclosure statement in advance, so a dissenter can move in after the case is filed and argue that the debtor failed to provide adequate disclosure and/or didn’t solicit its votes properly. If the court agrees, that means that the debtor must start all over again (which is both costly and time-consuming).
A “partial prepack” is a plan where some classes are solicited ahead of filing and others are solicited post-petition. For example, consider a case in which the debtor has one big bank, a few bondholders and a thousand or so trade creditors, each of whom has claims for $1,000. The debtor gets the bank and bondholders to agree to the plan before filing (meaning the plan has support from a majority in number and two-thirds in amount of each of those classes) and solicits the scattered trade creditors after the filing, once the disclosure statement is approved. The trade creditors may be more willing to accept the plan once they see that the bank and bondholders already have.
Pre-arranged or Pre-negotiated Bankruptcy
What about a pre-arranged or pre-negotiated bankruptcy? There’s no clear answer here. The term generally means that the basic terms of a reorganization plan are negotiated with the key creditor classes before the bankruptcy is filed, and put in writing, but the solicitation for votes takes place after the bankruptcy is filed and once the court has approved the disclosure statement. Then there are lock-up agreements. Instead of getting a vote, the creditors can sign an agreement to support a plan with certain basic terms. This happens often when a third party investor is looking to ensure creditor support. These agreements are typically signed before bankruptcy. Lock-up agreements executed after a case is filed have been frowned upon by courts (especially Delaware courts) as violating the Bankruptcy Code’s solicitation rules.
So what is the takeaway from all of this? For a business owner, you can and should negotiate with creditors before filing chapter 11. The decision whether to pursue a fully-out-of-court resolution, a prepack or a pre-negotiated case may come down to the number of creditors, debt concentration, and the ability to obtain certain chapter 11 protections that are needed. There is no “one size fits all” solution here, but the business owners would be well-advised to consult with experienced counsel in the early stages.
