PLI Nuts & Bolts of Corporate

Reorganization 2014

Reorganization (Chapter 11)

December 9, 2014

New York

Andrew DeNatale Judith Elkin Stroock & Stroock & Lavan LLP Haynes and Boone LLP

Reorganization (Chapter 11)

Key Players in Chapter 11 Process:

• Debtor in Possession

• Chapter 11 Trustee

• Examiner

• Chief Restructuring Officer

• Creditors’ Committee

1

Debtor in Possession

Who is the debtor in possession?

• In Chapter 11 cases, Debtor automatically continues as debtor in possession. Section 1101(1).

• Same corporate entity but with new duties. Section 1107(a).

2

Debtor in Possession

The rights, powers and duties of the debtor in possession include

• All of the rights and powers (other than the right to compensation), and

• All of the functions and duties of a chapter 11 trustee (except for investigation of the debtor). Section 1107(a).

3

Debtor in Possession

Fiduciary Obligations of Debtor in Possession • The Board of a debtor in possession bears

“essentially the same fiduciary obligations to the creditors and shareholders as would the trustee for a debtor out of possession.” Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 355 (1985).

4

Corporate Governance of Debtor in Possession

The normal rules of corporate governance apply while the chapter 11 case is pending —

• The board continues to function.

• The shareholders generally continue to exercise their normal rights.

5

Chapter 11 Trustee

Bases for Appointment

• Section 1104(a) provides that on request of a party in interest or the U.S. Trustee, the court shall order the appointment of a trustee —

• For “cause”, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management either before or after the commencement of the cases. Section 1104(a)(1).

6

Chapter 11 Trustee

Bases for Appointment (cont’d)

• If such appointment is in the interests of creditors, any equity security holders, and other interests of the estate. Section 1104(a)(2).

7

Chapter 11 Trustee

Bases for Appointment (cont’d)

• Section 1104(e) requires that the U.S. Trustee shall move for the appointment of a trustee

— if there are reasonable grounds to suspect that the current members of the Board, the current CEO or CFO, or members of the Board who selected the debtor’s current CEO or CFO participated in actual fraud or dishonesty, or criminal conduct in the management of the debtor or the debtor’s public financial reporting. Section 1104(e).

8

Chapter 11 Trustee

Bases for Appointment (cont’d)

Section 1112(b)(1) provides that:

• where grounds exist to convert or dismiss a chapter 11 case, the court may, as an alternative, appoint a trustee if such appointment is in the best interests of creditors and the bankruptcy estate. Section 1112(b)(1).

9

Chapter 11 Trustee

Selection

If court orders the appointment of a trustee

• U.S. Trustee, after consultation with the parties, appoints the trustee, subject to the Court’s approval. Section 1104(d).

• A party in interest may request that the U.S. Trustee convene a meeting of creditors for the purpose of electing a chapter 11 trustee to replace the U.S. Trustee’s selection. Section 1104(b)(1).

10

Chapter 11 Trustee

Duties of Chapter 11 Trustee

• Chapter 11 trustee displaces the debtor in possession and becomes the estate fiduciary charged with the role of operating the debtor’s business and managing the chapter 11 case.

• Duties of chapter 11 trustee are set forth in Section 1106 of the Bankruptcy Code.

11

Examiner

The Role of the Examiner

• Where no trustee is appointed, Section 1104(c) provides that the court shall order the appointment of an examiner to perform such “investigation of the debtor as is appropriate.”

12

Examiner

Bases for Appointment

• The Court shall order the appointment of an examiner if — – Such appointment is in the interests of creditors,

any equity security holders, and other interests of the estate, or

– The debtor’s fixed, liquidated unsecured debts — other than for goods, services or taxes, or owing to an insider — exceed $5 million. Section 1104(c)(1) and (2).

13

Examiner

• Perceiving that the appointment of an examiner is increasingly used as a litigation tactic, some courts have pushed back on the seemingly mandatory appointment —

• Strictly construing the $5 million threshold to exclude unsecured deficiency claims of unsecured creditors

• Limiting the scope of the investigation to what the court perceives as “appropriate”

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Examiner

• Some courts have gone so far as to flatly refuse to appoint an examiner:

“I find no sound purpose in appointing an examiner, only to significantly limit the examiner’s role when there exists insufficient basis for an investigation.”

In re Spansion, Inc., 426 B.R. 114, 127 (Bankr. D. Del. 2010) (denying motion to appoint trustee or examiner).

15

Chief Restructuring Officer

What is a Chief Restructuring Officer?

• A Chief Restructuring Officer — CRO — is an outside restructuring expert retained by a company in financial distress.

16

Chief Restructuring Officer

Retention of CRO

• The fact that there is no specific statutory authority for the role of CRO has led to some disagreement as to the proper statutory basis for retaining a CRO.

17

Chief Restructuring Officer

Jay Alix Protocol

• The lack of clear statutory guidance has led to the development of a protocol negotiated by the U.S. Trustee for Region 3 and Jay Alix in the Harnischfeger Industries, Inc. and Safety-Kleen Corp. cases. This protocol is commonly referred to as the Jay Alix protocol.

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Operation of the Business

Unless court orders otherwise, debtor-in-possession or trustee may operate the debtor’s business. Section 1108.

• Ordinary Course Transactions — debtor-in-possession or trustee may generally use, sell or lease property of the estate, in the ordinary course of business, without specific court approval. Section 363(c)(1)

19

Operation of Business

• Transactions Outside Ordinary Course — debtor-in-possession or trustee will require specific court approval to use, sell or lease property of the estate, not in the ordinary course of business. Section 363(b)(1).

20

Operation of the Business

What is “ordinary course” of debtor’s business?

• Horizontal Dimension Test — examines the transaction from an industry-wide perspective.

• Vertical Dimension Test —examines the transaction from perspective of a hypothetical creditor.

21

Operation of the Business

In operating the business, the debtor-in-possession or trustee is subject to —

• Duty of Care — to conserve the assets of the estate and to maximize distributions to creditors.

• Duty of Loyalty — to refrain from self-dealing, avoid conflicts of interest and the appearance of impropriety.

22

Operation of the Business

• The “business judgment rule” governs decisions of a debtor-in-possession or trustee made in the course of operating the debtor’s business. Richmond Leasing Co. v. Capital Bank, N.A., 762 F.2d 1303, 1311 (5th Cir. 1985).

23

Operation of the Business

• Debtors-in-possession and trustees are required to manage and operate business according to the requirements of State law. 28 U.S.C. § 959(b).

• Debtors-in-possession and trustees may be sued without leave of the court appointing them for any acts or transactions in carrying on the business of the debtor. 28 U.S.C. § 959(a).

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Official Committees Role of the Unsecured Creditors Committee

• Represents interests of all unsecured creditors

• Owes fiduciary duty to class of creditors it represents and each committee member acts as a fiduciary

• “Watch dog” for the Court

25

Official Committees

• Section 1102(a)(1) : U.S. Trustee must appoint an unsecured creditors’ committee in Chapter 11 cases and may appoint additional committees of creditors soon as practicable – Mandatory, assuming sufficient creditor interest, except in small

business cases where a party in interest may request that no committee be formed

• Section 1102(b)(1): Service on a committee is voluntary, and ordinarily, a committee of unsecured creditors will consist of a number of the largest unsecured creditors consistent with size and needs of the case – U.S. Trustee can appoint a creditors’ committee formed by creditors

prepetition if it adequately represents claimants and is fairly chosen – U.S. Trustee generally has broad discretion to appoint members and

additional members – A party in interest may seek review and approval by the court (Rule

2007).

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Official Committees

• Usually 5-7 members depending on size of the case and diversity of type of debt

• Usually includes trade, bondholders, indenture trustee, unsecured bank debt – can also include employee reps, unions and PBGC

• Committees are made up of those willing to serve (pros and cons) – Seat at the table

– In capacity of committee member, must act as a fiduciary

– May not engage in claims trading (subject to trading order)

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Official Committees

Eligibility Issues

– Claims purchased post-petition

– Claim holder representatives vs. claim holders themselves

– Creditors who are hostile to reorganization

– Competitors

– Insiders

– Fiduciary duty issues

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Official Committees

• Often sign confidentiality agreements – But must balance confidentiality with obligation to

provide information to its constituency (Section 1102(b)(3))

• May have diverse types of holdings that may at times conflict with other members of the committee – Committee should establish written by laws, for

operations and handling potential internal conflicts of interest

– Essential for both smooth operations of committee and credibility that this is done early

29

Official Committees

• Scope of Powers and Duties (Section 1103(c)) – Reviews the actions of debtor – Other duties include investigating acts, conduct, financial affairs and

other matters of the debtor – both pre-petition and post – and any other matter relevant to the case or formulation of a plan

– Reviews and takes positions on all matters • Party in interest under Section 1109(b)

– Negotiates various matters – DIP financing, use of cash collateral, sales, plan terms

– Investigates (and potentially prosecutes) potential estate claims and causes of action

– Has the right to seek appointment of a trustee or examiner, or to seek conversion of case

– Perform such other services as are in the interest of those represented

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Official Committees

Employment of Professionals • Official Committees have the right to retain professionals –

accountants, counsel, investment advisors, etc. (Section 1103(a))

• These professionals are paid by the estate on behalf of the committee (Sections 328, 330)

• Committee members may seek reimbursement of their own actual and necessary expenses (Section 503(b)(3)(F))

• Committee members may hire and seek reimbursement for reasonable compensation of their attorneys and accountants (Section 503(b)(4))

31

Official Committees

Other Official Committees • US Trustee has discretion to appoint other committees of creditors if

appropriate and also a committee of equity holders as the facts dictate

• Often happens in cases where different types of unsecured creditors such as trade, retirees and tort claimants

• Equity Committees operate similarly to unsecured creditors committees but have fiduciary duty to equity holders

• Some question whether equity committees are appropriate if debtor is insolvent

32

Official Committees

Ad Hoc Committees • Rule 2019 now recognizes that ad hoc committees exist and can

be useful. • Allows groups of similarly situated or motivated creditors to join

together, retain counsel and participate in a case – so long as the ground rules established by Rule 2019 are met.

• Act as counterbalance to official committee that is going in one direction and can act as a blocking position in a plan vote

• Ad hoc committee professionals are not paid by the estate • Ad hoc committees act on behalf of their members only, and

have no fiduciary duty to other similarly situated creditors • Nothing precludes such parties from seeking approval of their

fees at the end of the case as having provided a substantial contribution to the resolution of the case (Section 503(b)(3)(D)).

33

Disclosure Statements

• Section 1125(b): A disclosure statement must be approved by the court, on notice and hearing, before any postpetition solicitation of votes on a plan

– Hearing and notice procedures are addressed under Rule 3017

34

Vote Solicitation • What is solicitation?

– A majority of courts have interpreted solicitation narrowly to mean only the specific request for a vote with respect to a plan and not to include negotiations over plan terms. See Century Glove, Inc. v. First American Bank, 860 F.2d 94 (3rd Cir. 1988) (not improper solicitation to transmit a draft plan to certain creditors prior to approval of disclosure statement, even if intended to obtain objections to a competing plan); In re Indianapolis Downs, LLC, 486 B.R. 286 (Bankr. Court D. Del. 2013) (holding that “[w]hen a deal is negotiated in good faith between a debtor and sophisticated parties, and that arrangement is memorialized a written commitment and promptly disclosed, § 1126 will not automatically require designation of the votes of the participants”); but see In re California Fidelity, Inc., 198 B.R. 567, 571 (B.A.P. 9th Cir. 1996) (finding improper solicitation when debtor’s principal advised creditors to reject a plan).

35

Adequate Information • A disclosure statement must include information adequate

to enable a “hypothetical investor typical of holders of claims or interest of the relevant class” to make an informed judgment about the plan (Section 1125(a))

• Adequate information is a flexible concept evaluated on a case by case basis, but “there nevertheless is an irreducible minimum.” In re Michelson, 141 B.R. 715, 715 (Bankr. E.D. Cal. 1992)

• “The primary purpose of a disclosure statement is to give the creditors the information they need to decide whether to accept the plan.” In re Monnier Brothers, 755 F.2d 1336, 1342 (8th Cir. 1985)

• In addition to providing sufficient information, disclosure is required to be accurate, full, candid and complete. Michelson, 141 B.R. at 719-720.

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Types of Information to Include • Description of the plan and proposed means of implementation (In

re S.E.T. Income Properties, III, 83 B.R. 791, 792 (Bankr. D. Okla. 1988)) – It is most important that disclosure statement describe the

treatment of claims. See, e.g., In re Malek, 35 B.R. 443, 444 (Bankr. E.D. Mich. 1983) (A disclosure statement should summarize the proposed plan “in sufficient detail to give the creditors enough information to determine how their rights will be affected.”)

• Description of transactions with insiders (Id.) • Description of assets and claims against the estate (In re Cardinal

Congregate I, 121 B.R. 760, 765 (Bankr. S.D. Ohio 1990)) • Liquidation analysis (Id.) • Description of the debtor and events leading to bankruptcy (Id.) • Federal tax consequences of plan (Section 1125(a)(1))

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Objections to Approval of Disclosure Statements

• Inadequacy of Information

• Plan is Facially Unconfirmable – Denying approval of a disclosure statement when a plan

was unconfirmable because it violated the absolute priority rule. In re O’Leary, 183 B.R. 338 (Bankr. D. Mass. 1995).

– Refusing to approve disclosure statement when a plan included liability releases in violation of Section 524(e) and unfairly discriminated among creditors of the same class. In re Robert’s Plumbing & Heating, LLC, 2011 Bankr. LEXIS 2879, at *7-12 (Bankr. D. Md. July 20, 2011).

38

Procedure for Solicitation

• Rule 3017(d): For voting, a plan proponent must mail the following to creditors and equity holders, including those in unimpaired classes unless otherwise ordered by the court: – Plan or summary of the plan; – Approved disclosure statement; – Notice of time to file acceptances and rejections of plan; – Notice of deadline for objecting to plan confirmation and

hearing on plan confirmation; and – Ballot for voting

• A plan proponent should consider seeking approval via motion of its intended solicitation and plan confirmation procedures

39

Prepetition Solicitation • Section 1126(b): allows for prepetition solicitation of votes in what

is generally referred to as a “prepackaged plan”. • Rule 3018(b) addresses prepetition vote solicitation and provides

that (1) solicitation materials be transmitted to “substantially all creditors and equity security holders of the same class” and (2) that the time for voting must not be “unreasonably short.”

• Under Section 1126(b), votes solicited prepetition are only valid if (1) solicitation was in compliance with any applicable nonbankruptcy law, rule or regulation governing the adequacy of disclosure in connection with such solicitation, or (2) if there is not any such law, rule or regulation, each holder received disclosure of adequate information as defined in Section 1125(a).

• Failure to comply with these rules may result in invalidation of the plan proponent’s prepetition solicitation efforts

• Result is being required to solicit in accordance with Code

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Voting Classes

• Section 1129(a): Confirmation of a plan typically requires the approval of each impaired class of creditors and equity security holders.

• If all of 1129(a) is met, except for 1129(a)(8), then the plan of reorganization may still be approved through the cram down provisions of 1129(b) – so long as there is an impaired consenting class (not including insiders), and the plan does not discriminate unfairly, and is fair and equitable to each class of claims or interests that is impaired under and has not accepted the plan.

• Claims and interests of similar character are divided into classes for the purpose of voting.

• Claims, not holders are counted as votes. • Certain holders are entitled to vote in more than one class: such as an

under-secured creditor who has a secured and unsecured claim. • Vote of the class is significant for confirmation, not the respective

individual votes.

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Who is entitled to vote?

• Section 1126(a): “The holder of a claim or interest allowed under section 502 of this title may accept or reject a plan.”

• However, the holder of a claim or interest in an unimpaired class is deemed to accept a plan. (Section 1126(f)).

• Likewise, the holder of a claim or interest that is not receiving any distribution under a plan is deemed to reject the plan. (Section 1126(g)).

42

Claim Objections

• A pending claim objection renders the holder ineligible to vote. – “Section 502(a) provides that a claim is ‘deemed allowed, unless a

party in interest…objects.’ Accordingly, until a party is deemed to have an ‘allowed’ claim, or actually has an allowed claim, it has no right to accept or reject a plan.” In re M. Long Arabians, 103 B.R. 211 (B.A. P. 9th Cir. 1989); but see In re Goldstein, 114 B.R. 430 (Bankr. E.D. Pa. 1990) (distinguishing M. Long Arabians and finding that court has discretion to allow or disallow a claim for voting purposes, regardless of a pending objection).

• However, the holder may seek temporary allowance of its

claim for voting purposes (Rule 3018(a)).

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Claim Objections (Cont’d)

• Sections 502(b), (d) and (e) provide grounds for objecting to claim allowance, including – Claim unenforceable against the Debtor by contract – Claim unenforceable against the Debtor by state law – Creditor received a voidable preference

• Circuits are split as to whether recharacterization constitutes a claim objection or alternatively, derives from the court’s equitable powers under Section 105. Compare In re Lothian Oil Inc., 650 F.3d 539 (5th Cir. 2011), with In re Dornier Aviation (North America), Inc., 453 F.3d 225 (4th Cir. 2006).

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Designation of Votes

• Section 1126(e): “On request of a party in interest, and after notice and a hearing, the court may designate any entity whose acceptance or rejection of such plan was not in good faith, or was not solicited or procured in good faith or in accordance with the provisions of this title.”

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Effect of Designation

• A designated vote is not counted for purposes of plan confirmation.

• The Second Circuit has held that when an entire class of votes is designated, the whole class is ignored when deciding whether to confirm a plan under Section 1129(a)(8); however the Court did not rule on whether this holds true for confirmation under Section 1129(a)(10). In re DBSD North America, Inc., 634 F.3d 79 (2dCir. 2011) (noting split of authority between Ninth Circuit and Tenth Circuit as to whether a plan can be accepted by inaction).

46

Designation of Claims Purchased by an Affiliate of the Debtor

• In re Applegate Property, Ltd., 133 B.R. 827 (Bankr. W.D. Tex. 1991). – Debtor and a creditor had filed competing plans – Debtor “covertly” purchased eight unsecured claims

through a related entity and voted the claims in favor of its plan (to achieve cram down over the dissenting creditor) and against the creditor’s competing plan, blocking its confirmation

– The Court held both that (1) the related entity was an insider so its votes accepting the Debtor’s plan would not count for cram down purposes; and (2) the Debtor’s votes were disqualified under 1126(e) so they would not be counted in determining confirmation of the creditor’s competing plan

47

Designation of Claims Purchased by an Affiliate of the Debtor

• In re Applegate Property, Ltd., 133 B.R. 827 (Bankr. W.D. Tex. 1991).

– “The sole purpose was to ensure the confirmability of their own plan, partly by locking in an affirming impaired class… and partly by blocking an acceptance by the same impaired class in the [creditor’s] plan. That purpose will not withstand the ‘good faith’ hurdle imposed by Section 1126(e).”

48

Designation of Claims Created by a Debtor

• In re Bataa/Kierland, LLC, 2012 WL 3801329 (Bankr. D. Ariz. Sept. 4, 2012). – There is no bad faith under Section 1126(e) where a

debtor creates a claim prepetition in contemplation of its bankruptcy filing in order to create an accepting impaired class

– The court found important that the claim at issue was a separately classified secured claim such that the “Debtor/plan proponent has done nothing to dominate the votes or interests of any other class of creditors—the original concern of the drafters of the predecessor to § 1126(e).”

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Designation of Claims Purchased by a Creditor

• General Considerations: – “[W]e do not condemn mere enlightened self interest, even if it

appears selfish to those who do not benefit from it.” – “If a person seeks to secure some untoward advantage over other

creditors for some ulterior motive, that will indicate bad faith.” – “[P]ure malice, "strikes" and blackmail, and the purpose to destroy an

enterprise in order to advance the interests of a competing business, all plainly constituting bad faith, are motives which may be accurately described as ulterior.”

– Purchasing claims “for the very purpose of blocking confirmation of [a competing] proposed plan” does not constitute bad faith.

– “[T]he concept of good faith is a fluid one, and no single factor can be said to inexorably demand an ultimate result, nor must a single set of factors be considered.”

• In re Figter Limited, 118 F.3d 635 (9th Cir. 1997).

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Designation of Claims Purchased by a Creditor

• In re 255 Park Plaza Associates, Ltd. Partnership, 100 F.3d 1214 (6th Cir. 1996). – Upholding decision not to designate claims of creditor

– Facts: • Prepetition secured creditor in single asset real estate case

• Competing plans proposed by creditor and debtor

• After plans were proposed, creditor sought to purchase all non-insider unsecured claims, for the full amount, and succeeded with the exception of one claim

– Court focused on purchasing creditor not taking advantage of other creditors, receiving more than its fair share, or being a competitor of the debtor

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Designation of Claims Purchased by a Creditor

• In re DBSD North America, Inc., 634 F.3d 79 (2d Cir. 2011). – Upholding designation of claims purchased by creditor

– Facts: • Creditor was a competitor of debtor and not a prepetition creditor

• Purchased claims to obtain a blocking position after the debtor’s plan had been proposed

• Purchased claims at par and only purchased claims not subject to a plan support agreement

• Internal documents showed that the creditor wanted to use its claims to leverage some type of relationship with the debtor “that might allow us to… reach some sort of transaction in the future” with respect to certain satellite technology rights

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