Jul 22, 2020
Jonathan Friedland and Michael Brandess,[1] partners with the Sugar Law Firm
If you’re reading this article, then you are surely somewhat familiar with chapter 11 bankruptcy. In fact, you might deal with attorneys who do what we do (i.e. represent trade creditors and official committees of unsecured creditors) with some frequency. Still, with the tsunami of business bankruptcy filings really just beginning, the editors thought it timely to provide a little refresher.
So, as you find yourself following a customer into its chapter 11, who else is in the game?
The Debtor
Even though Chapter 11 cases are heard by a bankruptcy judge, sitting in a bankruptcy court, a bankruptcy case is not a lawsuit. There is no plaintiff and there is no defendant. Instead, there is (a) the company that files bankruptcy (or, if an involuntary bankruptcy, the party whose creditors put it in bankruptcy), called the “debtor;” and (b) everyone else.
The Debtor-in-Possession (or its replacement)
In a chapter 7 case, a trustee (commonly referred to as a “chapter 7 trustee“) is automatically appointed to take control of the debtor’s bankruptcy estate and liquidate its assets for the benefit of creditors. A chapter 7 debtor does not retain control of its assets and affairs.
In chapter 11, the debtor (or more accurately, its existing management as of the bankruptcy filing) does retain possession and control of its assets, unless removed for cause. A chapter 11 debtor is thus also a debtor-in-possession (a “DIP”) unless removed as such. Bankruptcy Code §1107 gives a debtor-in-possession most of the same powers a chapter 11 trustee would have if one were appointed—which is essentially the right to conduct business and liquidate assets.
However, the default of rule of chapter 11, that the debtor gets to remain “in possession,” can be overturned for cause.[2] A Chapter 11 trustee or examiner acts as independent third parties who either (a) takes control of a debtor’s estate in chapter 11 (in the case of a trustee); or (b) independently investigates the debtor’s affairs (in the case of an examiner). When appointed, each is charged with specific statutory duties under Bankruptcy Code §1106.
The U.S. Trustee
The Office of the United States Trustee (“UST”) is a division of the U.S. Department of Justice. It is charged with enforcing the Bankruptcy Code. The UST has specific powers and duties under the Bankruptcy Code. Bankruptcy Code §307 authorizes the UST to raise and be heard on any issue in any bankruptcy case. In one sense, the UST’s primary job is to advocate for that sanctity of the bankruptcy process.[3] When you get a formal notice about the opportunity for your company to serve on a creditors’ committee because it was listed by the debtor as one of its largest unsecured creditors, that notice comes from the UST.
Subchapter V Trustees
The Small Business Reorganization Act of 2019 (the “SBRA”) created a new kind of chapter 11: the subchapter V chapter 11 case.
Subchapter V was designed to make chapter 11 easier and cheaper for debtors. If one of your customers qualifies as a “small business debtor”(currently defined as a chapter 11 business debtor with aggregate noncontingent liquidated debts, excluding debts owed to affiliates or insiders, under $7,500,000) a Subchapter V trustee will be appointed by the U.S. Trustee. In essence, a Subchapter V trustee is an appointed bankruptcy consultant with some authority to conduct business or make bankruptcy-specific decisions. You can read more about subchapter V and its trustee in Bankruptcy Code Revised but the short version is that they are nothing like chapter or traditional chapter 11 trustees.
Secured Creditors & DIP Lenders
A secured creditor, of course, is a creditor who holds a security interest in specific property owned by a debtor. Stated another way, a secured creditor has a perfected lien on some of or all a debtor’s assets.
Businesses of any significant size typically have a term loan or line of credit (or both) from a bank or other lender, secured by substantially all the company’s assets. Outside of bankruptcy, secured creditors can foreclose on their collateral if their debtor defaults. Inside bankruptcy, the automatic stay prevents (at least temporarily) foreclosure. But bankruptcy also provides certain protections to secured creditors.
Many debtors don’t have or generate enough cash to operate their businesses during chapter 11 without borrowing. Such debtors may seek to borrow while in chapter 11, and such a loan is called a “DIP loan;” a lender who makes a DIP loan is usually referred to as a “DIP Lender.” You can read more about DIP loans in Dealing With Distress for Fun & Profit – Installment #17 – Overview of DIP Financing and Cash Collateral Motions. Prepetition blanket lien lenders commonly also serve as DIP lenders and, in so doing, are often able to extract major concessions from debtors.
The dynamic between debtors and their secured creditors is a major consideration in every chapter 11, and a principal goal of the unsecured creditor body must be to make sure that a senior creditor with a blanket lien on most or all a debtors’ assets is not allowed to ride roughshod over a chapter 11 debtor (and by extension, over the interests of its trade creditors). This, of course, is where an unsecured creditors’ committee comes in.
Official Committee of Unsecured Creditors
As we note above- and as you know- most sizeable chapter 11 debtors have at least one secured creditor (a lender) who has a lien on all or most of its assets. The Bankruptcy Code gives secured creditors powerful rights. And, chapter 11 debtors are often unable or unwilling to fight with their blanket lien lenders for various reasons. Moreover, since the blanket lien lender has so much at stake, it comes to the scene of a chapter 11 well-armed with counsel.
Contrast this with any single general unsecured creditor. It may have 30-days of A/R at risk, or perhaps more. Regardless of the amount, it will always be far less than the amount owed to a blanket lien lender. And, because of Bankruptcy Code realities relating to the priority of payment and other reasons, any one general unsecured creditor is likely to receive pennies on the dollar in terms of its recovery.
This creates a Hobbesian Choice that any single creditor would- in the absence of the Committee structure- be faced with: to meaningfully participate in a chapter 11 case, a creditor would have to invest additional time and money which may not improve its recovery—and while it occasionally makes sense, most of the time unsecured creditors conclude that retaining counsel and meaningfully participating in the case is tantamount to throwing good money after bad.
The Bankruptcy Code recognizes this and provides a solution. It authorizes unsecured creditors to take collective action in chapter 11 (but typically not in a Subchapter V chapter 11) by forming an official committee of unsecured creditors. An official committee of unsecured creditors consists of a small number of unsecured creditors with large claims against the debtor, selected by the UST. The Committee hires professionals (attorneys and financial advisors) whose fees and expenses are paid for by the debtor. The Committee has the standing to be heard in the case on any matter. In the authors’ experience, a strong Committee can meaningfully and positively affect the case trajectory for trade and other unsecured creditors.
Adversary Proceedings and Contested Matters Give Rise to Plaintiffs, Defendants, Movants, and Objectors
We explain above that a bankruptcy case is not a lawsuit, and it’s not. But lawsuits do get filed in a bankruptcy case. These are called adversary proceedings, and that’s how many disputes are litigated in bankruptcy. And these disputes, like any traditional lawsuit- have one or more plaintiff and one or more defendant.
The other vehicle for litigating a dispute in front of a bankruptcy court is through a “contested matter.” If a creditor, for example, wants to take back its property, and the debtor-company doesn’t want to give it back,[4] the creditor files a motion and that begins a contested matter. So, contested matters have movants and objectors (a/k/a “respondents”).
A Note About Future Articles
Your authors are uncertain whether you and most readers will benefit from a “back to basics” article like this one. If you found this article to be helpful, please let the editor of this newsletter know and we will be happy to continue with similar, “nuts and bolts” articles about chapter 11.
Michael Brandess and Jonathan Friedland are partners with the Sugar Law Firm, a national boutique that concentrates a substantial part of its practice in protecting trade vendors when contracting with their B2B customers. They regularly represent official committees of unsecured creditors in chapter 11 cases. Each is highly ranked by numerous attorney rating services, each writes and speaks extensively, and they pride themselves on their willingness to run through walls for their clients. They can be reached by email at restructuring@sfgh.com
[1] Brandess and Friedland are partners with Sugar Felsenthal Grais & Helsinger LLP. This article is based substantially on a prior article co-authored by one of the authors, Dealing with Corporate Distress 02: These Are the People in Our Neighborhood: An Overview of Parties in Chapter 11.
Many of the hyperlinks included in this article lead to DailyDAC, which offers a free chapter 11 alert system for credit managers.
[2] You can read more about appointing a chapter 11 trustee in The Good, the Bad, and the Ugly of Replacing a Debtor’s Management with a Chapter 11 Trustee.
[3] In contrast, the Court technically cannot advocate any position—it is a referee, not a player in the game.
[4] You can read more about lifting the automatic stay Chapter 11 – “101”: An Overview of the Automatic Stay.