The debt restructuring mechanism of Chapter 11 of the US Bankruptcy Code and some of its similarities with the scheme of arrangement process.
Lehman Brothers. WorldCom. General Motors. Enron. These companies are among the largest bankruptcies in US history. They held a total of US$900 billion in assets at the time of filing for protection under Chapter 11 of the US Bankruptcy Code, and with Lehman Brothers being the largest bankruptcy in history having assets totaling US$639 billion.
While a company seeking relief under Chapter 11 is often seen as entering ‘bankruptcy’ or insolvency, it will be shown that the Chapter 11 process is more akin to a debt restructuring mechanism rather than liquidation. The aim of this process is to allow the company to have some breathing space to reorganise its affairs and to then exit its financial distress.
This article will touch on some of the interesting features of the Chapter 11 framework while also drawing parallels with the Malaysian debt restructuring route under the scheme of arrangement under section 176 of the Companies Act 1965 (“Act”).
Section 176 of the Act provides for a statutory mechanism to facilitate a Court-sanctioned compromise which binds dissenting participants as long as the statutory majority has been achieved. This overcomes the difficulty of a company trying to implement an informal compromise with all its creditors since it would require unanimous agreement and the company would have to approach each and every creditor.
Therefore, there are several common features in both the Chapter 11 process and the scheme of arrangement.
A typical Chapter 11 process is initiated through the debtor company filing a petition with a bankruptcy court setting out a list of its creditors and a summary of its assets and liabilities. The debtor has a legal right to initiate the procedure subject to the court determining that the petition was filed in ‘good faith’ primarily for the purposes of reorganising its debts.
Technically, there is no requirement of ‘insolvency.’ For instance, in 1995, the Dow Corning Corporation filed for Chapter 11 protection from creditors when it faced massive personal injury suits involving silicone-gel breast implants. It emerged from Chapter 11 only after nine years.
DEBTOR IN POSSESSION
Unlike liquidation which involves a liquidator taking over the management of the company, in a Chapter 11 scenario, the control of the debtor remains with its management through the concept of ‘debtor in possession.’ A trustee is rarely appointed to oversee the debtor’s operations. The rationale behind this concept is the belief that the management represents the most economical and efficient means to reorganise since they would have the most knowledge of the company’s affairs.
As a safeguard, the debtor will be subjected to oversight by the bankruptcy court and the United States Trustee (a representative of the Department of Justice responsible for overseeing bankruptcy cases). Generally, a committee of creditors would also be appointed to act in a supervisory role.
Upon the filing of the Chapter 11 petition, an automatic moratorium would stay legal proceedings against the debtor and enforcement of judgments and security without leave of the bankruptcy court. The stay is effective during the entire time the petition is pending but creditors and other parties may apply to lift or modify the stay.
This is similar to the moratorium enjoyed under a restraining order granted pursuant to section 176(10) of the Act although there is no automatic grant of a restraining order. Instead, the requirements under section 176(10A) must be met for the grant of a time-limited restraining order as well as for any extension of this order.
PROPOSALS TO CREDITORS
Under Chapter 11, the debtor has the exclusive right to formulate the plan of reorganisation for 120 days from the date of filing and this exclusivity period can be extended up to a maximum of 18 months.
In contrast, in a scheme of arrangement, the company, any creditor, any member or the liquidator (where the company is being wound up) can apply to the Court to initiate the scheme of arrangement process.
Before the debtor solicits approval for the restructuring plan, it must provide creditors with a disclosure statement that has been approved by the bankruptcy court as containing adequate information to allow a reasonable hypothetical creditor to be able to consider the plan.
This is very similar to the scheme of arrangement requirement of the explanatory statement under section 177 of the Act. The explanatory statement must provide the creditors with sufficient or material information to make a meaningful decision. However, the explanatory statement is not subject to the added safeguard of requiring approval by the Court before its issuance to the creditors.
CLASSIFICATION OF CREDITORS AND VOTING
Chapter 11 requires creditors to be classified into classes on the basis that claims that are substantially similar should be classified together. This is similar to a scheme of arrangement scenario. An example for instance would be the different classification of creditors into a secured creditor class and an unsecured creditor class.
In Chapter 11, the creditors of each class would need to vote in favour of the plan by a majority in number and two-thirds in amount of those actually voting (while in a scheme of arrangement, the approval threshold is higher in that a majority in number and three-fourths in value is required). The minority is bound by the class vote.
Similar to winding up in Malaysia, the US Bankruptcy Code gives a debtor certain powers to avoid or recover certain transfers of property. Generally, a debtor can avoid such transfers made within 90 days before the filing of the petition to a creditor on account of a pre-existing debt if such a transfer allows the creditor to receive more than it would have received compared to other creditors. These are called preferences.
A debtor can also avoid fraudulent transfers made within one year before the filing of the petition. In this context, a fraudulent transfer is one which is made with the intent to hinder, delay or defraud a creditor.
Under the US Bankruptcy Code, the debtor generally has the power to pick which contracts or leases by which it wants to be bound following its reorganisation. Further, under certain circumstances, the company can adopt its favourable contracts and then assign them regardless of whether the contracts themselves prohibit such an assignment.
The Bankruptcy Code prescribes deadlines within which different types of contracts may be rejected. The debtor is not required to perform the obligations under the rejected contracts but will be liable for “rejection damages” that arise from its non-performance of the obligations under such contracts.
Chapter 11 therefore provides the debtor with wide-ranging powers with which it can reject, adopt or assign contracts. This power, especially when combined with the ability to sell assets and borrow money, enables the company to address its operational needs.
INCENTIVES FOR LENDER FINANCING
The Bankruptcy Code gives lenders incentives to provide financing to the debtor (called Debtor in Possession or DIP financing). DIP financing is unique from other financing methods in that it usually has priority over existing debt, equity and other claims. The lender may be given a lien over assets that are not pledged to other lenders. The bankruptcy court may also authorise liens superior to certain priority claims in the bankruptcy process or even grant new senior liens on collateral already pledged to another party.
The term ‘quick-rinse’ bankruptcy generally describes a pre-packaged bankruptcy where the debtor has negotiated a plan and solicited votes even before the filing of the Chapter 11 petition. An example of this is Chrysler in 2008, where it entered and exited Chapter 11 in less than two months with the sale of most of its assets to a new entity. Similarly, General Motors in 2009 exited Chapter 11 in just over a month, having also sold most of its assets to a new General Motors entity and shedding almost US$90 billion in debt.
The Chapter 11 procedure allows a great deal of flexibility for the resuscitation of a financially distressed company with the breathing space of a moratorium. However, criticisms have been levelled against the fact that the persons who caused the company to petition for relief continue to be the same ones in control; akin to leaving the fox in charge of the hen house.
This is an expanded version of my article which originally appeared in Skrine’s Legal Insights Issue 2/2013