Congress rarely accomplishes anything these days, but the need to reform Chapter 11 of the Bankruptcy Code seems to have “crossed over the aisle.” When the Bankruptcy Code was enacted in 1978, America boasted the world’s dominant manufacturing economy. Corporate debt was mostly unsecured trade debt. Secured loans provided tangible asset financing for property, plant, and equipment. The concept of several “tranches” of secured debt covering goodwill and intangible assets, resulting in debt well over any measure of a company’s worth, would have seemed nonsensical to both Congress and the lending industry.
The world has changed. The American economy today is primarily an information, service, and finance economy. But the Bankruptcy Code has not changed accordingly. Though the profession handled the bankruptcy challenges of the Great Recession with ingenuity and skill, the Code did not provide enough answers.
In 2012, the American Bankruptcy Institute, in coordination with legislative aides from both sides of the aisle, convened the Commission to Study the Reform of Chapter 11. Its members were the leading jurists, lawyers, academics, and turnaround professionals in the field. Every viewpoint was represented, and every constituency worked to draft common proposals for Congress to consider. BakerHostetler lawyers were active participants.
The Commission’s report was issued last December. It remains to be seen whether Congress will act on the unanimous proposals in the document, but the effort has produced an important reassessment of the conflicting needs of unpaid creditors, from the largest bank to the lowliest employee. Over the next few months BakerHostetler bankruptcy attorneys will summarize some of the most important proposals contained in the report. The first summary, regarding the conflicting rights and needs of secured and unsecured creditors at the beginning of a case, are set forth below.
Proposed Changes to Chapter 11 Affecting Secured Creditors
A business entering bankruptcy these days almost always has secured debt well in excess of company value. The development of bankruptcy and state law regarding secured creditor rights, over the past two decades, allows secured creditors to exert strong pressure on a business bankruptcy case from the outset. While secured lenders insist that is their right, the bench and bar share a concern that the pendulum has swung too far in favor of secured lenders.
Secured creditors frequently push for a sale of the company’s assets as a going concern, as quickly as possible. They can do so because of their rights to “cash collateral.” The Bankruptcy Code prohibits a debtor from using cash that has been pledged to a lender, without court approval. Almost all secured lenders have a lien on accounts receivables which generate the debtor’s cash. Secured lenders will insist that the debtor not have access to cash unless it protects the lender by: (1) commencing a sale process very quickly; (2) pledging all post bankruptcy assets, including the recoveries from preference lawsuits against unsecured creditors, to the lender; and (3) prohibiting any challenge to the lender’s receiving all proceeds of any sale.
The Commission attempted to balance the rights of a secured creditor with the needs of the company. This was a primary concern for the Commission. The unanimous compromises in the Commission report are described below.
60-Day Breathing Space Before Going-Concern Sales
The sooner the sale of a distressed business occurs, the faster the secured lenders can recover money. A longer marketing period might result in better recoveries, but lenders argue that all of the proceeds will go to pay their loans anyway. Therefore, they are the parties most affected by the sale process. Unsecured creditors argue that a proper marketing of the company might produce value for unsecured creditors. Even if that is rare, unsecured creditors are concerned with continuing customer relations. They argue for a lengthier sale process.
The Commissioners compromised by prohibiting, except in truly extraordinary circumstances, the conclusion of a sale in less than 60 days from the commencement of a bankruptcy case. The Commissioners felt that establishing certainty for the time period of a sale would allow secured creditors to protect themselves, and unsecured creditors to have an opportunity to enhance the sale process. The sole exception to the 60-day rule would be made in those situations where there is truly an emergency resulting from the debtor being what is colloquially called a “melting ice cube,” its assets quickly disappearing. A classic example of this situation was Lehman Brothers, whose financial assets would have evaporated were they not taken over by a bank (ultimately Barclays) immediately. In the absence of such extraordinary circumstances, the Commissioners recommend a reasonable, 60-day sale process.
“DIP” Lender Rights and Collateral
Debtor-in-possession financing provides a company additional loans to operate the business after the Chapter 11 filing. However, some lenders provide little if any new money to a debtor, instead characterizing the “roll-over” of pre-petition revolving loans into post-petition loans as “new lending.” In this manner, secured lenders sometimes obtain the significant advantages provided under the Bankruptcy Code to entice lenders to advance money to bankrupt companies.
The Commissioners viewed as abusive a lender’s ability to roll up its pre-petition debt into a post-petition facility, where the amount of new post-petition credit is nominal. The Commissioners therefore proposed prohibiting DIP financing that contains roll-up provisions unless: (i) the pre-petition and post-petition lenders are different; or (ii) there is an extension of substantial new credit in the post-petition facility or the facility provides financing on better terms than any other option offered to the debtor.
The Commissioners also addressed the problem of intercreditor agreements that prevent junior (subordinated) secured lenders from offering post-petition financing without the consent of senior secured lenders. This significantly limits a debtor’s options by removing a viable alternative bid for post-petition financing. The Commissioners therefore recommend that junior lenders subject to this kind of provision in an intercreditor agreement should still be able to provide post-petition financing in one of two situations: (i) the proposed facility does not “prime” (take a first lien before) the senior secured lender; or (ii) the senior secured lender is given a right of first refusal—that is, allowed to offer financing on the same terms as the junior lender, if approved by the court. The Commission also supported rendering unenforceable a senior lender lawsuit for damages resulting from a junior creditor offer of post-petition financing.
Limiting Adequate Protection Rights
Adequate protection allows the debtor to continue to use collateral during the reorganization, while ensuring that the value of the collateral does not erode during the case. There are three primary ways in which a secured creditor is afforded adequate protection: (i) cash payments; (ii) liens on additional property; or (iii) other protection that will result in the secured creditor’s realization of the “indubitable equivalent” of the collateral value. This latter clause provides a bankruptcy court flexibility in fashioning an appropriate amount of protection.
In an attempt to balance secured creditors’ interests and the objectives of the estate, the Commissioners first concluded that adequate protection, at the beginning of a case, need only be enough to cover the collateral’s “foreclosure value,” that is, the value the collateral would yield if the automatic stay were lifted and the secured creditor foreclosed. At later times, if the debtor reorganizes or sells as a going concern, secured creditors would be entitled to the reorganization or enterprise value of their collateral.
The practice of cross-collateralization was also considered an area of abuse. Cross-collateralization provides the lender a lien on post-bankruptcy property which may have higher value (including more collectible accounts receivable) than the pre-petition value of the lender’s collateral. Acknowledging the potential for impermissible improvement of a secured creditor’s interests, the Commissioners concluded that cross-collateralization should be used to provide adequate protection, but only to the extent necessary to protect against a decrease in value of the collateral.
Finally, the Commissioners decided against granting secured creditors a lien in “chapter 5” (mostly preference) “avoidance action” proceeds. Those recoveries are often an estate’s only unencumbered assets and should be available to pay unsecured creditors.
Who Pays the Costs for Helping the Secured Lender: Enhanced 506(c) and 552(b)
The Bankruptcy Code allows a secured creditor to be paid the value of its collateral, but also recognizes that the bankruptcy estate will incur costs to turn that collateral into cash. Section 506(c) and Section 552(b) of the Bankruptcy Code both provide a means to charge to secured creditors the costs of preserving or selling the collateral.
However, court decisions and bankruptcy practices have limited the usefulness of these provisions. In some instances lenders are only charged “direct” costs, even in situations where the lender wants the debtor to file a bankruptcy case and sell all of its assets at the enhanced price a bankruptcy court sale can obtain. Though the bankruptcy itself will cost substantial amounts of money, and all of the proceeds of the sale go to the lender, the cost of the case may remain unpaid. The Commission decided to address this imbalance of rights.
Section 506(c) allows a court to “surcharge” a secured creditor for the cost of preservation or sale of its collateral. This provision has gained importance because Chapter 11 filings are increasingly devoid of unencumbered assets. Any expenditure made for the benefit of a secured creditor’s collateral directly results in the depletion of funds available to rehabilitate the debtor. A secured creditor often agrees to “carve out” certain expenses from the proceeds of the collateral (quite common in DIP financing agreements), but usually in exchange for a waiver of debtor’s right to “surcharge” under Section 506(c). As a result, debtors are forced to rely on negotiated carve-outs covering only expenses closely related to the secured creditor’s collateral.
Although the Commissioners considered expanding Section 506(c) to expressly include expenses that are indirectly related to secured creditors’ collateral, such as costs to wind down the estate, they ultimately decided that the current language of Section 506(c) can be made appropriate. That language leaves the courts to determine which expenses are “reasonable” and “necessary” on a case-by-case basis. The Commissioners concluded that many courts have been sensible in that determination.
The Commissioners, however, focused on making certain the courts actually get to consider the issue. They reject allowing the debtor to waive Section 506(c) claims. Consensual carve outs usually reflect the estate’s limited negotiating power, and often do not represent what is best for the estate and its other stakeholders. Accordingly, the Commissioners’ final recommendation leaves the language of Section 506(c) as is, but prohibits waiver of a trustee’s 506(c) rights.
The Commission then focused on another, little-used statutory provision that can provide more negotiating power to a company in bankruptcy. Section 552(b) allows a court to charge costs of the case to a lender’s collateral “based on the equities of the case.” The section was originally intended to cover a situation where the debtor finishes off inventory and the like at the estate’s expense, and then sells the finished goods for the secured lender’s benefit. In essence, the provision allows the estate to be reimbursed for enhancing the value of collateral.
Similar to the right to “surcharge,” some court decisions had limited Section 552(b) to the “direct” costs of enhancing collateral, and not the general costs of, for example, the labor and overhead necessary to accomplish that goal.
The Commissioners agreed that a debtor should not be required to show actual direct expenses to demonstrate the estate enhanced the value of the collateral. Rather, costs that enhance collateral value should be recoverable by the estate. As with Section 506(c), the Commission felt it is imperative that courts are able to assess the “equities of the case” exception. Therefore, any waiver of Section 552(b) should be prohibited.
The Commissioners effort to “level the playing field” regarding secured lender rights was perhaps the most contentious and important issue the Commission reviewed. While the report reflects substantial compromises and relays the differing views expressed during the negotiations, the end result appears to provide debtors a more reasonable opportunity to survive the bankruptcy process.