As the economy worsens and the value of corporate assets declines, unsecured creditors are finding that very little, if anything, is left for them at the bankruptcy table after the secured creditors have taken as much as they can from a debtor’s assets. Now, after a period of having copious credit available on attractive terms, debtors are going into bankruptcy without sufficient assets to pay even their secured creditors in full. In such circumstances, prospects for unsecured creditors are bleak indeed.
Tough economic times exacerbate the problem in other ways, too. Chapter 11 was designed and intended to facilitate reorganizations to give the debtor-enterprise a chance to stay in business and return to profitability. Under better economic conditions, when more debtors appeared able to successfully reorganize, the creditors could look not only to the underlying asset value, but also to the expected profits from the continuing business as a source of recovery. This potential for added value gave secured creditors and unsecured creditors a reason to cooperate with each other in the reorganization planning process for the benefit of all sides.
Increasingly, however, Chapter 11 is being used not to reorganize, but as a way to sell assets quickly. A Chapter 11 is preferable to a Chapter 7 for this purpose because the debtor’s management can remain in place and the business can be sold as a going concern. In a Chapter 7 case, a trustee takes control of the debtor and is rarely able to effectuate a going-concern sale. Yet a sale of assets, even as a going concern, will produce only a finite current benefit, with no ongoing upside for the debtor’s creditors. In such a situation, it’s not surprising that secured creditors are loath to give up value for the benefit of junior creditors, unless the courts force them to do so.
Typically, junior creditors have argued that secured creditors should be required to make funds available from the proceeds of their collateral to pay administrative costs and for the benefit of unsecured creditors as the price for using Chapter 11 to liquidate the secured creditors’ collateral. This argument has received little support from most courts. In particular, Delaware courts, which oversee a disproportionate share of the nation’s bankruptcies, particularly larger ones, appear willing to let secured creditors utilize the bankruptcy process for their own benefit without regard to the claims of other creditors. While courts will generally require a secured creditor to carve out funds from the proceeds of its collateral to pay lawyers and advisors for the debtor and the unsecured creditors committee, they generally won’t require more. Worse for unsecured creditors, courts sometimes allow secured creditors to get liens on the anticipated proceeds from lawsuits to recover prepetition preference payments, proceeds that are usually reserved for unsecured creditors in exchange for bankrolling the cost of the lawyers for the debtor and the unsecured creditors committee.
Even some unsecured creditors that are given special statutory priority are not faring well. A few years ago, Congress amended the Bankruptcy Code to give a special administrative priority to those creditors that ship goods to a debtor in the 20 days prior to the debtor’s filing for bankruptcy (“20-Day Creditors”). By so providing, Congress attempted to enhance the likelihood that such claims would be paid, since administrative claims are equal in priority to postpetition claims and rank ahead of general prepetition claims. This priority is valuable if the debtor wants to reorganize, since administrative priority claims must be paid in full before a plan of reorganization can be confirmed. However, when the goal is straight liquidation through a quick sale, 20-Day Creditors have less leverage. Courts have generally not required debtors to pay 20-Day Creditors at the outset of the case, which would force secured creditors to fund these payments or have the case converted to the less advantageous Chapter 7. Courts have similarly refused to require payment of 20-Day Creditors as a prerequisite for authority to conduct a sale of assets to benefit the secured creditors.
Once a customer files for bankruptcy, is there anything that can be done? A supplier of goods or services to the debtor may ask the debtor to designate it as a “critical vendor.” In theory, a critical vendor is one that provides a product or service of such unique value that the debtor could not operate postpetition without it, such as the sole supplier of a particular part used in the debtor’s manufacturing business. In practice, in most jurisdictions, a debtor is given some latitude in the definition of “critical,” and many non-unique providers are identified as well. The debtor will then ask the court for authority to designate these vendors as critical vendors. The debtor will be allowed to pay a designated critical vendor’s claim in full; in exchange, the vendor will be required to do business with the debtor going forward on the vendor’s normal prepetition credit terms. In most cases, this is no hardship at all, for a debtor’s postpetition financing will almost always provide for payment of postpetition purchases. Even if there is a slight credit risk, this is a small sacrifice, given that the prepetition claim will be paid ahead of other creditors of equal or higher priority. Increasingly, though, courts have become reluctant to recognize large numbers of critical vendors in any given case.
Of course, the best strategy for dealing with insolvent entities is to not become their creditor, or to minimize credit exposure as much as possible. Advance planning is essential.