This article is an extract from The Restructuring Review, 14th Edition

General introduction to the restructuring and insolvency legal framework

i Statutory overview

Title 11 of the United States Code (i.e., the Bankruptcy Code) governs bankruptcy cases filed in the United States.25 The Bankruptcy Code is premised on the theory that an honest debtor deserves a fresh financial start and thus relief from its unsecured debts. The Bankruptcy Code endeavours to allow for this fresh start, while at the same time balancing the rights of the debtor's various constituents as fairly and equitably as possible. The Bankruptcy Code was enacted by Congress in 1978 and has been amended several times – including notably in 2005 and also (as discussed below) in 2019 and 2020.

The filing of a petition by a debtor (for business entities, this is usually a petition for relief under either Chapter 7 or Chapter 11 of the Bankruptcy Code) commences a bankruptcy case. There is no requirement that a debtor be 'insolvent' to commence a voluntary bankruptcy case. Rather, case law has developed to require only that a petition be filed in 'good faith'. Immediately upon filing a petition, a debtor obtains the benefit of an automatic stay. The stay prohibits most creditors from taking actions against the debtor and its property on account of pre-petition liabilities or agreements, without express authorisation from the bankruptcy court.26 Thus, the stay gives the debtor the necessary breathing space to complete its reorganisation or orderly liquidation consistent with the terms of the Bankruptcy Code.

A company hoping to reorganise or liquidate with its management in place will file a petition under Chapter 11; a company with no option but to liquidate under court supervision will commence a Chapter 7 case. Banks, savings and loan associations, insurance companies, stockbrokers and commodity brokers are not eligible to file for Chapter 11 protection. In general, these types of entities are liquidated under other federal or state winding-up laws or, in the case of stockbrokers and commodity brokers, under their own subchapter of the Bankruptcy Code.27

Unlike many insolvency regimes in other countries, in a Chapter 11 case, the debtor's management and directors generally remain in place and continue to manage the business and guide the restructuring (the filing entity is referred to as a debtor-in-possession).28 A trustee is rarely appointed to oversee a Chapter 11 debtor's operations unless the situation suggests that one is necessary (e.g., due to fraud or mismanagement).29 By contrast, in a Chapter 7 case, a trustee is appointed to manage the liquidation.

The bankruptcy court judge is typically heavily involved in the bankruptcy case. Indeed, many of the debtor's activities (e.g., financing, major asset sales, plan of reorganisation) must be brought to the bankruptcy court judge for approval. Also, the US Trustee (UST), a representative of the Department of Justice, acts as a watchdog over the debtor's case – particularly at the outset before creditors have had time to organise. In a Chapter 11 case, the debtor-in-possession's actions will often be subject to scrutiny by one or more official committees appointed by the UST.30 The most common official committee is one composed of unsecured creditors. In larger cases, the committee typically retains its own professionals (including counsel) to represent the unsecured creditors' interests, and the debtor's estate pays for the cost of these professionals. In some cases, equity holders or retirees will convince the UST to appoint a separate committee for their constituency, especially in cases in which it appears that the debtor might be solvent. Other official committees can be formed to represent other creditor groups, although such committees are rare, except in cases driven by mass torts such as asbestos liability.

The goal of a debtor in commencing a Chapter 11 case is to confirm and consummate a Chapter 11 reorganisation plan. Unless a trustee has been appointed, the debtor initially has the exclusive right to file a reorganisation plan.31 The exclusivity period, however, is not indefinite. Indeed, with the bankruptcy court's permission, plan exclusivity can be extended, but only to a maximum of 18 months after the petition date.32

Before a debtor can solicit votes on its reorganisation plan, it must provide creditors with a disclosure statement (generally, that has been approved by the bankruptcy court). The bankruptcy court does not approve the contents of the disclosure statement; rather, its role is to ensure that the disclosure statement contains adequate information to permit a creditor to make an informed decision to accept or reject the related plan. Following approval of the adequacy of the disclosure statement, the debtor may solicit votes from creditors and equity holders entitled to vote on the plan.33 Parties who are entitled to vote on the plan are those whose debt claims or equity interests are being affected by the plan, unless they receive no distribution, in which case they are deemed to have rejected the plan. Groups of creditors and equity holders will be categorised into different classes. If the requisite votes are received, the debtor will seek confirmation, or approval, of the plan by the bankruptcy court.

Aside from the required votes, the most critical requirement of the Bankruptcy Code for the plan is the 'best interests of creditors test'. This test requires that each impaired (i.e., affected) creditor and equity holder either accept the plan or receive under the plan a distribution at least as much as it would receive if the debtor were to liquidate rather than reorganise.34 In some cases, the test requires valuation of property given to dissenting creditors. Because valuation is a complex and fact-intensive undertaking, a 'best interests fight' can lead to time-consuming and expensive litigation.

The second critical requirement is that at least one class of claims votes for a plan if there is a class of impaired – or affected – claims. For this vote, the votes of insiders do not count.35 A class will be deemed to accept the plan if two-thirds in amount and more than 50 per cent in number of voting creditor class members vote in favour of it. In the event that equity security holders are proposed to receive a distribution, classes of equity security holders must vote for the plan by at least two-thirds in amount.36

Usually, at least one class will either affirmatively reject or be deemed to have rejected the plan because that class is not slated to receive a distribution under the plan. In those cases, the debtor can confirm its plan by cramming down these creditors or equity security holders. Cramdown requires the debtor to prove that the plan does not discriminate unfairly and is fair and equitable with respect to each class of claims or interests that is impaired under the plan and has not accepted it.37 The 'fair and equitable' test is fairly straightforward and follows an absolute priority waterfall, under which secured creditors are entitled to full payment (at least over time) before unsecured creditors and equity holders receive a distribution.38 Despite this rather simplistic concept, valuation and issues regarding the present value of future payments to secured creditors are often hotly contested. The unfair discrimination requirement is more difficult to grasp but, at a minimum, it prevents creditors and interest holders with similar legal rights from receiving materially different treatment under a proposed plan without compelling justification for doing so.

Confirmation of a reorganisation plan provides a reorganising Chapter 11 debtor with the fresh start that most debtors hope to obtain by reorganising under the Bankruptcy Code. The discharge that the debtor receives under the Bankruptcy Code is key to the fresh start. This discharge bars creditors and equity security holders from looking to the debtor for satisfaction of claims owed to them prior to the commencement of the Chapter 11 case. Rather, their sole source of recovery is the distribution proposed to be made to them under the plan. Corporate debtors liquidating under either Chapter 7 or Chapter 11 of the Bankruptcy Code, however, do not obtain a discharge.

ii Absolute priority rule

A basic premise under the Bankruptcy Code is that, in the absence of consent (obtained through the votes of classes of claims and interests), distributions to creditors must follow the 'absolute priority rule'.39 In applying this rule, lower-priority creditors may not receive a distribution unless the Chapter 11 plan provides that each holder of a claim in a dissenting senior class is paid in full. Secured creditors are first in the priority scheme. Secured claims typically include pre-petition collateralised loans and trade obligations with security interests (such as mechanics' liens and materialmen's liens). Administrative expense claims are second in priority. Included in this bucket are claims relating to the post-petition operations of the debtor, and 'cure' claims that arise when debtors 'assume', or agree to be bound by, pre-existing contracts. The Bankruptcy Code also elevates to administrative expense priority status certain pre-petition claims of vendors of goods that would otherwise be treated as general unsecured claims. Next in order of priority come priority claims, which include certain pre-petition wages and commissions, employee benefit plan contributions, unsecured claims in connection with certain prepayments for goods or services from the debtor (e.g., the pre-petition purchase of goods laid away with the debtor, up to a cap) and certain taxes. A Chapter 11 reorganisation plan must provide for payment of administrative expense claims and priority claims in full on the plan's effective date, although individual creditors may instead agree to a payout over time. An unimpaired class is deemed to have accepted the plan, and thus does not vote.40 Administrative expense claims and certain priority claims also do not vote.41

General unsecured claims, in terms of priority, come after secured claims, administrative expense claims and priority claims, but before subordinated debt claims.42 Equity interests (including equity-related damage claims that are treated as equity) are lowest on the distribution waterfall and, as a result, equity holders rarely receive a bankruptcy distribution. As mentioned above, if a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan must accept the plan for it to be confirmed by the bankruptcy court (determined without including any acceptance of the plan by any insider).43

iii Duties of directors

In the United States, the duties of directors are defined by state law. In particular, Delaware is the most common state of organisation. Businesses can take a number of forms, including the corporation (which is under the control of a board of directors), the partnership or the limited liability company (or LLC) (which shares the characteristics of both a corporation and a partnership, and can be managed either by the owner – member-managed – or by a manager or board of managers – manager-managed).

The seminal ruling in North American Catholic Educational Programming Foundation, Inc v. Gheewalla, issued by the Supreme Court of Delaware in 2007,44 explained that, for Delaware corporations, 'It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders.' Shareholders rely on directors acting as fiduciaries, whereas creditors are protected by legal mechanisms including contract law (and the terms of their contracts), security interests, clawback actions and bankruptcy law. For a solvent corporation (even one operating close to insolvency – the 'zone of insolvency' that Gheewalla explained was legally irrelevant), the focus of directors is to 'discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners'.

Per Gheewalla, the fiduciary duties of the directors to the corporation do not change because of the corporation's insolvency. However, the creditors 'take the place of the shareholders as the residual beneficiaries of any increase in value'. Therefore, creditors become able to sue the directors 'derivatively' (i.e., on behalf of the corporation) – but not 'directly' (i.e., on their own behalves) – for alleged breaches of fiduciary duties.

For an LLC, governance matters are flexible and depend on the contents of the limited liability company agreement (also called an LLC agreement or operating agreement), which represents an agreement among the members of the LLC.45 This agreement can expand, restrict or eliminate the fiduciary or other duties of members, managers and other persons to the LLC, except that the agreement 'may not eliminate the implied contractual covenant of good faith and fair dealing'.46

Accordingly, depending on the terms of the LLC agreement, fiduciary duties may largely be eliminated. Moreover, Delaware LLCs differ from Delaware corporations in that LLC creditors do not have standing to sue members or managers, either derivatively or directly. Under the statute, only a member (or an assignee of an LLC interest, who is entitled to share in profits and losses but has not necessarily become a member47) is a proper plaintiff to bring a derivative action.48

What are these duties that the aforesaid parties may be able to litigate to enforce? There are multiple duties, and their complexities are beyond the scope of this review. The two key duties are the duty of care and the duty of loyalty (the latter of which includes the duty of good faith). Although under certain circumstances a higher standard of review can apply (e.g., if a director had a conflict of interest), generally when a court reviews corporate decision-making, it focuses on process rather than outcome and applies the business judgement rule – the presumption that in making a business decision the decision-maker acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. If the business judgement rule applies, the business decisions of disinterested directors will not be second-guessed by a judge applying his or her judgment ex post if they can be attributed to any rational business purpose.49 In a Chapter 11 case, many transactions by the debtor-in-possession are subject to bankruptcy court approval and are reviewed by the bankruptcy court using this business judgement standard.

Finally, what is the ultimate point of corporate governance from a Delaware perspective? The goal of the fiduciary is to maximise long-term corporate value, rather than, for example, balancing that interest with the interests of employees or other constituents, or furthering social or environmental considerations.50 Even for a company in financial difficulty, a value-maximising board of directors is not obliged to shut down operations or otherwise minimise risk, but neither should it buy lottery tickets or otherwise take unwise, risky bets at the expense of creditors for the benefit of out-of-the-money stockholders.51

iv Treatment of contracts in bankruptcy

A debtor generally has the power to determine those executory contracts and unexpired leases by which it will continue to be bound following its reorganisation. A contract is usually found to be executory when both the debtor and the non-debtor party to the contract have material performance obligations outstanding. If the debtor chooses to assume (or keep) a contract, it will be bound under all the terms of the agreement. Alternatively, if the debtor no longer seeks to be bound by the agreement, it will reject it. Upon rejection of a contract, the debtor is no longer required to perform and the contract is deemed breached as of the date that the bankruptcy commenced. Damages resulting from such a breach are referred to as rejection damages and are generally given low status in the sequence of priority of payments (i.e., prepetition general unsecured claims). Under certain circumstances, a debtor may be able to assign its interest in a contract or lease to a third party.52

In the event that a debtor does not assume an agreement, the default option under the Bankruptcy Code is rejection.53 In Chapter 11, the deadline to make the assumption or rejection decision with respect to executory contracts and unexpired leases (other than unexpired leases of non-residential real property) is the date that a plan is confirmed by the bankruptcy court.54 The deadline for a debtor to assume or reject an unexpired lease of non-residential real property can be much sooner (i.e., generally 210 days after commencement of the bankruptcy case, absent landlord consent, which deadline as discussed below has been temporarily extended to 300 days in light of the covid-19 pandemic, until 27 December 2022, and which extension is permanent as to subchapter V cases commenced before 27 December 2022).55 In a case where leased real property locations number in the hundreds, as in large retail cases, the debtor should make preliminary decisions on which leases it wants to assume or reject prior to commencing its bankruptcy case, and thereby attempt to avoid assuming leases it may not ultimately need.

v Security interests

In the United States, Article 9 of the Uniform Commercial Code (Article 9 and the UCC, respectively), as adopted by each of the 50 states, generally applies to any security interest created by contract in personal property and fixtures to secure payment or other performance of an obligation.56 There are three components to the creation and enforcement of a security interest under Article 9: attachment, perfection and priority. Under Article 9, a security interest attaches to collateral at the moment that the security interest becomes enforceable against the debtor. Only an attached security interest may be perfected under Article 9. Perfection is the process by which a secured party gives public notice of its security interest in collateral. A perfected security interest will prevail over other claims of an interest in collateral by other parties (including liens of creditors using the judicial process to obtain liens on the collateral). State law, generally uniform throughout the United States, will dictate the method for perfecting a consensual security interest.

In many cases, two or more creditors may have security interests in the same collateral. In such cases, Article 9 provides general rules as to the ranking of security interests – that is, which security interest takes priority over the others. As a general rule, an earlier-secured party will prevail over later-secured creditors. There are, however, exceptions to this general rule and, therefore, practitioners must refer to Article 9 in the applicable jurisdiction relevant to a particular transaction or consult local counsel.

Article 9 has a critical interplay with the Bankruptcy Code. Upon the bankruptcy filing, the debtor steps into the role of a hypothetical lien creditor.57 This means, in general, that it may void any unperfected security interest. Accordingly, it is critically important for secured creditors to ensure that their liens are properly perfected, especially when transacting business with a distressed company on the verge of bankruptcy. Again, while there are some variations in the details, security interests are usually perfected by filing in a governmental registry or by taking possession of the collateral.

Whereas the UCC, which deals with the creation of security interests in personal property, is fairly uniform as adopted in all 50 states, security interests or mortgages in real property are controlled by different laws in each of the 50 states. However, most state laws provide for the recording of mortgages in local governmental offices. As with security interests in personal property, a bankruptcy trustee or debtor-in-possession can avoid improperly recorded mortgages by stepping into the shoes of state-law creditors.

vi Clawback actions

The Bankruptcy Code gives a debtor certain avoidance powers to recover property transferred by the debtor to third parties before the petition date. Generally, these avoidance actions fall into two categories: the transfers had the effect of preferring one creditor over others; or the transfers were made for the purpose of hindering, delaying or defrauding creditors from collecting on their claims.

'Transfer' is defined broadly and encompasses payments as well as the granting and perfection of liens. Transfers that the debtor can prove to be fraudulent or preferential can be treated as voidable transfers. In many instances it is unnecessary to prove that the debtor or the recipient, or both, had a wrongful motive – the Bankruptcy Code is concerned only with ensuring equal treatment of creditors, even if that means unwinding well-intentioned arm's-length transfers of property. That said, the recipient of a voidable transfer has certain affirmative defences to shield all or a portion of the transfer from the debtor.

The most common voidable transfer is referred to as a preference. Preferences are those payments that a debtor makes to a pre-petition creditor on the eve of the bankruptcy filing58 that allow such creditor to receive more on account of its claim than it would have received had it waited in line with other creditors and received its distribution in a hypothetical liquidation of the debtor pursuant to Chapter 7 of the Bankruptcy Code. The amount that the creditor received in connection with the transfer will be voidable, subject to certain defences, such as receipt of the transfer in the ordinary course of business. To the extent that the transfer is avoided, the preference recipient would have an unsecured claim against the debtor.

Fraudulent transfers (also known as fraudulent conveyances) that can be recovered include transfers made with the actual intent to hinder, delay or defraud creditors (known as actual fraud or intentional fraud). Recoverable fraudulent transfers also include transfers for inadequate consideration when the debtor (transferor) was insolvent, undercapitalised or unable to pay its debts as they became due (known as constructive fraud). The Bankruptcy Code has its own fraudulent transfer provisions, but the debtor-in-possession may also prosecute such claims under similar state law provisions.

vii Pre-planned bankruptcies: a quick escape from an all-out bankruptcy

Pre-planned bankruptcies continue to be a useful tool for debtors as they try to manage the time and expense of a US bankruptcy filing. There are two types of pre-planned bankruptcies: pre-packaged and pre-negotiated bankruptcies. Pre-packaged bankruptcies (pre-packs) are typically utilised by companies seeking to right-size their capital structures (e.g., to address maturities or deleverage from existing secured lender or bondholder indebtedness). The pre-packaged bankruptcy mechanism is not useful for companies seeking to achieve an operational turnaround or that need to modify other significant liabilities such as pension, retiree medical or mass tort liabilities.

In a pre-pack, the Chapter 11 case is commenced after the plan proponent has obtained the requisite votes to approve a reorganisation plan (or at least begun to solicit those votes (a 'straddle' pre-pack)).59 In a pre-negotiated (also known as pre-arranged) bankruptcy, the creditors entitled to vote on the plan indicate their support for the plan before the commencement of the case, often in the form of a lock-up agreement (also known as a restructuring support agreement (RSA) or plan support agreement (PSA)), but the vote occurs following the commencement of the case. Pre-packs are generally 30 to 60 days in duration. Absent complications, pre-negotiated bankruptcies will take 45 to 60 days longer than a pre-pack. These periods are far shorter than the duration of traditional Chapter 11 cases that are not pre-planned (i.e., 'free-fall' bankruptcies) or that require operational fixes.

The pre-pack concept is an important negotiation tool as companies attempt to obtain concessions from their constituents. The requirement to achieve an accepting class of creditors for a Chapter 11 plan (and, therefore, to bind non-accepting class members) under the Bankruptcy Code is two-thirds in amount and greater than one-half in number of those creditors who cast a vote.60 If acceptance is received from almost all of the creditors from whom votes are solicited, companies will often consummate the restructuring without filing for bankruptcy. Moreover, the threat of a pre-pack makes it less likely that a filing will be required, because there is little reason for creditors to withhold their acceptance once the company has received acceptances sufficient to satisfy the minimum threshold for an accepting class in the Chapter 11 context. Ultimately, in order for a pre-pack to move swiftly through the Chapter 11 process, class consensus is critical. An impaired class or classes will have accepted the plan prior to the bankruptcy filing. Often, general unsecured claims (e.g., trade payables) are paid in full and do not vote, whereas the impaired accepting class required by Bankruptcy Code Section 1129(a)(10) will be composed of a bond or loan issuance that is less broadly held, and more practical to negotiate with and solicit in advance. In contrast, a pre-negotiated bankruptcy may involve key classes that are not voting in favour, and thus must be crammed down.

Over a decade ago, bankruptcy attorneys developed techniques for implementing 'super-fast' pre-packs involving only a handful of days in bankruptcy (e.g., Bluebird Bus Company in 2006). While these cases remain rare, a number have occurred since 2019, such as Belk, Inc in 2021. In some cases, a plan has been confirmed and become effective within 24 hours.61 While these cases do not work in all circumstances, and require significant coordination and planning, they present an intriguing option for streamlining consensual cases. It remains to be seen whether 'super-fast' bankruptcy cases will increase in popularity in a post-covid world.