Distressed Investor Bankruptcy Basics
This memorandum reviews bankruptcy basics and is designed for the investor that is considering distressed investments for the first time or the more seasoned investor looking for a refresher. It highlights just a few bankruptcy basics, such as the automatic stay, types of bankruptcy claims, adequate protection, debtor in possession financing, the plan process and bankruptcy creditor claim priorities.
1. The Automatic Stay
Once a debtor commences a bankruptcy case, the statutory “automatic stay” bars creditors from taking any steps to recover on the debt, except through a distribution in the bankruptcy case. Creditors are barred from making a phone call requesting payment, sending a letter demanding payment, commencing a legal action to collect on the debt, foreclosing on their collateral and just about everything else in between. The bottom line is once the debtor has commenced the bankruptcy case and has the protection of the automatic stay unless you obtain authorization from the bankruptcy court, your remedies are limited to participating in the bankruptcy process and any enforcement or recovery actions will subject you to court-imposed sanctions.
2. Types of Bankruptcy Claims
Creditor payments or distributions in a bankruptcy case are based on the nature of the claim. It is important for distressed debt investors to know what types of claims they have in order to determine how their claims will be treated in bankruptcy and estimate anticipated returns on the claims. There are four basic types of claims, secured claims, administrative claims, unsecured claims and equity interests.
(a) Secured Claims
Creditors with secured claims have been provided with a lien on an asset of the debtor; the lien could be on real property, equipment, accounts receivable, patents and copyrights, or anything else of value. The claims of secured creditors are secured only to the extent of the value their collateral. To the extent the value of the collateral securing the claim is less than the amount of the claim, the difference, or the unsecured portion, will be treated as a general unsecured claim. Secured creditors with second lien positions are more likely to end up with some or all of their claims treated as unsecured claims because the value of the collateral may be insufficient to satisfy both the senior secured claims and the second lien claims. For example, Lender A lent the debtor $100 and has a security interest in the debtor’s plant which was worth $150 on the bankruptcy filing date. Lender B lent the debtor $100 and took a second lien on the same plant. In a bankruptcy, Lender A has a fully secured claim for $100, because the value of the collateral, the plant, fully covers this claim and Lender B has a secured claim for $50 (the value of the plant after the lien of Lender B is satisfied) and an unsecured claim for $50. If we change this example so that the value of the plant is $75, then Lender A has a secured claim for $75, an unsecured claim for $25, and Lender B has an unsecured claim for the full $100.
Secured creditors are entitled to interest on their fully secured claims and may be entitled to reasonable fees and expenses if provided for in the loan documents. Secured creditors are also entitled to protection of the value of their collateral during the bankruptcy case -known as “adequate protection”, which will be discussed below. For distressed investors who hold secured claims, it is important to know the value of your collateral, whether you are fully secured and to contact counsel to assist you in protecting that interest. Likewise, unsecured creditors and holders of equity will want to assess the extent of the debtor’s unencumbered assets.
(b) Administrative Claims
The Bankruptcy Code specifies that certain, types of claims, are entitled to be paid in full ahead of all other creditors from any unencumbered assets of the bankruptcy estate. These so-called “administrative” claims are primarily the costs associated with keeping the debtor’s business operating during bankruptcy (either as an ongoing business or to conduct an orderly liquidation). Administrative expenses include the actual and necessary costs and expenses of preserving the debtor’s business post-bankruptcy, the post-bankruptcy wages of the debtor’s employees, the fees and expenses of the debtor’s and official committees’ post-bankruptcy attorneys and other advisors, post-bankruptcy taxes and trade creditor claims for goods received by the debtor within 20 days of the bankruptcy filing. As discussed below, the debtor’s postpetition lenders, usually referred to as the “DIP” lenders, typically are provided super-priority administrative status which entitles them to be paid in full (subject to certain carve-outs for the United States Trustee’s fees and professional fees) before any other administrative creditors are paid. Distressed investors with unsecured claims or equity interests generally want to limit administrative claims since holders of these claims will be paid in full ahead of their claims.
(c) Unsecured Claims
There are many types of unsecured claims. As discussed, a “secured” creditor may have an unsecured claim to the extent the value of the collateral is less than the claim. There can also be unsecured bond debt, trade debt, employee claims, landlord claims, litigation claims and others. Some unsecured creditors also may have administrative claims. For example, Supplier A is owed $150 a month after the bankruptcy. However, Supplier A delivered $50 worth of widgets 40 days before the bankruptcy, another $50 worth of widgets within 20 days of the bankruptcy and the final $50 after the bankruptcy. Supplier A will have an unsecured claim for the $50 delivered 40 days before the bankruptcy, and an administrative claim for $100, the widgets delivered within 20 days of the bankruptcy and after the bankruptcy filing. Landlords also may have unsecured claims for pre-bankruptcy rent and administrative claims for postbankruptcy rent.
Distressed investors should also consider that while all unsecured debt is the same vis a vis the debtor, some may be treated differently vis a vis other unsecured creditors based on subordination agreements. The most common example is subordinated bond debt. For example, the debtor has two issues of debt, $100 in senior unsecured debt and $100 in subordinated debt. The holders of the subordinated debt agreed that they would not accept payments until the senior debt was paid in full and to the extent they received a payment would turn it over to the senior debt holders. The debtor has $150 to distribute to unsecured creditors and the only creditors are the senior and subordinated creditors with each owed the same amount by the debtor. The senior and subordinated creditors will be allocated $75 each; however, because of subordination, the subordinated creditors will turn over $25 of their distribution to the senior creditors so that the seniors can be paid in full and the subordinated creditors will end up with only $50. If the facts were changed so that there is only $100 to distribute then the entire amount will go to the senior creditors and the subordinated creditors will get nothing. Under either scenario, even if there were other unsecured creditors, the senior creditors would recover more than other general unsecured creditors, such as trade creditors and landlords, because under this scenario the latter are not entitled to the benefit of subordination and the turn-over of the subordinated creditors’ recovery.
Distressed investors should carefully evaluate the nature of unsecured claims to determine whether some unsecured creditors are going to end up with more favorable treatment because they also have an administrative claim, or secured claim or the benefits of subordination.
(d) Equity Interests
Equity interests are common and preferred stock of the debtor. Equity interests are the last to get paid. Distressed investors should only consider equity if their analysis indicates that the value of the debtor is sufficient for a distribution that will pay all of the creditors in full.
(e) Proofs of Claim
In order to participate in bankruptcy distributions, all creditors and holders of equity interests must file a proof of claim or interest (unless the debtor has properly listed the claim in the debtor’s schedules). The debtor will obtain a deadline or bar date for filing claims from the bankruptcy court and all claims must be filed by that date or they will be barred and not entitled to any distributions. Proofs of claim must assert all claims against the debtor, including contingent and unliquidated claims. Distressed investors should keep an eye out for bar date notices and contact counsel to ensure that proofs of claim are properly and timely filed. In the case of bond debt, the indenture trustee will file the proof of claim on behalf of all bondholders.
3. Adequate Protection
Creditors with secured claims are entitled to adequate protection to protect against a decrease in the value of their collateral during the bankruptcy case. In order to obtain protection, the creditor must apply to the bankruptcy court, or, alternatively, it may be offered adequate protection if its claim is collateralized by “cash collateral”-i.e., cash and receivables, and the debtor wishes to use these liquid assets to operate its business.
Adequate protection is typically structured as a priority claim for any loss in the value of the collateral during the bankruptcy, although, typically, in lieu of such calculations the debtor will make monthly payments sufficient to cover interest on the debt and legal fees and expenses.
If there is substantial equity in the collateral (i.e., an “equity cashon”), the secured lender may be deemed to be adequately protected —and receive nothing for the use of its collateral or it may simply get a “replacement” lien on new assets created with the proceeds of its collateral. Depending on the value of the security interests, secured creditors holding a second lien position may not be entitled to adequate protection since it is only offered to the extent of the value of their security interest. For example, Lender A lent the debtor $100 and has a security interest in the debtor’s plant which was worth $150 on the bankruptcy filing date. Lender B lent the debtor $100 and took a second lien on the same plant. In a bankruptcy, Lender B would only be entitled to lost value in proportion to its secured claim of $50 (since it is undersecured by $50). If we change this example so that the value of the plant is $75, then Lender A has a secured claim for $75, an unsecured claim for $25 and would be entitled to adequate protection for the portion of its claim that is secured, the $75. However, Lender B will have an unsecured claim for the full amount of $100 and will not be entitled to any adequate protection. In most cases the form of adequate protection is negotiated.
Secured creditors should seek adequate protection promptly as some courts have held that they are only protected against the loss in the value of their collateral from the time the motion is filed. In other words, if the collateral is worth $100 on the bankruptcy filing date and $50 six months later when the adequate protection motion is filed, the secured creditor will only be able to obtain adequate protection relating to $50 of collateral, not the $100 worth of collateral it would have been entitled to if it had promptly filed the motion.
4. Debtor in Possession Financing
Chapter 11 debtors usually require financing, known as “debtor in possession” or “DIP” financing in order to fund continued operations or to ensure an orderly liquidation. Usually the DIP loan is provided by the debtor’s pre-bankruptcy lenders. Typically, the DIP loan is structured so that the pre-bankruptcy lenders agree to allow the debtor to use their pre-bankruptcy cash collateral (usually all receivables and operating cash) and provide additional borrowings for business operations, subject to borrowing formulas and restrictions on the use of the funds per an agreed to budget. In exchange, the debtor agrees to give the DIP lenders a first lien on all post-bankruptcy collateral, a lien on all other collateral not previously encumbered by the lender group, a super-priority administrative claim for all post-bankruptcy lending, monthly payments of post-petition interest on the pre-bankruptcy and post-bankruptcy bank debt, payment of the bank group’s fees and expenses, and an agreement that the banks’ claims are properly and fully secured. In certain circumstances, a DIP lender will be entitled to “prime” other lenders’ liens (requires consent or proof that liens that will be primed are adequately protected through an equity cushion). DIP loan motions are usually filed with the bankruptcy petition and the bankruptcy court will very quickly grant interim relief (i.e., interim access to the borrowed funds with a final hearing 15 days later). Distressed investors should carefully review DIP motions to determine whether the DIP loan will prime other secured claims, attaches to previously unencumbered assets, provides the debtor with sufficient flexibility to operate, and sufficient value remains for other creditors after payments are made to the DIP lenders.
5. Plan Process
A chapter 11 debtor has the exclusive right to file a plan of reorganization or liquidation for an initial 120 days. The debtor may seek an extension from the court of the 120 day exclusive period to file a plan for “cause”, for up to 18 months after the bankruptcy filing. Typically, extensions are granted in 60 to 90 day increments. If the debtor is unable to file a plan within that time period, any creditor or equity holder will be permitted to file a plan.
The purpose of providing a debtor with plan exclusivity is to give the debtor some control over the process and to attempt to balance the interests of creditors. Bankruptcy plans are usually based around the restructuring or reorganizing of the business and debt or the orderly or liquidation sale of some or all of the business and distribution of the sale proceeds. Bankruptcy plans are typically negotiated by the debtor and the major creditor constituencies (including distressed investors who have bought substantial positions). Moreover, creditors whose claims are affected by the plan (because the distributions are less than the full amount or are being made in a different currency than originally agreed to) are entitled to vote on the plan. A plan can only be confirmed by the bankruptcy court if the requisite percentages of creditors vote (50% in number who hold 66⅔% of the amount of claims actually voted) to approve the plan and it meets various statutory requirements. Once confirmed and effective, the plan and order confirming (i.e., approving) the plan govern the distribution of assets and treatment of all claims and interests.
6. Bankruptcy Creditor Priorities
Creditor payments in a bankruptcy plan are prioritized based on the nature of the claim. It is important for distressed debt investors to know where the claims fit in order to determine anticipated returns. Payments in bankruptcy cases are determined by a waterfall subject to negotiated deviations. Administrative claims (including DIP loan claims) are at the top of the waterfall and must be paid in full in cash. Secured creditors are entitled to the value of their collateral (which could take the form of cash, a new loan or other securities) and an unsecured claim for any unsecured amounts. Note, that an administrative claim cannot be paid from a secured creditor’s collateral (or cash proceeds thereof), so administrative claims must be paid from free cash or assets. General unsecured claims need not be paid in cash and typically share equally in the assets that remain after the administrative creditors and the secured portion of the secured creditors’ claims are satisfied in full. If there is any value remaining after the unsecured creditors are paid, that will go to the equity holders. This basic framework may be adjusted based on creditor agreements.
The following are examples of possible plan distributions. The debtor has assets worth $500. It has administrative claims of $50, secured claims of $200, unsecured claims of $200 and equity. Here, the administrative claims will be paid $50, the secured creditors $200, the unsecured creditors $200 and equity will receive the remaining $50 (although since the debtor is solvent, that amount may be further reduced by post-bankruptcy interest payments to unsecured creditors). Assuming the same creditors and assets valued at $400, the distributions change as follows: administrative creditors will be paid $50, secured creditors $200 and unsecured creditors are not paid in full. However, it must be noted that creditors’ claims do not always neatly fall into a particular class of claims. For example, the validity and value of security may be disputed, the amount of claims may be disputed, the nature of subordination may be disputed or the claims may be subject to equitable subordination or avoidance actions. As a result, the basic framework is often adjusted to accommodate a negotiated resolution of open issues. Counsel can assist in identifying and pursuing legal and equitable theories that might enhance recoveries.
Conclusion
This memorandum is designed to highlight some of the key concepts in bankruptcy. If you have any questions or concerns regarding this memorandum, would like additional information on bankruptcy or some assistance in distressed investing, please contact John Ashmead or Ron Cohen. Messrs. Ashmead and Cohen regularly advise distressed debt investor clients (and others) on the matters discussed herein.
