Prepackaged bankruptcy filings (colloquially referred to as "prepacks") and other alternatives to traditional chapter 11s appear to be on the rise. While companies can utilize prepacks to achieve a rapid financial restructuring, they may forsake the opportunity to implement needed operational changes. As a result, more companies that emerge from chapter 11 may need to re-file, resulting in a phenomenon known as chapter 22, which often entails liquidation. Nevertheless, astute investors will find ways to benefit from these opportunities.
Benefits of Prepacks
Ongoing turmoil in the credit markets and uncertain economic conditions may engender restructuring opportunities. Sophisticated players, however, have become concerned that the costs and delays inherent in chapter 11, especially in light of additional burdens imposed by the 2005 amendments to the Bankruptcy Code ("BAPCPA"), undermine reorganization prospects and erode recoveries. Thus, parties have been exploring alternatives to traditional chapter 11s, including out-of-court restructurings, foreclosure, appointment of receivers, assignments for the benefit of creditors and prepacks, each of which presents its own set of advantages and disadvantages.1 The principal benefit of prepacks is the relatively short stay in chapter 11, which dramatically reduces the risks and costs of the chapter 11 process. Thus, prepacks allow a company to completely overhaul its balance sheet in a matter of weeks, if not days (although significant effort will be required prior to the chapter 11 filing), thereby avoiding the panoply of risks and costs generally associated with the chapter 11 process.
The Downside of Prepacks
While the speed inherent in prepacks has many virtues, it carries some downside risk especially for companies that may need more than simply financial restructuring. Chapter 11 affords companies an opportunity to address a host of non-financial issues such as rejecting burdensome contracts and leases, selling non-core assets, shedding excess capacity, etc. A longer stay in chapter 11 gives a company time to tinker with its business plan and emerge on a sound footing, both financially and operationally. This opportunity is lost in a prepack. That may be especially problematic for smokestack industries such as auto suppliers, where management may need to consider shedding legacy costs, rejecting or re-negotiating collective bargaining agreements, closing or relocating manufacturing facilities, reducing staffing, upgrading and retooling antiquated production lines, repositioning market focus, changing product mix, and implementing other policies to cut costs and increase efficiency and profitability. Thus, companies that file prepacks may solve their financial problems, but fail to address equally pressing operational issues.
Moreover, companies in financial distress often do not fully comprehend their non-financial problems. The time and flexibility afforded by the chapter 11 process provides ample opportunity for management to uncover and rectify a host of issues plaguing the company that may cause future problems if left untended. For instance, the distractions associated with the company's financial difficulties may prevent management from discovering operational problems or addressing known issues that do not seem as pressing as the causes and effects of the financial distress. In addition, the passage of time and changes in the business cycle often reveal operational problems that were not otherwise capable of being discerned.
A prime example of an industry that has benefited from relative lengthy stays in chapter 11 is the retail industry. Historically, before BAPCPA imposed a deadline of 210 days to assume or reject commercial real estate leases,2 retailers would file right after the Christmas season when they were flush with cash, and then implement a host of operational changes, a major component of which was the closing of poorly performing stores. Retailers would then "test drive" their new business plan through at least one more Christmas season, so that further operational changes could be implemented, e.g., leases of additional underperforming stores would be rejected. Generally, only after having gone through at least one full cycle in chapter 11 would retailers even consider formulating a plan of reorganization, and it was not uncommon to see retailers spend two or more years in chapter 11 to be certain that all operational issues had been discovered and addressed.
Thus, while a long stay in chapter 11 is certainly no virtue (and carries significant risk, uncertainty and expense), it does at least provide the opportunity to discover and attempt to rectify a host of issues facing the company that would not otherwise have been addressed or even uncovered. As a result, all things being equal, companies with the luxury of a longer stay in chapter 11 may emerge stronger than competitors that underwent a prepack, and thus may have a better chance of avoiding chapter 22. Because of the technical inability to modify a plan of reorganization after substantial consummation,3 chapter 22s generally result in liquidation unless holders of claims can be convinced to modify their rights.
Conclusion
The authors do not mean to suggest that prepacks are inherently evil. Quite the contrary – prepacks will continue to be an important tool for practitioners, and may present the optimum solution for many troubled companies. Moreover, in light of the challenges associated with the changes wrought by BAPCPA, it is likely that prepacks will become more common. Nevertheless, prepacks are best-suited for those companies that only require financial restructuring, and which need little or no restructuring of the business operations. Prepacks do not afford sufficient time and flexibility for those companies that may require significant operational and other nonfinancial changes. As a result, the increasing prevalence of prepacks may lead to more chapter 22s, thereby resulting in more liquidations and the loss of going concern value, to the detriment of troubled companies and their investors and other constituents.
Of course, astute investors will find ways to benefit from these opportunities. For instance, distressed securities can be sold or shorted if other investors fail to realize that prepacks have left companies vulnerable, and senior debt can be acquired at opportune prices to position aggressive investors for the next restructuring. Creditors of companies that fail to address non-financial issues will need to be especially vigilant. Industry players that fix both financial and non-financial problems may gain a competitive advantage.
Footnotes
1 Mr. Kajon explored some of the causes and effects of the increasing popularity of prepacks in a June 6, 2006 Client Alert which is available at http://www.stevenslee.com/news/bankruptcy/PrepackFilings_0606.pdf. Other alternatives to traditional chapter 11s will be analyzed in the coming months.
2 11 U.S.C. § 365(d)(4)(B). This provision of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 applies to cases filed on or after October 17, 2005.
3 11 U.S.C. § 1127(b)
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