How The Legal Proceeding WILL PROBABLY Work

As anticipated by many, including this author, all the billions that the US government has poured into Chrysler has not been enough to get all the players in that game to agree to a plan of reorganization. Now that august name is going into a Bankruptcy Chapter 11 proceeding. GM has another 30 days to get all the players to agree to a plan, and what few reports leak out are not optimistic that everybody will agree. There may be a few key holdouts as there have been in Chrysler, and a Chapter 11 proceeding may be necessary for GM to pull things in a neat package. As you will see, not so easy. The government is the biggest creditor, the only real source of money, and the protector of the public weal, but a contract is a contract. That's what the recalcitrants keep saying.

Chapter 11 Applies to Any Industrial Company Wanting to Reorganize with Bankruptcy Court help.

Here are a few thoughts on what might happen down the road in bankruptcy reorganization. Chapter 11, the Bankruptcy Law Reorganization section is a very structured and at times very difficult labyrinth within which to maneuver. The world's economic downturn is going to be with us for a long time and this background will generally apply to any business which becomes the subject of a Chapter 11 proceeding. Volumes have been written on this subject but here is a broad brush approach to how Chapter 11 works.

The company needing the protection of the Bankruptcy Law, will petition the Bankruptcy Court for a Chapter 11 proceeding. A Chapter 11 proceeding is a corporate reorganization. It is thorough and drastic. That law permits, even requires, the players to negotiate a plan of reorganization while holding the creditors at bay.

Background

The Constitution gives the US Congress the exclusive right to pass laws regarding bankruptcy. Although the states have statutes setting up means to compromise debts those provisions are little used and certainly have no place in reorganizing a large public company,

There has been a bankruptcy law on the US statutes since the earliest days of the country. (Prior to 1898, the bankruptcy laws lasted only an aggregate of 16 years.) Traditionally the function of those laws was to permit people to start afresh. They could declare bankruptcy. That means they could declare that they did not have assets sufficient to pay their debts, give up their assets and start over without going to a debtors' prison. Exemptions permitted them to keep the homestead, the family bible, and a few other things of limited monetary value. Until recent decades it was considered morally reprehensible to declare bankruptcy, and even today bankruptcy may subject the unfortunate soul to social stigma as well as divesting him/her of almost all assets save the few exempt items (now including social security type payments). However, in this discussion the exempt items are of no importance.

The bankruptcy laws have developed a good deal from that early theory. For more than 100 years the bankruptcy law has contained different chapters dealing with different kinds of debtors, different kinds of assets, different degrees of insolvency, and other special situations.

For instance there were, (and are) separate sections and chapters dealing with the bankruptcy of entities in special positions; such as, municipalities and railroads. Those are only mentioned here in that their approach was to keep the assets as operating units in the economy. A municipality might not be able to pay its debts as they matured, but there still has to be police and fire departments and school systems – and there are few or no assets to sell off. One might "liquidate" a railroad but the tracks and rolling stock are usually necessary sinews of the national economy. Consequently, those sections provided for the reorganization of the debtors. There will still be a municipal police department, but the time within which and the extent the debts might be paid would change. The stockholders of the railroad might be wiped out, creditors might become the new stockholders, and there might be new management, but the trains will still run over the tracks. And they will continue to employ people.

There is no special section of the bankruptcy law dealing with large automobile companies – and there never was one. There used to be a special Chapter dealing with public companies but that was abolished in 1978 – and Chrysler is owned by a "private equity" fund anyway.

CHAPTER 11 REORGANIZATIONS

The Players

There are frequently many players in the negotiation, even stakeholders who may not be able to vote on the final plan. In reading this, bear in mind the hierarchy of participants in a business corporation: stockholders, boards of directors, management, secured creditors, and unsecured creditors (in various classes). (At the bottom of the heap are common stockholders. They are often the least important, as stockholders' interests may be eliminated in Chapter 11 where unsecured creditors receive less than 100% of their debt. In the Chrysler situation it is reported that private equity funds holding preferred stock are balking. On a legal basis, they must think their stock has value.)

How does a Chapter 11 proceeding get started? First, the board of directors authorizes the filing of the petition in bankruptcy. Normally this happens when the management goes to the Board to ask for such a resolution. Why would management ever do this? Isn't it an admission of failure? Yes and no. It may be the last best chance to save whatever there is. Senior managers have a stake in the company, such as stock options, and actual stock. Chapter 11 gives them an opportunity to save some aspect of their stock holdings and, if things go the way they plan, they will save their jobs. Also there is the ego factor. Managers believe they need just a little more time and money. If that turns out to be true, they will be the heroes of the day. Even the creditors will still have their old customer to sell to.

Once the petitioner is filed, the debtor is represented by attorneys selected by its management. Their retention is approved by the bankruptcy court. Under the Constitution, secured creditors cannot be divested of their interest in the assets securing their debt. They must receive "adequate protection" during the proceeding and the "indubitable equivalent" of their interest in the final plan. That means that during the proceeding their assets must be protected, and they have to be paid an adequate periodic sum if their agreement calls for periodic payments. They must also have fair and equitable treatment in the plan of reorganization. In exchange for this protection, attempts they make to foreclose on their collateral during the proceeding will either not be heard or will fall on deaf ears.

The unsecured creditors are typically represented by an official creditors committee. This is composed of the largest unsecured creditors; that is, the unsecured creditors holding the largest economic stake in the enterprise. After the stockholders (who may have already have lost everything), the unsecured creditors have the most to lose. Those represented on the official creditors committee hopefully have the votes needed to approve the final plan. There may be a hierarchy of creditors and there may be different creditors' committees representing those different classes of debt. A special provision allows renegotiation and even rejection of a labor contract. Even pension plans can be dealt with although strict provisions apply. Underfunded pension plans can be terminated, with the assets and liabilities transferred to the Pension Benefit Guaranty Corp. There may be a committee of stockholders, or committees representing different classes of stockholders. The extent to which they have influence will be proportionate to the extent that they have any equity left in the company. That might be subjected to an early determination, and if that is the case, they will have little or no say in the ultimate outcome. The bottom line is the interested parties must listen to each other knowing that nothing is sacrosanct.

Chapter 11 does not in so many words deal with the public interest; that is, deal with keeping the assets working in the economy or keeping the workers employed. There is no room for presumptions in the language of Chapter 11 that these corporations are icons of the economy, that we need these corporate structures to provide tanks, trucks and other armaments, or these assets must remain operating intact, such as is true of railroads or government units. But bankruptcy practitioners and bankruptcy judges live in this world and understand quite well those pressures play a part in determining what to do. How many workers will lose their jobs if the machinery, plant and equipment are sold off piece by piece on the courthouse steps?

The real negotiation typically takes place between the representatives of the debtor and the Official Creditors Committee. Their job is to come up with a viable Plan of Reorganization. That really means that they are trying to preserve the entity so each party can obtain the largest piece of the pie as rapidly as possible. They also know that they are all going to give up something to get anything. All the economic elements you can think of come into play, but the key is that CASH IS KING.

The debtor in possession

In a Chapter 11 proceeding, the debtor becomes a debtor-in-possession. That neat legal handle separates the before-petition filing obligations from the post-petition filing obligations. Creditors holding debts incurred before the petition in bankruptcy is filed cannot take action to collect except in bankruptcy court. That means that with rare exception pre-petition creditors must wait until a Plan of Reorganization is approved to receive anything on their claim. That can take anywhere from a few months in a simple case to many years. However, post-petition filing obligations are much better off. Except for the cash problem, the company is instantly a going concern – with the old management still in charge, and obligations paid as they mature – that is, if there is cash to pay them. If there's not adequate cash for post-petition operations, and if post-petition funding can't be obtained or operations reduced to make them at least break-even on a going-forward basis, then the debtor will promptly be liquidated and the reorganization process short-circuited.

When management decides that it needs the protection of the Bankruptcy Code, it must figure out how it is going to pay its bills during the time it takes to negotiate and get final approval of a plan. Loans approved by a bankruptcy court to be made to a debtor-in-possession take priority over all other debts except the cost of administration. In normal cases, banks are quite ready to lend to a debtor-in-possession, but that will not be the case when it comes to the US automakers. That is where the government must enter this picture. Initially the US Treasury will have to lend to the debtor-in-possession. And the federal government will likely have to provide the long term cash, and/or guarantee it, and get back some paper, debt or stock, for its favor. For months, the current hot topic was whether the government should fund the US automakers in or out of bankruptcy. As to Chrysler, the "ins" have it. We shall see as to GM.

Pre-packaged plans

In the normal case, whenever possible, debtors try to set up pre-packaged plans of reorganization before they file. These are delicate secretive negotiations with major creditors and funders. These negotiations require the company and the major creditors to recognize that the debtor cannot pay its debts as they mature and continue in business as it is currently operating. That is a scary proposition. Even so, in normal cases the negotiation may fail because somebody decides that his obligations to continue have been completed and a bankruptcy petition may get filed, voluntarily by the debtor or involuntarily by disgruntled creditors. Normally these negotiations take place behind closed doors. In the case of Chrysler that has failed. And whatever anybody does will result in plenty of second guessing.

A successful pre-packaged plan will also need a commitment from a lender to provide working capital to the debtor-in-possession and ultimately to participate in the reorganized enterprise. In the case of Chrysler – and behind closed doors GM, the US Treasury continues to the giant elephant in the room when the creditors, the management (technically representing the company), and others, negotiate. The supplicants certainly need its blessing.

In the course of the negotiations, management will have to agree to drastic cuts in compensation, labor will have to renegotiate their contracts or risk having them rejected by the bankruptcy court, and agreement may be necessary that subsidiaries and divisions of the company may have to be sold off or liquidated. Only then might a Plan pass the ultimate test that it is "fair and reasonable". The plan must have reasonable expectation of economic feasibility. It has become quite clear that only with substantial creditor, management, shareholder, and labor concessions will the US Treasury get the political support to fund any reorganization.

The bankruptcy proceeding

If a pre-packaged plan is agreed upon, there still has to be a bankruptcy proceeding. In that proceeding, there would be some formal discovery, a report (a disclosure statement) will be written dealing with the causes of the bankruptcy and explaining the financial ramifications of the proposed reorganization plan, more than two-thirds in dollar amount and one-half in number of various voting classes will have to be convinced to support the plan. After the statutorily required ritual has been completed, the bankruptcy court will then have to confirm the proposed plan. That means it will have to find that the plan compiles with all the statutory requirements, one of which is that it appears economically viable. All of that takes time.

The passage of time

During the time that the bankruptcy proceeding is being used to develop and confirm a Plan, the company will be operating as the debtor-in-possession. By the time a final plan is voted upon, at least twelve months will probably have passed, and the economy will have changed. The company may have succeeded, stayed in the doldrums, or simply sucked up more and more cash. At the one extreme, the proceedings could be dismissed since the company could now stand on its own feet. Hopes and prayers for a completed proceeding in 30 to 60 days are just that. That quick result would require everybody to agree to a detailed plan almost from day one, a disclosure report to be prepared and circulated, hearing held, and votes taken virtually helter skelter. Undoubtedly somebody will appeal something. Need I say more? But remember, the company can be in business as a debtor-in-possession building and selling cars and trucks all this time.

The very passage of time would make difficult any attempt to provide repeated interim financings to the debtor-in-possession while the statutory requirements of getting a plan approved were carried out. Several more dips in the well will be very problematic. At the other extreme, the proceedings might be deemed a failure and converted to liquidation.

In December, 2008, a spokesman for GM claimed that GM was only facing a "short-term liquidity crisis that needs a bridge loan". I have never heard of a company which filed a Chapter 11 proceeding which did not claim that it needed just a little more time and just a little cash to resume its ever onward upward climb to some wonderful golden nirvana. Twenty-twenty hindsight shows it was true of Chrysler around 1978 because it survived as an independent for another twenty years. Chapter 11 is a drastic remedy. Lack of immediate cash may be a symptom but it is rarely the reason a Chapter 11 proceeding is necessary. The US auto companies may have been taking steps to repair their business models but the appearance to the public is that they are not nimble enough to compete with the foreign companies. Economics may no longer be a dismal science but the variables make the outcome of the application of Chapter 11 supported by the US Treasury one of high risk.

With thanks to David M. Green, Esq. of Steven & Lee for his insightful review on the original edition of this article.
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