Chapter 11 Can Help Companies Experiencing COVID-19 Induced Business and Financial Distress
The COVID-19 pandemic continues to spread throughout the world and has unfortunately been making recent headway here in America. An oil price war compounds the misery because America is now a major producer and exporter, and shale companies are extremely over-levered. While the health care repercussions are beyond the ken of the author, this alert can assist you in analyzing the economic, business, financial and legal consequences of the pandemic, and options to minimize adverse outcomes.
Business and Financial Effects of the COVID-19 Pandemic
In these trying times, media headlines are replete with stories concerning economic, financial and other uncertainties; closures of retail outlets, factories and other businesses, whether voluntary or government mandated; cancellation of flights, sporting and other events; layoffs, lost benefits, rising unemployment claims, and their effects on consumer spending; supply chain disruptions; plummeting revenues and commodity prices; defaults, foreclosures and evictions; extremely volatile markets that make it difficult if not impossible to raise needed capital or refinance debt that may soon be coming due; concerns over the possibility of a global recession and further market volatility; illiquidity and margin calls; tripped market circuit breakers and trading halts; trouble in the commercial paper and repo markets; social distancing, lockdowns and quarantines; depleted store shelves; and investors, lenders, buyers and other counter parties walking away from negotiations or even deals that were seemingly “done.” In fact, while nearly all businesses are being negatively impacted, certain industries including energy, airlines, cruise ships, restaurants, bars, gyms, entertainment and hospitality, are in freefall.
Most of the issues in today’s headlines will generate negative feedback loops. For instance, layoffs lead to a reduction in consumer spending and a rise in defaults related to student and car loans, rent, mortgages, etc., all of which has ripple effects across the broader economy. Likewise, lost business, disrupted supply chains and cutbacks in consumer spending engender financial distress for a multitude of businesses, as well as their suppliers, customers, employees, lenders and investors.
To make matters worse, all this turmoil is occurring at a time of record levels of debt brought on by over a decade of easy money. As a result, companies may be unable to satisfy or refinance upcoming debt maturities or even continue servicing unmatured debts. Moreover, plunging revenues and other adverse business factors may cause companies to breach covenants in loan documents. Any of the foregoing would provide lenders with the option to begin exercising default remedies.
Despite extraordinary actions by central banks and other governmental authorities, for now the economic and financial crisis endures. While fiscal stimulus, bailouts, tax relief and other government programs may ultimately provide some relief to some industries or entities, it is too early to tell what form such relief may take; whether it will arrive in time, if at all; whom precisely it will be designed to assist, and which companies will have to fend for themselves; and whether it will provide a sufficient reprieve for companies experiencing pandemic-related distress. Therefore, Chapter 11 may provide the only safe haven to buy time, stabilize operations, keep the wolves at bay and, if a liquidation is the only alternative, then at least provide a venue that will assure an orderly liquidation rather than a chaotic outcome.
Initial Actions and Considerations
Before determining whether Chapter 11 is appropriate, management should tune out the doom and gloom; keep a cool head; realistically assess business prospects and liquidity needs; reduce expenses and conserve cash, which is always “king” during any crisis; fully draw down on any existing lines of credit to enhance liquidity; identify mechanisms to generate additional liquidity such as selling non-core assets and/or shutting down unprofitable lines of business; and continue monitoring potential government relief programs.
Companies should also hire professionals to undertake a careful analysis of loan documents, key contracts and insurance policies to assess negotiating leverage and what options may be available. However, it is unlikely that these documents will provide sufficient flexibility in a crisis absent agreement by counter parties, and once a default is declared, the company will have even fewer options. Fears of financial contagion may cause counter parties to be less inclined to make concessions. Therefore, experienced restructuring professionals should be consulted to explore whether Chapter 11 can ameliorate the adverse business and financial effects of the pandemic.
Management should establish open and candid lines of communications with lenders and other key constituencies, but if efforts to negotiate an agreement for a standstill, forbearance, extension, refinancing, or out-of-court restructuring prove fruitless, the company needs to be able to transition swiftly to Chapter 11 before lenders exercise remedies and value deteriorates.
Initial Benefits of Chapter 11: Breathing Space and Statutory Tools to Stabilize the Business
The first, and most obvious, benefit of Chapter 11 is the automatic stay, which is imposed immediately upon the filing of a Chapter 11 petition without the need to seek court intervention. It provides a company experiencing financial distress with much needed breathing space by immediately enjoining, inter alia, the commencement or continuation of any litigation or other legal proceedings; the declaration of any defaults; and the enforcement of any remedies against the company’s property, including any actions by senior lenders to foreclose, repossess collateral, or create, perfect or enforce any lien.
The automatic stay thus prevents creditors who are in a senior position, or who win the proverbial race to the courthouse steps, from dismembering the company, destroying going concern value, and procuring a recovery solely for their benefit to the detriment of all of the creditors. The automatic stay promotes the fundamental bankruptcy goals of preservation of value and equality of distribution for similarly situated creditors.
Once a Chapter 11 petition has been filed, the Bankruptcy Code provides a number of statutory provisions to allow companies experiencing financial distress to right the ship. Unlike many foreign jurisdictions, under Chapter 11, management remains in place to continue operating the debtor’s business, subject to supervision of the court, and oversight by the United States Trustee and any official committees appointed in the case. Operations can be funded through so-called DIP financing or use of lender cash collateral, including without lender consent. Subject to court approval, the company can sell non-core assets outside the ordinary course of business (a so-called Section 363 sale), reject noneconomic leases and executory contracts, and abandon property that is burdensome or of inconsequential value. Creditors and parties in interest will have the right to object to any such relief; however, generally, such applications are governed by a business judgment standard and honest debtors are accorded a significant degree of deference.
These mechanisms, coupled with the automatic stay, will give the company the time and relief it needs to stabilize operations; formulate a new business plan to deal with the post-COVID-19 landscape; determine whether the business can be salvaged and if so what measures need to be implemented, including disposing of burdensome assets, contracts and leases (all of which can be shed with minimal expense); reinvest in profitable lines of business; and calculate how much debt the restructured operations will be able to carry and service.
Thus, the company will have significant freedom of operation and flexibility in running its business, while negotiating with major constituencies over how newly-saved going concern value should be apportioned.
Using Chapter 11 to Confirm a Plan of Reorganization that Binds All Parties Regardless of Consent
The ultimate goal and benefit of Chapter 11 is the ability to confirm a plan of reorganization that binds all parties irrespective of consent. Once management has formulated its new business plan to address current realities, it will have to be implemented under a plan of reorganization that resolves all claims of creditors and shareholders. The company will have the exclusive right to file a plan during the first 120 days of the case (and an additional 60 days to solicit acceptances thereto), which deadlines can be extended for a total of 18 months and 20, respectively. However, a plan cannot be confirmed unless it has at least some creditor support.
Therefore, the company will need to engage in plan negotiations with its major constituencies. Fortunately, unlike an out-of-court restructuring, unanimity or near unanimity is not required. Instead, if any class of claims is impaired under the plan (as is likely), then the company will only need at least one impaired class of claims to vote to accept the plan. Acceptance is predicated on the votes of at least two-thirds in dollar amount and more than one-half in number of allowed claims in such class of creditors who actually cast ballots.
The company will also need to demonstrate it can satisfy various other provisions of the Bankruptcy Code, including that the plan provides adequate means for its implementation and is feasible, that creditors who have not voted to accept the plan will receive no less than they would receive under a Chapter 7 liquidation, and that all administrative and priority creditors will be paid in full.
Importantly, even if one or more impaired classes vote to reject a plan (and provided at least one impaired class of claims has voted to accept the plan), the plan proponent can seek to have the plan “crammed down.” Cramdown requires that the plan does not discriminate unfairly, and is fair and equitable with respect to each impaired class of claims or interests. With respect to secured claims, fair and equitable means, inter alia, creditors retain their liens and receive deferred cash payments equal to the allowed amount of their claims, or their collateral is sold, subject to their right to credit bid, and their liens attach to the sale proceeds. With respect to unsecured claims, it means creditors are paid in full or no junior class such as shareholders receive or retain any value. With respect to equity holders, fair and equitable means, inter alia, that no junior class will receive or retain any property under the plan. Once the plan is confirmed, whether fully accepted or crammed down, it is binding on all constituencies, even creditors or classes of claims who voted to reject the plan, or who did not vote at all.
Alternative Goals of Chapter 11: Implementing a Distressed M&A Transaction or Liquidating if Necessary
Unfortunately, cramdown may set the stage for a lengthy, expensive and uncertain fight between senior and junior creditors over the value of the business and how such enterprise value should be allocated among the different constituencies. Then again, other issues may make confirmation of a plan too difficult, time-consuming or costly. Nevertheless, if the plan process cannot work or is too unwieldy, then a distressed M&A transaction under Section 363 can be employed to save a viable business.
Section 363 provides a mechanism to sell assets, including the entire business, outside the ordinary course of business under a streamlined procedure with a lower threshold for approval than the plan confirmation process. The assets are sold free and clear of claims and liens of creditors and the transaction is insulated from challenge as a fraudulent conveyance. In addition, in bankruptcy, executory contracts and leases can generally be assigned to the buyer notwithstanding anti-assignment clauses or counter party non-consent. Buyers can “cherry-pick” – acquiring only favored assets, leases and contracts, and leaving behind those that are not essential to the operation of the acquired business. As part of this process, favorable executory contracts and leases will be assumed and assigned to the buyer, while burdensome contracts will be rejected to limit damage claims.
In the alternative, if the business cannot be saved, then a Section 363 “free and clear” order can be utilized to conduct an orderly court-supervised liquidation that is more likely to maximize value and minimize counter party exposure than would occur in a foreclosure sale or other non-bankruptcy transaction.
Downsides of Chapter 11
Chapter 11 is no panacea. Management may be frustrated by the need to seek court approval, endure creditor criticisms and negotiate modifications to the requested relief every time that court approval is required. Management will also need to endure public reporting and disclosure, compliance with requests for information and documents by official committees and other constituencies, the possibility of formal discovery techniques such as Bankruptcy Rule 2004, investigation of insider transactions, and litigation threats. In Chapter 11 there will also be new players to contend with: the Court, the United States Trustee, and any official committees.
However, most of the foregoing are minor annoyances compared to what would happen outside of Chapter 11 – the prompt dismemberment of the business and the destruction of any going concern value. Moreover, litigation threats will occur whether the company is in or out of bankruptcy, the major counterpoint in bankruptcy being that most litigation claims will now belong to the debtor’s estate, and thus cannot be prosecuted by creditors or shareholders without court authorization (which courts are reluctant permit if the debtor is proceeding in good faith).
While Chapter 11 cannot cure the coronavirus, repair supply chains, induce consumers to spend money, or open currently shuttered establishments, it can provide a needed respite to the business setbacks and financial distress generated by the pandemic and the mechanisms needed to repair the business and the balance sheet. Obviously, Chapter 11 cannot resuscitate a zombie company; it can only give a viable business a chance to survive without having to deal with an onslaught of litigation and enforcement actions, or facilitate an orderly liquidation if that is the best course of action. Ultimately, a negotiated resolution supported by key constituencies can be effectuated in Chapter 11 notwithstanding opposition from even significant groups of recalcitrant creditors and shareholders.
For more information on how these issues may affect your rights, contact Nicholas F. Kajon at 212.537.0403. Mr. Kajon is a Shareholder of Stevens & Lee and the Co-Chair of the Bankruptcy and Corporate Restructuring Group practicing in the firm’s New York office.
This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.
 Why so many companies have chosen to fund stock buybacks with borrowed money has puzzled and troubled the author for years, but it appears that the chickens are now unfortunately coming home to roost.
 11 U.S.C. § 362(a).
 11 U.S.C. §§ 363(c)(1), 1107 & 1108.
 11 U.S.C. § 364(c)-(d).
 11 U.S.C. § 363(c)(2)&(e)(conditioning use of cash collateral without lender consent on provision of adequate protection of lender’s interest therein.
 11 U.S.C. § 363(b)(2).
 11 U.S.C. § 365.
 11 U.S.C. § 554.
 11 U.S.C. § 1121.
 11 U.S.C. § 1126(c).
 11 U.S.C. §§ 1123, 1129(a).
 11 U.S.C. § 1129(b)
 11 U.S.C. § 1141(a).
 11 U.S.C. § 363(f).
 Outside of bankruptcy, creditors of an insolvent company who believe the sale consideration was inadequate can sue the buyer to avoid the transfer as a constructive fraudulent conveyance. Creditors also have standing to sue the company’s fiduciaries who approved the transaction for breach of fiduciary duty.
 11 U.S.C. § 365(f). An important exception is a license of intellectual property where consent is generally required.