Utah Bar Journal

A. Burdens of Bankruptcy
Even before the Amendments, bankruptcy tended to be a course pursued only as a last resort. As to individuals, the concerns centered on the stigma of bankruptcy and the long term impact on credit worthiness. For businesses, experience showed that bankruptcy was an expensive, cumbersome and usually unsuccessful way to deal with financial pressures. Companies shied away from bankruptcy realizing, among other things, that uncertainties attendant to a bankruptcy filing would make it even more difficult to compete with companies whose continued existence was not in question.

Competitive disadvantage was not the only problem. With bankruptcy came a whole new set of players. Not only was there oversight by a bankruptcy judge but, in many jurisdictions, bankruptcy filings triggered administrative supervision by the Office of the United States Trustee. It also involved the appointment of a committee or even multiple committees to represent the interests of both creditor constituencies and equity holders responsible for monitoring the debtorÕs reorganization activities and, on occasion, opposing those activities and directions. Bankruptcy also implicated a new set of professionals Ð attorneys, accountants, financial advisors and even public relations specialists - to advise and represent both the debtor and the appointed committees. The cost of this cadre of new professionals imposed huge burdens on already financially strapped companies.

Bankruptcy also imposed its own frequently restrictive operating requirements and limitations. The "open book" philosophy of bankruptcy required debtors to file detailed operating reports, and, as a matter of course, to provide information to committees. These committees, the United States trustee and the bankruptcy court carefully scrutinized asset purchases, sales and termination of contracts; actions that might have been taken without substantial oversight before bankruptcy. This was a high price for the protection that bankruptcy offered.

If cost and added scrutiny were not enough, many debtors quickly realized that bankruptcy came with its own time pressures. Even before the Amendments, the Bankruptcy Code, 11 U.S.C. ¤ 101 et seq., imposed numerous statutory deadlines. These included deadlines to perform under certain leases (11 U.S.C. ¤ 365(c)(5)), to assume or reject contracts and leases (11 U.S.C. ¤ 365(c)(4)), to resume payments to real estate secured creditors (11 U.S.C. ¤ 362(d)) and to file and confirm plans of reorganization (11 U.S.C. ¤ 1121).

Given these burdens and demands, it was small wonder that so few businesses that sought chapter 11 relief successfully reorganized and emerged from bankruptcy. Indeed, less than one in five chapter 11 cases resulted in court -approved plans of reorganization. The vast majority of reorganizations ended in liquidation.

B. Potential Benefits of Bankruptcy
While the foregoing factors operated as clear disincentives, there were still situations in which bankruptcy was a prudent, and sometimes the only, strategy for individuals and businesses to cope with financial pressures. Bankruptcy probably offered the only effective way for large manufacturers to deal with thousands of suits stemming from asbestos contamination, defective medical products and other product liability issues. Bankruptcy frequently was the only way to deal with a contentious secured creditor positioned, because of its lien, to shut down operations. In a turn on that theme, secured creditors themselves, on occasion, would actually condition cooperation on a bankruptcy filing believing it to be the best way to control a debtor and to prevent loss of collateral value as a result of enforcement actions by other creditors. In other cases, bankruptcy, with the accompanying opportunity to prepare a reorganization plan that bound dissenting creditors under 11 U.S.C. ¤ 1126(c), was the only practical way to deal with a disgruntled, but minority, block of unsecured creditors. Finally, bankruptcy could be an effective tool in maximizing the return on assets through a bankruptcy court-approved sale to a third party, free and clear of liens, claims and encumbrances pursuant to 11 U.S.C. ¤ 363(f).

Because of the significant burdens and low success rates, bankruptcy practitioners and their clients historically have been drawn to other ways to address financial problems. This sensitivity and openness to non-bankruptcy solutions has also applied to creditors who likewise have recognized the potential negative impact of bankruptcy. Even secured creditors recognize that delay is a fact of life in bankruptcy. The automatic stay under 11 U.S.C. ¤ 362 prevents lien enforcement, sometimes for a lengthy period. That delay would be less painful for secured creditors if interest continued to accrue and attorneys fees and costs could be collected in accordance with loan agreements. That frequently was not the case, however. Even if a contract provided for recovery of interest and applicable fees and costs, 11 U.S.C. ¤ 502 limited such ÒadditionsÓ if the collateral was not of sufficient value to cover the entire debt. Thus, bankruptcy was particularly difficult for under-secured creditors.

For unsecured creditors, the problem with the "bankruptcy alternative" was even more acute. With less than 20% of companies successfully reorganizing, bankruptcy did not offer the best odds of being repaid and maintaining a customer.

Because bankruptcy was not a panacea, even before the Amendments, businesses and their creditors considered other options in determining how best to resolve financial problems. Some of those alternatives2 included (1) forbearance agreements and debt restructurings, (2) composition/extension agreements, (3) deeds in lieu of foreclosure, (4) assignments for benefit of creditors, and (5) liquidations, with or without bankruptcy court supervision.

The remainder of this article will touch upon advantages, disadvantages and issues associated with each of these alternatives and conclude with a brief discussion of pre-negotiated and pre-packaged bankruptcy plans in situations in which bankruptcy presents itself as the most viable debt relief strategy.

II. Some Bankruptcy Alternatives

A. Forbearance Agreements and Loan Restructurings with Secured Creditors
If a company has lender financing, financial difficulties almost inevitably lead to payment or other defaults under loan agreements, usually both. Although contractually such defaults permit creditor action, enforcement usually is not instantaneous. The "dance" which follows a default usually involves explanations and excuses, then threats (both of enforcement by the lender and bankruptcy by the borrower), and then requests either for short or long term forebearance and finally negotiation of an agreement. This "dance" reflects a recognition that the alternatives (lien enforcement and bankruptcy) are time consuming and expensive and that a negotiated solution is usually best for both sides. Because the "solution," whether temporary or permanent, rarely is immediately apparent, time is needed, without enforcement pressure, to identify the problem and the "fix," and to document appropriate changes.

Although creditor forbearance can be informal, more typically it is governed by an actual forbearance agreement which reflects the terms under which the secured creditor will defer enforcement action. Such an agreement usually includes the duration of the standstill and may dictate required interim payments, special reporting requirements and other conditions. For example, in cases involving lines of credit, a forbearance agreement may modify advance rates and other provisions. The practical effect of some modifications is either (1) to pressure a borrower to locate alternative financing, or (2) to reduce the outstanding loan by tightening credit and forcing at least a partial liquidation of collateral through a borrower's operations.

From a borrower's standpoint, a forbearance agreement is beneficial because it provides needed time to attempt to fix a problem in a way that is more flexible and less expensive than filing a bankruptcy. From a lender's standpoint, a forbearance agreement is beneficial for several reasons. It eliminates the possibility that, by failing to act promptly, the lender has waived otherwise actionable defaults. It clearly sets the "rules" that govern any forbearance. It also can, and frequently does, include a release of claims that a borrower otherwise might assert against a lender. Finally, as noted, it can be used to pressure a borrower to rationalize its operations and/or to locate alternative financing.

The goal of any short term forbearance is a long term solution to a financial problem. For companies experiencing a "minor blip," it can provide sufficient time for a company to return to profitability and to cure loan defaults. In other cases, it provides time, among other things, to locate alternative financing. When neither a cure nor a refinancing materializes, the parties must decide whether permanently to restructure the secured debt. Such a restructuring may include, among other things, a waiver of defaults, restructure of covenants, new loan advances, sometimes supported by the grant of additional collateral.

There are several legal issues associated both with temporary forbearance and permanent debt restructuring agreements. Perhaps the most significant relates to lender control of its borrower. Standard contractual covenants and restrictions necessarily impose some controls on a borrower's operations. Enforcement of those standard provisions normally does not create a legal problem. An issue may arise, however, if a secured creditor "shifts hats" and involves itself directly in operating decisions of its borrower. An example might involve a lender that dictates the specific trade creditors to be paid while a borrower is experiencing financial difficulty. Such involvement in day-to-day operating decisions may create a basis for allegations that the lender, in effect, has become a venture partner with its borrower and, as such, potentially liable for its borrower's debts.

Another problem may arise if a bankruptcy follows hard on the heels of a restructuring under which a lender has received additional collateral. In such case, unless the lender provides new consideration, the grant of additional collateral may be subject to a preference attack in the bankruptcy under 11 U.S.C. ¤ 547.

Finally, any material changes to loan agreements could affect lien priority. Each of these factors should be considered in connection with forebearance agreements and loan restructurings.

B. Agreements with Unsecured Creditors
Out-of-court restructurings of secured debt typically are conditioned on the "stabilization" of trade debt. In a bankruptcy, trade debt is "handled" through the reorganization plan. Creditors are entitled to vote on proposed plan treatment. Acceptance of a bankruptcy plan requires the affirmative vote of a majority in number and two thirds in amount of unsecured creditors voting. 11 U.S.C. ¤ 1126(c). Such an affirmative vote binds dissenters if the reorganization plan satisfies several other statutory requirements, including the "best interest" standard. That standard requires that a plan provide to creditors at least what they would receive in a liquidation of the debtor's assets (11 U.S.C. ¤ 1129(a)(9)).

The non-bankruptcy equivalent of a reorganization plan is a contractual agreement with creditors in the form of a composition, an extension, or a combination of both. A composition involves a payment of less than the full outstanding balance. An extension involves deferred payments either of the outstanding balance or some lesser amount. Composition/extension agreements are contractual understandings with each individual creditor. Unlike bankruptcy, there is no device to bind creditors who refuse a proposed treatment. Consequently, debtors normally condition any composition/extension proposal on acceptance by a large percentage of creditors so that dissenters represent such a small minority that they will not disrupt the out-of-court restructuring.

C. Liquidation of Assets
There are situations in which rehabilitation is not feasible, and liquidation is the only viable option. In such instances, a debtor's fiduciary duty to creditors requires that it act to protect and maximize the value of its assets. Although it may in some cases be the preferred means (see below), bankruptcy is not the only liquidation vehicle. In addition to liquidation through a bankruptcy, other possible liquidation approaches include the deeding of collateral to a secured creditor in lieu of a foreclosure, an assignment for benefit of creditors and self liquidation.

If there is a secured creditor, it usually will attempt to dictate the manner of liquidation. A secured creditor has rights in collateral which are implicated, particularly upon a default. Interference with those rights could expose management to an action for conversion. In recognition of that leverage, some debtors simply deed the collateral to the secured creditor in lieu of a foreclosure. Although this may be the easiest way to "wash hands" of a problem, it ultimately may not be the wisest course of action. For one thing, management's decision could be questioned by junior creditors if there is even a remote possibility that the value of the collateral exceeds the secured debt. There also are circumstances in which secured creditors actually prefer that management supervise a liquidation of the business and of their collateral. An orderly liquidation by current management, presumably operating under a restrictive liquidation budget, usually maximizes the return for all creditors.

There are instances in which management's participation either is not desirable (lack of creditor confidence) or not possible. In those cases, another non-bankruptcy liquidation option is an assignment for benefit of creditors. In this state, Utah Code Ann. 6-1-1 permits a debtor to assign all of its assets to a designated agent responsible for liquidating the assets, determining claims and distributing cash proceeds to creditors. From that standpoint, an assignment looks much like a liquidation by a trustee in bankruptcy under chapter 7 of the Bankruptcy Code. With fewer statutory and administrative restrictions, however, assignments tend to proceed more quickly than bankruptcy liquidations and at a lower overall cost. An assignment usually is not feasible if there is substantial secured debt. There are several other potential drawbacks. In bankruptcy, a trustee may exercise statutory avoiding powers to recover pre-bankruptcy preferences and fraudulent transfers and thereby increase the "pot" for distribution to creditor. An assignee does not have that power, although individual creditors do have standing to pursue fraudulent conveyance suits but for their own and not general creditor benefit. Also, Utah statutes do not provide the detailed framework for resolution of disputed claims that is available in a chapter 7 bankruptcy.

In some situations, management itself can supervise a liquidation and distribute proceeds ratably to creditors without the additional cost overlay of a bankruptcy or an assignment for the benefit of creditors. This assumes, of course, that creditors refrain from individual enforcement actions (to "get a leg up") long enough for assets to be liquidated. If enforcement actions do ensue, and assuming that management is opposed to permitting one creditor to seize a disproportionate share, either an assignment or a bankruptcy will be necessary.

If liquidation is inevitable, bankruptcy has to be considered. It can be an effective tool in maximizing liquidation proceeds. In most cases, if a seller is in financial distress, prospective purchasers will know it. Sales under distress usually depress the number and amount of offers. Prospective purchasers "look for a deal" either because the seller has limited "staying power" or out of concern for the potential "baggage" (loss of employees and customers, successor liability, among others) associated with a distressed sale. Bankruptcy can provide a solution to these problems. In bankruptcy, a sale can be effected pursuant to a court order which transfers assets to a buyer free of liens, claims and encumbrances. 11 U.S.C. ¤ 363(f). That "protection" tends to increase offers. In addition, bankruptcy is structured to encourage competitive bidding, and that increases the likelihood of a fair market price. Not only sellers, but also prospective purchasers recognize these potential benefits. Indeed, it is not uncommon for a prospective purchaser of a distressed business to make an offer contingent on there being a bankruptcy filing followed by a court supervised and approved asset sale so that the deal is as clean as possible.

III. Pre-Negotiating and Pre-Packaging Bankruptcy Plans
If informal restructuring proves unsuccessful, bankruptcy is probably the one way to deal with creditors and reorganize a business. Because of its disadvantages (e.g., expense and lack of flexibility), however, if bankruptcy is advised, there are pre-bankruptcy steps that should be considered to expedite the process, shorten the time in bankruptcy and minimize the related cost. Negotiation, and even approval, of a reorganization plan, does not have to await the filing of a bankruptcy petition. Claim treatment can be negotiated, and even voted on, before a filing in what, in bankruptcy rubric, is known either as a pre-negotiated or pre-packaged plan. Pre-filing negotiation of the treatment of a financing bank is not unusual. Such pre-bankruptcy negotiation is more difficult with regard to bondholders and trade creditors where, instead of negotiating with only one, a debtor must deal with multiple claimants. However, even in those cases, there are numerous examples of agreements being reached pre-bankruptcy with representatives (a trustee for bondholders or a committee of trade creditor representatives) of the creditors. Although pre-negotiated plans may not be binding in a subsequent bankruptcy, they can expedite the process once a bankruptcy has been filed.

In some cases, there is sufficient time not only to negotiate the framework of a plan but to solicit actual creditor acceptance in what is known as a pre-packaged bankruptcy. The process requires an informed vote based upon adequate disclosure to creditors. Provided that the manner of pre-bankruptcy solicitation was in compliance with applicable nonbankruptcy rule, law or regulation or, after disclosure to creditors of "adequate information" as contemplated by 11 U.S.C. ¤ 1125(a), a bankruptcy court may proceed directly to consideration of confirmation of a plan whose approval has been solicited before bankruptcy. This approach, if successful, can streamline the process to the point that a plan can be confirmed and the debtor emerge from bankruptcy in only a few months.

IV. Conclusion
Bankruptcy is not always the option of choice in dealing with and resolving financial difficulties. The recent Amendments to the Bankruptcy Code clearly do nothing to change that reality. Whether the goal is liquidation or rehabilitation, debtors and creditors alike recognize that there are available non-bankruptcy options. As noted, those options can avoid or minimize some of the disadvantages of a bankruptcy. However, there still are situations in which bankruptcy, even with its disadvantages, remains the best vehicle to address and resolve financial problems.

1. Lawyers who regularly handle personal bankruptcy work advise me that, as practice becomes more routine, the impact of the Amendments may not be as dire as first thought. Indeed, Òmeans testingÓ a major change under the Amendments, may only be significant as to a small percentage (10-15%) of those filing personal bankruptcy.

2. Although the referenced alternatives are discussed with respect to businesses, some may be equally applicable to individual insolvencies.