Balancing Creditor and Equity Interests Provides Incentive to Utilize Chapter 11 for Mutual Benefit
As a result, the use of chapter 11 as a business tool for fixing sick companies has diminished over time. In many cases, because debtors have elected to delay filing, chapter 11 has become a substitute for foreclosure proceedings for the benefit of creditors. Certainly, selling assets in a chapter 11 proceeding allows for sales as going concerns and, therefore, should provide more benefit to creditors than liquidation by foreclosure. Because many companies that could be otherwise restructured significantly delay filing chapter 11, this leads us to conclude that a substantial loss in value to creditors and equity alike is prevalent. Put another way, the opportunity for creditors and equity-holders to realize the going-concern value from a successful reorganization may all too often be squandered in favor of "better-than-liquidation" value realized in §363 sales.
A professional approached to advise a debtor (including a closely held business) in financial difficulty is often faced with moral and ethical dilemmas because of the current trends in chapter 11 cases favoring creditors. The professional must harmonize his or her duty toward the fictional corporate entity, which may be at odds with the interests of management and equity that are often focused on their own financial plight (notwithstanding their own duties to all constituents). Creditor interests often differ from those of management and stockholders. The developing corporate-law theory of applying an additional fiduciary duty to creditors when the zone of insolvency is reached further complicates the decision-makers' conundrum.
Business Arrangements and Reorganizations Under the Bankruptcy Act
Prior to the passage of the Bankruptcy Code in 1978, there were essentially two choices available for business debtors under the Bankruptcy Act—chapters X and XI.4 These were designed to reflect a distinction between closely held businesses and large, public companies.5 That is, closely held businesses were expected to restructure under chapter XI, while large, public companies were expected to look to chapter X. This distinction reflected Congress's awareness that different debtor types required different frameworks for reorganization.
Under chapter XI, certain leverage was afforded to the debtor. For example, while under chapter XI, the debtor, which typically remained in possession of its assets, was the plan only entity permitted to file a reorganization plan and was not limited by an exclusive period for filing a plan. In addition, the absolute priority rule did not apply. Creditor protections included an absence of a cramdown and, at least on the surface, the plan of arrangement could not alter the debtors' secured debt. In practice, however, the imposition of the automatic stay usually generated positive negotiations with secured creditors.
Chapter XI reflected a public policy favoring the ability of closely held businesses to reorganize. Because chapter XI allowed value to flow to stockholders of closely held businesses, it naturally was less threatening to the principals of the closely held business. Further, the closely held business debtor, as the exclusive plan proponent, could propose to maintain its current management. This leverage, coupled with the absence of an absolute priority rule, aided the closely held business in its reorganization efforts and provided an incentive for proposing a plan that shared the going-concern value between the creditors and the stockholders.
While a successful reorganization was not certain, it was clear that the possibility of the business being retained by equity interests was likely. With no limitation on the exclusivity period, the closely held business debtor was given time to solve the operational and/or leverage problems that forced the debtor to reorganize in the first place. In an arrangement under chapter XI, unsecured creditors would realize significantly greater value than they would through a liquidation, and equity-holders were permitted to retain value.
As a matter of policy, many have argued that it is unfair for stockholders to retain any interest until creditors are paid in full. On the other hand, a major purpose of a reorganization-based system (vs. a liquidation-based system) is to produce more overall value for constituents. If a case is filed with sufficient time to incorporate a business solution, then there should be more value to share between the various stakeholders than is likely to be available to creditors alone when the reorganization is commenced too late to provide a higher level of benefit to all of the debtor's constituents.
In chapter X cases, creditors' interests were paramount. Under chapter X, a trustee was automatically appointed to exercise control over the administration of the estate and businesses operations; the absolute priority rule was imposed and could not be waived. In addition, the likelihood that management would be replaced and stockholders' interests would be eliminated was all but a foregone conclusion.
It does not take an economic genius to recognize that if chapter X was a likely disaster for the very people deciding whether to file, few chapter X petitions would be filed. Of course, that is precisely what happened. In addition, the creditors found chapter X cumbersome and too costly. Because the Bankruptcy Act did not specifically define the type of debtor required to file under chapter X or XI, the choice of chapter XI over chapter X predominated, even by large, public corporations. Today, the more chapter 11 appears to the corporate decision-makers to resemble old chapter X, the less likely it is that corporations will file in a timely manner.
Obstacles to Reorganization Under the Bankruptcy Code
Under the Bankruptcy Code, no differentiation is made between closely held businesses and large, public companies. Underlying policy considerations, however, may warrant different rules for different types of business debtors. In drafting the current Bankruptcy Code, many provisions of chapters X and XI of the Bankruptcy Act were merged into chapter 11. During Congress's debate over the adoption of the Bankruptcy Code, no significant challenge was raised as to the application of the proposed "one-size-fits-all" chapter 11 system for closely held and publicly held businesses. While the Bankruptcy Code distinguishes debtors in certain circumstances,6 most business bankruptcies are required to file under chapter 11, which contains uniform provisions that do not allow for differentiation based on debtor type.7
The problems with the Bankruptcy Code's lack of differentiation between closely held businesses and public companies stems from the classic corporate structure of these two entities. The construct of a corporation as a separate entity was created as a legal fiction to enable entrepreneurs to invest in a business with little risk to their personal wealth, other than to the extent of their own personal investments in the corporation. Closely held businesses frequently have few stockholders, most of whom are involved in the day-to-day management of the business and many of whom are likely to be guarantors of the company's bank debt. The shares of a closely held business are not exchanged in a public market and are often subject to transfer restrictions.
When such a closely held business is contemplating chapter 11, usually the stockholders/managers initiate a professional consultation (e.g., lawyer and/or investment banker). In this scenario, the stockholders likely are concerned with their personal business problems as well as the problems of the business. The professional here has a fiduciary duty to his or her client (i.e., the closely held business), but unless the business is reorganized and the stockholders' interests survive, the professional has not truly achieved the objectives presented by the individuals who consulted with him or her at the outset of the case.
The management and stockholders contacting the professionals will view the corporate fiction as a mere instrumentality for their entrepreneurial endeavors. That is, of course, why we have corporations in the first place. Corporations allow the entrepreneur to further his or her business interests while providing a fictional vehicle used to protect the entrepreneur's assets. The growth of the American economy was due in no small part to this development. It would be consistent with this protective philosophy to allow entrepreneurs an opportunity to restructure their instrumentalities during difficult times. Such a policy choice was inherent under chapter XI of the Bankruptcy Act, but not under chapter X.
The policies surrounding reorganization of public companies are somewhat different from those presented by the closely held business. In public companies, stockholders are often separate from management. This results in professional managers running the company and a diverse body of stockholders serving as absentee owners. Generally, these stockholders are independent investors who, in purchasing the stock, assumed the risk of the success or failure of a company. However, we would also observe that in order to preserve the flow of equity capital to larger, public entities, stockholders must not have their investments eradicated because of a snapshot at a particular point in time when a business has stumbled and enterprise valuation of a company may ebb at or below the face amount of the debt for what may be a temporary period.
A creditor-oriented case can be made that it is appropriate to distribute value according to the priorities the parties contracted for and what the non-bankruptcy law already dictates. While the result may or may not be fair and appropriate on a case-by-case basis, the question is whether the reorganization system is working. Again, because preservation of value for stockholders in chapter 11 may be viewed as problematic by the decision-makers, many companies do not file until it is too late to preserve the optimum value of the business.
There are pre-packaged cases that work, where much of the reorganization is done prior to filing so as to lessen the uncertainty inherent with chapter 11, but those cases typically provide balance-sheet fixes only. If a company requires the protection of the automatic stay to undergo an operational fix, chapter 11 is less likely to provide the time necessary to accomplish that goal and consequently will be less favorably viewed by the constituency making the decision of whether to file.
Therefore, this problem is prevalent with respect to both public and closely held companies, but it may be more pronounced with respect to closely held businesses. While it is beneficial that value is being realized for creditors, the blood, sweat and tears of the owners are not being accorded the same consideration as under chapter XI of the Bankruptcy Act. These facts seem to diminish the use of chapter 11 for traditional reorganizations, particularly where operational remedies are required.
The difficulties faced by a closely held business in reorganization under chapter 11 often stem from the debtor's limited exclusive period provided under §1121(b) to file a reorganization plan, and the application of the absolute priority rule pursuant to §1129(b)(2)(B)(i) and (ii).
As discussed above, chapter XI of the Bankruptcy Act did not have a defined exclusive period within which the debtor must file a plan. Under chapter XI, the debtor retained exclusivity throughout the case. This gave the debtor an opportunity to fix the business, not just to mend the balance sheet. Under chapter 11 of the Bankruptcy Code, however, the debtor retains an exclusive period for only 120 days to propose a reorganization plan.8 For many companies, this 120-day exclusive period is hardly sufficient to correct their balance sheets and is not a sufficient amount of time in which to stabilize the business and fix the problems that forced the company to file for relief in the first place. Often, a business needs an opportunity within chapter 11 to solve business problems that cannot be adequately addressed without the benefit of the automatic stay. The mere hope of a court-allowed extension of exclusivity (which is certainly to be expected in larger, public-company filings)9 can be perceived as too risky to make chapter 11 an attractive option to management and stockholders—particularly in closely held businesses.
Once exclusivity ends, the debtor loses much of its leverage, and the creditors are able to propose a plan that likely would seek to oust current management and obtain ownership of the debtor. Another possible alternative is that the creditors could propose a reorganization plan that calls for a sale of the business's assets, and the price may not fetch enough to leave anything for equity interests of the closely held business. As a result, closely held companies may not be encouraged to file a chapter 11 at the point in time where values are most likely to be preserved.
Absolute Priority Rule
Under the Bankruptcy Act, a chapter X case was confirmed if found to be "fair and equitable." To be "fair and equitable," a plan must respect the "role of full or absolute priority,"10 which means "to the extent of their debts[,] creditors are entitled to priority over stockholders against all the property of the insolvent corporation."11 The absolute-priority rule under chapter X was paramount and could not be avoided, even with consent. The absolute-priority rule applied, not only between creditors and stockholders, but between different creditor classes as well.
Conversely, chapter XI left the issue of fairness to be bargained for between the debtor and its creditors. This bargaining often resulted in the sharing of the going-concern value of the debtor's assets between its creditors and its stockholders. The absence of an absolute-priority rule under chapter XI of the Bankruptcy Act provided an incentive for the management and stockholders of the business to pursue a timely chapter 11 filing rather than to risk continued diminishment of the company.12
Under chapter 11, unlike chapter XI of the Bankruptcy Act, the absolute-priority rule applies to every business debtor type eligible for relief under chapter 11. Unlike chapter X, however, chapter 11 permits an affected class to waive the absolute-priority rule upon consent of the affected class. Depending on the circumstances of a given chapter 11 case, creditors and equity-holders may agree consensually to transfer value among the classes outside of the normal priority scheme. It is becoming increasingly difficult, however, to obtain waivers of the absolute-priority rule.
A Trend Toward Differentiation
During the 1980s, family farmers were hit hard due to severe economic deflation coinciding with reduced exports.13 In response to the economic hardship facing family farmers, Congress enacted The Family Farmer Bankruptcy Act of 1986, which was codified as chapter 12 of the Bankruptcy Code to address the unique interests of the family farmer contemplating reorganization.14
The concern is that in seeking to provide "fairness" to creditors, there may be insufficient incentive for decision-makers to utilize the benefits of chapter 11.
In addition, pursuant to the Bankruptcy Reform Act of 1994 (the "1994 Amendments"), Congress attempted to ease the procedural requirements of a reorganization for small businesses, including a shortened 100-day exclusivity period to file a plan.15 In practice, however, few small-business debtors elect to be considered a small business under chapter 11 because the provisions for small businesses are often worse for such debtors. A reduced exclusivity period is rarely sufficient for management and stockholders to fix the underlying business problems. The 1994 Amendments also added a new concept—the "single-asset real estate" case. The amendments dealing with single-asset real estate cases were developed to address the primarily two-party disputes inherent in these types of cases.
These recent changes represent a philosophical change that, under chapter 11, one size does not necessarily fit all. This article raises the question of whether the Bankruptcy Code provides, or should provide, an appropriate incentive and opportunity for reorganization of companies. The concern is that in seeking to provide "fairness" to creditors, there may be insufficient incentive for decision-makers to utilize the benefits of chapter 11.
This reticence to file means that corporations that could be saved are not being "fixed" in time, and that significant value for creditor constituencies is possibly being lost—not to mention opportunities for shareholders to realize on their investments. In other words, while creditor value is currently being monetized at the point in time of sale or balance-sheet fix, even greater value to creditors (and others) might be realized if reorganizations were undertaken at an earlier time, before significant value is lost.
1 Richard E. Mikels is a shareholder in Mintz Levin's Boston office and chairman and manager of the Bankruptcy, Restructuring and Commercial Law Section. The authors are grateful and appreciative to Adrienne K. Walker, an associate with the Boston office of Mintz Levin, for her assistance in the preparation of this article. Return to article
3 This concern was addressed more than 30 years ago in the 1973 report of the Commission on Bankruptcy Laws, when it recognized that "[i]nitiating relief should not be a death knell. The process should encourage resort to it, by debtors and creditors, that cuts short the dissipation of assets and the accumulation of debts. Belated commencement of a case may kill an opportunity for reorganization or arrangement." See Report on the Commission on the Bankruptcy Laws of the United States, H.R. Doc. No. 137, 93d Cong. 1st Sess. (1973). Return to article
4 The Bankruptcy Act, as amended from time to time, also had separate chapters for Agricultural Compositions (chapter VIII), Railroads (chapter VIII), Municipal Debt Readjustment (chapter IX), Real Property Arrangements by Persons Other Than Corporations (chapter XII), Wage Earner Plans (chapter XIII) and Maritime Commission Liens (chapter XIV). Return to article
5 See H.R. Rep. No. 95-595, at 242-46 (1977); see, also, Posner, Eric A., "The Political Economy of the Bankruptcy Reform Act of 1978," 96 Mich. L. Rev. 47 (1997) (noting that although the drafters intended chapter XI for closely held corporations and chapter X for public corporations, the wording of the statute did not actually reflect this requirement). Because of this lack of clarity as discussed herein, most companies, large and small, preferred to file under chapter XI rather than chapter X. Return to article
6 See subchapter III of chapter 7 (stockbroker liquidations), subchapter IV of chapter 7 (commodity broker liquidations), chapter 9 (municipalities), subchapter IV of chapter 11 (railroad reorganizations) and chapter 13 (individuals with regular income). Return to article
7 The legislative history, however, reveals that the proposal by the Commission on the Bankruptcy Laws of the United States for a single, consolidated business reorganization chapter differed significantly from what Congress ultimately enacted as chapter 11. See Peebles, Ralph E., "Staying In: Chapter 11, Close Corporations and the Absolute Priority Rule," 63 Am. Bankr. L.J. 65 (1989) (summarizing the above differences, including a relaxed application of the absolute priority rule in the context of reorganizing close corporations). Return to article
9 Extensions are often granted in smaller cases as well. It is the lack of assurance and the enormous change in leverage when extensions cease that make this issue paramount to decision-makers. Return to article
12 When the Bankruptcy Act was amended in 1952, it eliminated the fair and equitable test for chapter XI debtors. The congressional history suggests that the amendment was necessary because, if the absolute priority rule was applied, "no individual debtor, and under chapter XI, no corporate debtor where the stock ownership is substantially identical with management, could effectuate an arrangement except by payment of the claims of creditors in full." House Report No. 2320 on S. §2234, 82nd Cong., 2nd Sess. (1952). Return to article
14 Chapter 12 has yet to be adopted as a permanent chapter under the Bankruptcy Code. When enacted, chapter 12 included a seven-year sunset provision. This chapter has been re-enacted several times, however, and is currently due to expire on Jan. 1, 2004. It is interesting to note that family farmers seem more sympathetic to Congress than family businesses. Return to article