The free flow of capital is a cornerstone of a free society. Perhaps the greatest strength of our economy is enabling capital to seek its highest return. The mechanisms and structure supporting this include:

• enforcement of contractual obligations and the right to petition for specific performance including litigation against the state;
• enforcement of property rights against third parties and the state;
• the predictability of potential outcomes without arbitrary interference from third parties or governmental authorities;
• established transaction procedures and known processes;
• low transaction costs;
• a highly developed and widely understood basis for presenting financial information and documenting transactions; and
• an established and stable currency.

Liquidity-creating vehicles, such as stock and bond markets, bank lending markets, private equity markets and the mergers and acquisitions market, are a direct result of these "enablers." But once these markets are developed, the key enabler is information, principally financial information.

For companies seeking to participate in these liquidity-creating markets, the financial information requirements are extensive and the costs high. For example, companies with registered securities listed on national stock exchanges are required to have audited financial statements prepared in accordance with generally accepted accounting principles and file voluminous reports and financial information with the Securities and Exchange Commission. By contrast, private companies may have substantially fewer reporting requirements, depending on their size and the source of their debt or equity financing and the respective covenants and reporting obligations attached to such financing.

In chapter 11, the need for financial information is accentuated. Debtors need to address critical issues such as short-term and long-term viability, debtor-in-possession and post-petition trade finance, and their potential to consummate a plan of reorganization. Communication channels must also be maintained with a myriad of constituencies including employees, customers, creditors, the bankruptcy court and the Office of the U.S. Trustee.

However, for many chapter 11 debtors, the disclosure of current and relevant financial information is lacking. The purpose of disclosing financial information is threefold: to enable parties to (1) monitor the debtor's financial performance, (2) attempt to influence the reorganization process and (3) for creditors, to evaluate whether to hold or sell their claims.

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Proper financial disclosure by debtors enables creditors and other parties to make decisions based on information rather than rumor, speculation or supposition.

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Disclosure Obligations

The disclosure obligations are vast and complex:

• Debtors must file schedules providing a complete list of assets and liabilities and a statement of financial affairs describing, among other items, the debtors' business, the location of its records and listing its officers, directors and "insiders," and payments made to them within 12 months preceding the petition date.
• Debtors must file a separate list containing the name, address, phone number and claim amount of the 20 largest unsecured creditors excluding "insiders."
• Debtors must file operating reports with the U.S. Trustee and the bankruptcy court. Operating reports must also be submitted to the debtor's attorney and to the chair of any creditors' committee appointed in the case. All operating reports must be filed no later than 20 days following the end of the month covered by the report. Guidelines issued by the Office of the U.S. Trustee state that operating reports should include, among other items, a schedule of cash receipts and disbursements, a statement of operations and a balance sheet.
• Following confirmation of a reorganization plan, debtors must file quarterly operating reports with the U.S. Trustee and the bankruptcy court no later than 20 days following the end of the quarter covered by the report. Quarterly operating reports are required until a reorganization plan has been substantially consummated and the bankruptcy court has entered a final decree closing the case.
• Debtors with securities registered with the SEC or securities listed for trading on a national securities exchange or the over-the-counter market must continue to file annual and quarterly reports, proxy statements and reports of material events with the SEC within specified mandatory time periods. Additionally, Regulation FD promulgated in 1999 established an obligation to disclose material non-public information in a fair and accessible manner. (The obligation to file with the SEC is subject to certain exceptions including an exemption for a relatively small number of security-holders.)
• Debtors must file a disclosure statement if there is a voting class on a reorganization plan. The disclosure statement must contain adequate information to enable voting class members to make informed judgments on the merits of a proposed reorganization plan. While there are no statutory standards to evaluate the adequacy of information presented in a disclosure statement, case law has established certain reporting and information standards.

Financial Transparency

The key objective should be to capture and report on the economic substance of underlying business or financial activity. This also means that the financial information presented should be relevant, timely, reliable and capable of objective verification. Given the critical issues chapter 11 debtors need to address and creditors and other parties-in-interest need to respond to, relevance and timeliness should be paramount.

In addition to financial statements prepared in accordance with GAAP, debtors should disclose additional information that enables creditors to estimate potential recoveries from cash, assets or debt and equity securities distributed as part of a reorganization plan or liquidation. Debtors should also disclose sufficient information so that parties can reasonably estimate whether a debtor can reorganize. This additional information could include financial projections (which are often included in a disclosure statement for debtors attempting to reorganize), recognizing that projections will never be truly reliable or capable of objective verification because they forecast future events. Finally, ongoing business or economic activities should be reported separately from reorganization or non-recurring activities.

Enforcing Disclosure Obligations

Despite the disclosure requirements, compliance is frequently spotty. For public companies, the SEC often takes no action against debtors failing to maintain current filings, especially after their securities are delisted. Bankruptcy courts and U.S. Trustees often take no action regarding the adequacy of the information contained in operating reports. Failure to file operating reports can potentially lead to a conversion to chapter 7 or dismissal of a bankruptcy filing.

Where debtors no longer file 10-Ks and 10-Qs with the SEC and no longer provide financial statements prepared in accordance with GAAP, creditors and other parties look to the information provided by operating reports. Operating reports are typically presented by individual debtors on an unconsolidated basis and without notes or other explanatory material. Where there are multiple debtors, operating reports often fail to provide meaningful information regarding overall results from operations or estimates of potential recoveries. The unconsolidated financial information in operating reports tends more to obscure rather than to inform.

Bankruptcy courts and U.S. Trustees have the power to enforce adequate disclosure by debtors. Creditors and other parties should be able to petition the courts to force debtors to comply with financial disclosures that satisfy the objectives of timeliness and relevance. The Office of the U.S. Trustee can also change the form or standards of the operating reports to make them more relevant and useful.¹

Conclusion

Proper financial disclosure by debtors enables creditors and other parties to make decisions based on information rather than rumor, speculation or supposition. Better information facilitates a distressed trading market that can provide liquidity to creditors wishing to sell claims instead of having to wait for a recovery from a reorganization plan or liquidation with potentially limited opportunities for liquidity.

The lack of financial disclosure can have the same effect on liquidity as court-imposed trading restrictions. Such restrictions or potential restrictions, whether court-imposed (to preserve tax attributes for a reorganized debtor) or resulting from a lack of financial disclosure, ultimately raise the cost of capital to business.

Like Hebrew National hot dogs, bankruptcy courts and U.S. Trustees should answer to the needs of a higher authority: the debt, equity and trade finance markets. These markets constantly need current and relevant financial information. Without this information, there would be no debt, equity or trade finance for companies operating as debtors-in-possession or attempting to reorganize.

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Footnotes

¹ In enforcing disclosure requirements, bankruptcy courts and the U.S. Trustee should consider that the larger the debtor, the more important it is that financial disclosures are consistent with the reporting requirements established by the SEC. Return to article