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Control the Denominator to Enhance Creditor Recoveries

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For example, assume that there is $500 million of asset value to distribute among creditors, and that the reorganization plan provides for payment in full of all priority claims before any funds are distributed to general unsecured creditors. Further assume that the claims asserted by the creditors are as presented in the table below:

Asserted Claims
(millions) Claims Payout Return
Secured Debt $200 $200 100%
Priority Debt $50 $50 100%
Reclamation and Cures $100 $100 100%
General Unsecured Claims $1,000 $150 15%

After paying $350 million to priority creditors, there is only $150 million available to pay $0.15 on the dollar to general unsecured creditors based on asserted unsecured claims of $1 billion. Appropriate strategies and processes for addressing these various categories of claims can improve the return to creditors by minimizing claims in all classes.

Secured Claims

In addition to secured-lender claims, secured claims often include lien assertions, claims made by lessors for value of equipment and claims for which there is no basis to assert a security interest. Lien assertions should be scrutinized, as these asserted liens might not have been properly or timely perfected or filed. Secured claims asserted by equipment lessors can be avoided simply by returning the equipment. Where, as is often the case, the debtors cannot locate the equipment, the lessor's assertion of the fair market value of the equipment should be challenged, as these values are usually overstated.

Priority Claims

Priority claims usually consist of claims by taxing authorities and employees. In sum, tax claims are typically overstated, and most employee priority claims are paid through first-day orders and filed in excess of the statutory priority amount. Any other type of creditor asserting a priority claim should be questioned in most cases. Reviewing priority claims to identify the types of creditors and bases for claims of priority assertions will quickly reveal many asserted claims that simply do not qualify for priority status.

Taxing authorities are notorious for filing "jeopardy assessment" claims that are substantially overstated. Commonly, taxing authorities have not fully evaluated any liabilities of the debtor at the time of the claims bar date. As a result, taxing authorities often file claims seeking the maximum amount potentially due. Moreover, taxing authorities often include claims from many years past, even though priority status is generally accorded only to tax debts arising within three years prior to the petition date. Thus, tax claims should be thoroughly investigated with the tax department, and attempts should be made to expedite tax audits in order to resolve these claims.

Employees are entitled to priority claims to the extent that the liability arose during the 90 days prior to the petition date. Moreover, the priority amounts of an employee cannot exceed $4,925 (pursuant to 11 U.S.C. §104, effective for all cases filed on or after April 1, 2004). Proper analyses of pre-petition amounts owed to employees often reveal that amounts owed to employees, if any, were earned over time. Most or all amounts that arose during the 90 days prior to the petition date are paid in connection with first-day orders allowing for payment of employee obligations.

Reclamation and Executory Contract Cure Claims

Spending adequate time evaluating and challenging reclamation claims and cure costs will substantially reduce these claims. Claims asserted by vendors for goods shipped during the reclamation period and asserted executory contract cure costs are typically gross amounts that are significantly overstated. A thorough understanding of the debtor's accounting systems and detailed calculations are necessary to perform these analyses.

Vendors that assert reclamation claims usually do not properly consider the applicable time period for reclamation shipments and, more importantly, the amount of goods that were shipped during the reclamation period that remain on hand at the time of the reclamation demand. In general, vendors are entitled to reclamation claims to the extent that the goods were received during the 10 days prior to the petition date, and these same goods were on hand at the time of the reclamation demand.

Any product that has been sold or consumed by the time of the reclamation demand does not qualify for inclusion in a valid reclamation claim. Analyses of the shipment detail of asserted reclamation claims may also reveal other causes for reducing asserted reclamation claims.

Executory contract cure costs can also be significantly reduced through proper analyses. It is common to find that parties to assumed executory contracts expect the cure amount to include all amounts that are owed by the debtor, including liabilities that are not associated with contracts that are being assumed.

Recent telecom cases have provided good examples of overstated cure cost assertions in connection with circuits. Although some of the circuits are associated with master service agreements that have created many complexities regarding attempts to "cherry pick" circuits and calculate cure costs, many of the circuits are not associated with master service agreements.

For example, assume that a circuit vendor provides the debtor access to 500 circuits for which the debtor only assumes 300 circuits and the circuit vendor has an outstanding claim of $50,000. It is common that the circuit vendor will assert a $50,000 cure claim. Moreover, logic may suggest that three-fifths of the circuits are being assumed and that the cure cost would be $30,000 (3/5 multiplied by $50,000).

However, analyzing the circuit-level billing detail will reveal the proper amounts of these claims. Through a thorough understanding of the debtor's accounting records, analyses can be performed to determine the exact amounts owed on a circuit-by-circuit basis to determine the amounts owed for each circuit that is being assumed. This concept can be applied in calculations of cure costs with all types of executory contracts. In general, the liabilities need to be traced specifically to the contracts being assumed.

General Unsecured Claims

The process for evaluating general unsecured claims in large bankruptcy cases can initially appear to be overwhelming. Certain initial steps will, however, create a manageable process. The first useful step is to identify and focus on the primary reconciling claims that make up the bulk of the overall reconciling difference, which I refer to as the "needle movers."

Another useful step is to categorize the reconciling claims by type of claim. Although there are many types of general unsecured creditors in large bankruptcy cases, there are four common types: (1) unsecured debt claims, (2) trade claims, (3) executory contract rejection claims and (4) litigation claims. Upon categorizing reconciling claims based on claim type, processes can be established to evaluate and resolve these claims.

Unsecured debt claims are typically few in count and fairly simple to evaluate. In general, the unpaid principal and interest amounts as of the petition date should be determined.

Trade claims are best reconciled through computerized methods to identify the reconciling invoices that are included in the creditor's claim, but not included as unpaid items in the debtor's accounts payable records. These reconciling invoices can be researched through additional computerized methods to determine conclusions.

Executory contract rejection claims are often filed at gross amounts, and are thus often greatly overstated. Most bankruptcy professionals are familiar with the rejection damage-claim limitations for real property lessors per §502(b)(6) of the Bankruptcy Code (the greater of one year or 15 percent of the lease, not to exceed three years). Despite this limitation, landlords often file claims that assert the entire amount of the remaining lease as contract rejection damages. In addition, for all rejected contracts, rejection damages are subject to reduction based on state law mitigation obligations.

Litigation claims are often difficult to analyze in any systematic fashion and can be time-consuming to resolve, since litigation of the unique underlying issues through discovery and trial may be necessary. However, alternative dispute resolution processes have proven to be an effective process for expeditiously reaching resolution of litigation claims more quickly and inexpensively than the standard claims-objection process. In addition, in cases where the projected percentage recovery for unsecured creditors is fairly low, many litigation claimants are willing to negotiate settlements in lieu of incurring the legal costs attendant to litigation over the claim.

In addition to reconciling and resolving unsecured claims based on their merits, preference claims can serve as strong leverage for additional claim reductions. The evaluation of preference claims can tend to be very subjective (especially with respect to the ordinary-course-of-business defense), and the parties tend to have disparate views on the merits. This uncertainty can often facilitate claim reductions based on waivers of preference claims.

Using the hypothetical distribution chart on p. 68, assume that proper claim-resolution methods such as those described above are employed, and the following claim reductions are achieved: secured debt reduction of 5 percent, priority claim reduction of 30 percent, reclamation and cure reductions of 30 percent and general unsecured claim reductions of 40 percent. The table below summarizes the significantly better result for general unsecured creditors:

Final Resolution of Claims
  Claims Payout Return
Secured Debt $190 $190 100%
Priority Debt $35 $35 100%
Reclamation and Cures $70 $70 100%
General Unsecured Claims $600 $205 34%

The result is a substantial cent-on-the-dollar increase to general unsecured creditors, where the return increased from 15 to 34 percent.

In conclusion, while many focus on maximizing the value of assets in a bankruptcy, that is only part of the equation. The proper management of liabilities as well can significantly improve the percentage of return to creditors.


Footnotes

1 Meade Monger is a principal with AlixPartners LLC in Dallas, where he leads AlixPartners's case-management services practice, which primarily assists bankrupt companies with case management, reorganization and/or liquidation initiatives. He has significant experience in many industries and has worked on many of the nation's largest bankruptcy cases, including Kmart and WorldCom. Return to article

Journal Date: 
Wednesday, September 1, 2004

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