Turning a Debtors World Upside Down

Turning a Debtors World Upside Down

Journal Issue: 
Column Name: 
Journal Article: 
Unfortunately, many debtors seem to enjoy the bankruptcy process a little too much. They do not have to service substantial pre-petition debts. They can use new-found powers of a bankruptcy trustee to undo the same deals they put together shortly before they filed their case. They can even sue some of their suppliers for something that the debtor did—paying part of its debts—even though the creditor did nothing more than open its mail and deposit a check it was expecting to receive. Under current law, debtors can start to believe that they are the masters of their own destiny and that creditors cannot defeat them. [Editor’s Note: But see the changes being considered by Congress; "Legislative Update," page 6.] With all of these benefits, debtors can get too comfortable with the chapter 11 process and, consequently, may need something to push them out of the bankruptcy court and bring them back to reality.

If the debtor is larger than a "mom & pop" operation, it might be able to stand on its own without its current top management. In fact, replacing existing management also might be exactly what the business needs if it is to return to a healthy and growing enterprise. What can creditors do to replace management?

In general, management is replaced in three different scenarios: (1) appointment of a chapter 11 trustee; (2) an internal change in control using the appropriate corporate governance mechanisms; and (3) confirmation of a creditor’s plan of reorganization. These turn a debtor’s world upside down, since the debtor loses the very thing it sought in filing bankruptcy: control of its destiny.

Appointment of a Chapter 11 Trustee

Of the three scenarios, appointment of a trustee is the most drastic. It generally requires proof that either (a) the debtor is guilty of fraud, dishonesty, gross mis-management or incompetence, or (b) that appointing replacement management is in the best interest of creditors.1 Courts are generally reluctant to oust the debtor from possession without very strong proof. Removing the debtor from possession runs counter to Congress’s presumption that the debtor is the best party to decide how to restructure itself.

Appointing a trustee also increases the cost of the case by adding to the admin-istrative fees and expenses being borne by the estate, and could slow down the process (in order get the trustee and new professionals up to speed).2 However, these costs and delays can be well worth the price if the debtor and its management are bad enough.

New Management Through Internal Corporate Governance

Replacing management through the company’s internal corporate governance process is probably the most cumbersome method of the three. Most creditors do not have an ownership position that would allow them to vote on candidates for the board of directors. In these cases, creditors (or the creditors’ committee) should explore the possibility of approaching a dissident shareholder group that might want to join in the effort (and even become the new management). Before devoting much time and effort in this process, the debtor’s bylaws should be reviewed to see if they allow an expeditious replacement of the board, or if they have been drafted to insulate existing management from removal.3

Creditors’ Plan of Reorganization

The Bankruptcy Code gives a debtor-in-possession the exclusive right to file a plan during the first 120 days of a case.4 This period can be shortened or lengthened "for cause." The realistic possibility (or threat) of a plan prepared by the creditors’ committee or a large creditor increases the chance that the court will terminate the debtor’s exclusivity (by either not allowing an extension of the 120 days or shortening the period).5

An active creditors’ committee is uniquely positioned to file a creditors’ plan. Its members are familiar with the debtor, its operations and personnel as well as its industry. The committee’s professionals probably obtained enough information in their due diligence process to draft a workable plan of reorganization and the basis for an adequate initial disclosure statement. Once those documents have been prepared and filed, they can be refined to include anything that might have been unknown, over-looked or concealed, as well as information obtained in discovery from the debtor.6 The creditor or committee should take care, however, to include all available information as to assets and liabilities, including potential claims. Discovery can often be taken prior to submission of the disclosure statement through Rule 2004 or otherwise.

A hostile plan also can be used to cure a debtor’s "terminal euphoria" about the value of litigation. Plans have been proposed to compromise litigation pursued by a debtor against it lenders or others.7 Settling litigation through a plan allows the ultimate beneficiaries of the litigation (the creditors) to decide whether the possible recovery justifies the time and expense of the litigation.

Creditors’ plans can take many other forms. They can be operating plans (where the business continues) with or without current management. The plans can be liquidating plans that appoint a person to liquidate the assets (similar to a chapter 7 trustee). The plan can give the creditors’ committee as much or as little control over the post-confirmation process as the situation dictates. A plan is limited only by the facts of the case and the imagination of the drafters (so long as it complies with the Bankruptcy Code).

There are also many subtle benefits to a creditors’ plan. It usually provides a stark contrast to anything the debtor is proposing (and is almost always more generous to creditors than the debtor would be), which gives the creditors real negotiating leverage.8 A creditors’ plan can be attractive to a judge because it allows the creditors direct input as to how they will be paid, instead of the "yes" or "no" choices provided when the debtor’s plan is the only one on the table. Creditors’ plans are economic democ-racies in action. They let the creditors truly control their own destinies.

Finally, a creditors’ plan puts the debtor’s attorney in the ironic and uncomfortable (sometimes even humorous) position of opposing the very thing that most recite like a mantra—confirmation of a plan of reorganization.9

There are some instances where a creditors’ plan is simply not a feasible alternative, such as when the management really is crucial to the enterprise, or when the cost of the fight will not materially increase the return to creditors. In those instances, the creditors could win the battle and lose the war by taking over a less valuable debtor.

Conclusion

Congress did not give a debtor absolute control over its destiny, and there is no reason for the creditors to cede that right to the debtor. Creditors and creditors’ committees should consider all of their options, including the possibility that the existing management should be replaced. Knowing their rights and options allows creditors to maximize their recoveries by using the protections of the Bankruptcy Code to their fullest advantage—even if it turns the debtor’s world upside down.


Footnotes

1 11. U.S.C. §1104 provides that, after notice and a hearing, "the court shall order the appointment of a trustee (1) for cause, including fraud, dishonesty, incompetence or gross mismanagement of the affairs of the debtor...or; (2) if such appointment is in the interests of creditors, any equity security holders and other interests of the estate..." Return to Text

2 On the other hand, if the debtor was going nowhere and merely stalling for time, appointing a trustee could actually expedite the reorganization process. Return to Text

3 Common takeover defenses include staggered director terms (requiring a few years to take control of a board of directors) and the lack of cumulative voting rights (e.g., allowing anyone controlling over 50 percent of the equity to control the company to the exclusion of minority owners). Return to Text

4 11 U.S.C. §1121(b). Return to Text

5 If a trustee has been appointed, exclusivity terminates with that appointment. 11 U.S.C. §1121(c)(1). Return to Text

6 The debtor will undoubtedly file an objection to the disclosure statement to point out additional information that should be provided to creditors. This process allows the creditors access to even more information from the debtor to be included in its disclosure statement and projections. The debtor must be very circumspect in drafting its objection to the committee’s disclosure statement since it faces the real prospect of winning the disclosure statement battle and losing the war by arguing that no plan can be confirmed. Return to Text

7 See In re Kendavis Industries Inc., 91 B.R. 742, 745 (Bankr. N.D. Tex. 1988). See, also, In re Texas Extrusion Inc., 844 F.2d. 1142 (5th Cir. 1988), cert. denied, 488 U.S. 926, 109 S.Ct. 311, 102 L. Ed.2d 330 (1988). In a similar case, a bank’s plan compromising a lender liability suit was overwhelmingly accepted by creditors and confirmed by the court, much to the debtor’s dismay. Return to Text

8 It is always better to have a comparison instead of being relegated to saying "no" to the debtor’s proposals. Return to Text

9 The irony in this juxtaposition is rarely lost on a judge who may see the debtor’s attorney arguing for plan confirmation in case after case. Return to Text

Journal Date: 
Friday, May 1, 1998