The New Paradigm for Restructurings and Chapter 11 Reorganisations in the United States

01 March 2007

Harvey R Miller and Michele J Meises, Weil Gotshal & Manges LLP

This change has been precipitated by globalisation, the expansion and predominance of secured creditors, technological advances in all areas – particularly communications and access to information – the shift from a manufacturing to a service economy, major business consolidations and an unparalleled access to credit. The emergence and rapid growth of hedge funds, private equity firms and other non-traditional investors have resulted in an enormous expansion of a capital-markets driven economy. The foregoing has caused a different paradigm for restructuring and reorganisation situations. 

The United States has enjoyed a very robust economy for the past several years. High consumer spending and low borrowing costs have supported this economy. It has enabled companies facing potential liquidity issues and defaults to refinance existing debts with investments and loans, provided in many cases by hedge funds. Hedge funds have rapidly moved toward becoming primary lenders and sometimes participants in second lien and other esoteric forms of financing that enable the avoidance of default. The consequence has been an unprecedented low default rate. 

The confluence of the above and the enactment of the Bankruptcy Abuse Prevention and Consumer Act of 2005 (the BAPCPA), with its major revisions to certain of the fundamental precepts underlying US bankruptcy law, have led to the continuing decline in major restructurings and reorganisation cases. The top five bankruptcy cases in 2006 totalled only $13 billion in assets, compared with $101.3 billion in 2005. In the 12-month period ending in September 2006, chapter 11 cases filed by businesses rose in number to slightly over 6,000 cases, continuing the lowest levels since the mid-1990s. According to Standard & Poor’s estimates, corporate default rates were down to 1.6 per cent last year, compared with a high of 10.51 per cent in 2001. Both Standard & Poor’s and Moody’s Investors Service predict that the default rate for US speculative-grade corporate bonds will only rise to between 2.5 per cent and 3 per cent in 2007. 

The factors that may account for the recent decline in chapter 11 cases are discussed below.

The Changing Environment

Among the most significant changes since 1978 are: (i) globalisation and consolidation of customers and suppliers; (ii) the growth of distressed-debt investing and trading by hedge funds, private equity firms, and other nontraditional lenders; (iii) the increasing use of secured financing; (iv) expansive capital markets providing greater access to credit and funding; (v) the contraction of domestic manufacturing and the development of an overarching service based economy; and (vi) the transferability of assets without the loss of going concern value. 

The changes, accompanied by the enormous technological improvements in access to information and the analysis of such data, have resulted in new dynamics for restructurings and reorganisations. Contraction in the supplier chain and the virtual disappearance of relationship banking have substantially enhanced the power of creditors in dealing with distressed debtors in and out of chapter 11. 

Distressed-debt traders and investors have likewise grown dramatically over the past five years and are now fuelled by the large amounts of money provided by hedge funds and private equity firms. The objective of a quick return on investments desired by such traders and others may conflict with the rehabilitative concept of the classic reorganisation paradigm. When the Bankruptcy Code was enacted in 1978, a more ‘symbiotic’ relationship existed between debtors and creditors. Debtors had longstanding relationships with their financial institutions, customers and vendors, who often shared a desire to support the debtor’s rehabilitation. 

Those symbiotic relationships may no longer exist. Their disappearance may signal a permanent change to the reorganisation dynamic, a consequence that may result in the restructuring and reorganisation arena becoming a playground for financial players. The influence of such players has been demonstrated in a variety of reorganisation cases including: Delphi Corp, Adelphia Communications, Interstate Bakeries Corp, Solutia Inc, WorldCom, Owens Corning, Kmart, Enron, Mirant, Oneida Ltd, Pliant Corporation, Radnor Holdings Corporation, and others. 

Changes in the dynamics of reorganisation have also arisen from the robust capital markets that have made increasing leverage more accessible. The ability of third parties to access substantial sums in the capital and credit markets has enabled a single investor or group of investors to obtain sufficient funds to purchase an entire business entity or substantially all of the entity’s assets no matter how high the price. Such sales could expedite credit or recovery and remove the risk of potential losses that might occur because of an extended chapter 11 administration or dismemberment of debtors’ assets and the increased cost associated with breakups. Moreover, the goal of distressed-debt traders and hedge funds to realise recoveries quickly may be obtained by a sale of all or substantially all a debtor’s assets as soon as practicable after the commencement of a chapter 11 case so long as a marketplace for the debtor’s assets exists. 

It is likely that hedge funds and other distressed investors will play an even larger role in the upcoming year. 

Service industries have been expanding in the United States as manufacturing is steadily migrating outside of the United States. As a consequence, there has been an increase in the outsourcing of product development, manufactured products and components, clerical duties, and data processing, and a corresponding decrease in hard assets associated with a debtor. Indeed, physical assets that do exist have become fungible and not dependent on being part of a particular firm or management. Consequently, the assets are more compatible with a potential sale rather than an extended stay in chapter 11.

These changes in the economy, together with the expansion of secured and second lien financing and the different composition of the creditor constituency, have created a different reorganisation environment. The underlying reorganisation paradigm that derived from railroad reorganisations and was basically incorporated into the Bankruptcy Reform Act of 1978 may no longer be viable. 

The 2005 Amendments

The reorganisation paradigm that a distressed business could be reorganised and rehabilitated and emerge as a viable economic unit through the use of chapter 11 was a basic precept to the Bankruptcy Reform Act of 1978. Congress intended that chapter 11 balance the interests of debtors and creditors. Chapter 11 continued the debtor’s management in control during the reorganisation process and afforded the debtor a host of provisions which protected the debtor’s ability to reorganise, while concurrently providing certain safeguards to protect the interests of creditors. Preserving debtor organisations as a going concern to avoid losing value was a paramount objective of the reorganisation scheme. Congress, however, has continued to respond to the needs of certain special interest creditor groups since 1978 by enacting legislation to claw back debtor-oriented provisions, and enlarge creditors’ rights and remedies. The special interest groups that have benefited from such legislation include real and personal property lessors, unions, asbestos claimants, financial institutions, retirees, equipment manufacturers and lessors in the transportation industry, utilities, and trade creditors. The 2005 Amendments to the Bankruptcy Code have further disrupted the balance between the protections of debtors and the rights of creditors that may impair the traditional reorganisation process for distressed businesses. 

The enactment of the 2005 Amendments has further eroded the reorganisation paradigm adopted in 1978. The Bankruptcy Code has been amended several times since its 1978 enactment, with each amendment effectively circumscribing the provisions that had been intended to facilitate and encourage the reorganisation of distressed businesses. The 2005 Amendments effectively repealed the 107-year-old fresh start for individuals who fall within the parameters set forth in the amendment. For business entities, the ability to reorganise has been materially affected. After more than eight years of expensive lobbying’ the special interests of financial institutions, secured creditors, landlords and other groups have prevailed. While certain revisions contained in the 2005 Amendments appear to be designed to address assertions that chapter 11 cases are too lengthy and need to be streamlined, the net result is that a debtor’s ability to reorganise and emerge as a stand-alone rehabilitated entity will be hindered. 

Many of the 2005 Amendments compel the debtor to make major substantive decisions before it may be reasonably determined that the debtor can be reorganised. One of the most significant revisions of the Bankruptcy Code concerns the debtor’s exclusive right to file a chapter 11 plan. Prior to 17 October 2005 the debtor had the exclusive right to file a chapter 11 plan during the first 120 days of the case and the right to solicit and obtain acceptances of such plan during the first 180 days of the case – periods the bankruptcy court could extend for cause. However, for chapter 11 cases commenced on or after 17 October 2005, the 2005 Amendments provide that the 120-day period may not be extended beyond 18 months from the commencement of the case; and the 180-day period may not be extended beyond 20 months from the commencement of the case. This amendment circumscribes the exercise of discretion by the bankruptcy court. Debtors in complex cases will no longer have the ability to extend the exclusive right to formulate and file a chapter 11 plan for as long as cause exists. While limiting the exclusive periods may appear to be desirable, it removes the flexibility and leverage that often resulted in consensual plans of reorganisation. Patently, the change has tipped the playing field in favor of creditors. 

Under the 2005 Amendments, as the 18-month deadline is looming, creditors may cease negotiating with the debtor and wait for the expiration of exclusivity. Recalcitrance of creditors will no longer be cause to extend exclusivity. After the initial 18 months, competing chapter 11 plans may lead to embattled and drawn out chapter 11 cases fighting over valuation issues and related matters. One must conjecture what would have happened to cases such as Enron, United Airlines, Adelphia Communications, etc under the limited exclusivity provision? Restricting the discretion of the bankruptcy court in this respect and others to evaluate the needs of a particular case may be prejudicial to the reorganisation process and the interests of all. 

Similarly, debtors will need to make quicker decisions regarding whether to assume or reject their unexpired leases of nonresidential real property. Under the former section, non-residential real property leases were deemed rejected 60 days after the commencement of the chapter 11 case unless, prior to that time, the court, for cause, extended the 60-day period or the debtor assumed the lease. An extension of this period could be granted until confirmation of the debtor’s chapter 11 plan. The 2005 Amendments change the initial 60-day period to the earlier of 120 days or the date of entry of an order confirming a plan. The 120-day period can be extended by the court, for cause – only once, for 90 days – for a total period of 210 days. The court may grant a subsequent extension only upon prior written consent of the lessor in each instance, an occasion hardly likely to occur. Again, the discretion previously exercised by bankruptcy courts has been eliminated by a mandatory limitation, which will not permit a debtor to monitor the performance of its business for a sufficient amount of time to make an informed decision. The debtor may be coerced into making a premature rejection or assumption of such leases, with possible loss of value or creation of imprudent administrative expenses. 

In addition to the possibility that leases may need to be assumed at an earlier point in a reorganisation case, utilities, under the 2005 Amendments, have the right to seek adequate assurances of future payments in the form of cash or cash equivalents, such as letters of credit, as security deposits, as determined by the utility and not the bankruptcy court. Larger debtor in possession financing facilities and exit financings also will be needed to finance such additional costs, which may result in higher pricing and fees, as well as more restrictive covenants. The 2005 Amendments also provide more rights for reclaiming trade creditors (ie, vendors with a right to be paid for goods delivered shortly before the commencement of a bankruptcy case) to reclaim goods delivered within a 45- day period or have an administrative expense claim for goods sold within a 20-day period. 

Other pertinent changes concern the composition of statutory committees of unsecured creditors and the mode of operation of such committees. The increased rights given to reclamation creditors and trade creditors who would have served on an unsecured creditors’ committee may cause such creditors to decline or remove their need to serve on such a committee. And as discussed above, hedge funds and distressed-debt traders often purchase a large portion of such claims. In all likelihood, creditors’ committees will comprise financial creditors interested only in fast returns on their investments and not the rehabilitation of the debtor for the benefit of its creditors, employees and the general public interest. In addition, creditors’ committees will have to be more responsive to their constituencies by sharing information and soliciting their views. 

The foregoing does not comprise all the changes and political implications of the 2005 Amendments. Other provisions enacted similarly curtail debtors’ protections and limit the discretionary powers of the bankruptcy court. Maximisation of creditor recoveries now appears to transcend rehabilitation. That objective appears to be the intent of the 2005 Amendments. Consequently, chapter 11 of the future will no longer be the reorganisation process contemplated in 1978. 

Conclusion 

A robust economy, an increasing amount of liquidity available primarily through hedge funds, private equity firms and relaxed credit standards by financial institutions, as well as the creditor-friendly revisions to the Bankruptcy Code under the 2005 Amendments, have led to a significant decline in the commencement of chapter 11 cases. 

One of the objectives of the 1978 statute was to encourage debtors to commence chapter 11 cases before they dissipated their assets and prejudiced the ability to reorganise. The effect of the 2005 Amendments is to eradicate that objective. In the future, debtors may resort to chapter 11 only as the last possible alternative, by which time the value of the business and the ability to reorganise may have substantially diminished. It is ironic that as the United States moves away from the classic reorganisation paradigm, many European countries are moving towards a reorganisation model similar to the concept adopted in 1978. 

Of course, in certain instances, the statutory changes may be beneficial. Creditors may be able to obtain higher returns through a sale than an extended chapter 11 case. However, that result also was attainable prior to the 2005 Amendments. The difference is that the scale has been weighted in favour of the secured creditors and in certain circumstances other creditors, none of whom may have a long-term perspective that encompasses all the factors and objectives once considered part of the fabric of chapter 11. Accordingly, debtors will need to do a great deal more planning in advance of commencing a chapter 11 case or risk losing control of the reorganisation process and future businesses. 

While capital will continue to flow readily in 2007, a new wave of chapter 11 reorganisations may emerge in the not too distant future. Leveraged buyouts by hedge/ private equity funds are on the rise. Some experts anticipate a deterioration in credit quality. Risky strategies may be clouding serious business problems, leading to an increase in defaults and the need for restructuring and reorganisation. Hedge/private equity funds and other nontraditional creditors will be dominant forces as the drama unfolds.

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