Introduction I. Statutory Framework / Key Players and Concepts

Overview of US Bankruptcy Law Chapter 9 Plan of Adjustment
U.S. Workout/Insolvency Law Course University of Belgrade Faculty of Law FALL 2014 J. Robert Stoll Mayer Brown LLP Visiting Professor University of Belgrade Faculty of Law Aaron Gavant Mayer Brown LLP Fall 2013

Introduction I. Statutory Framework / Key Players and Concepts
II. Overview of Asset Sales Under Section 363 of the Bankruptcy Code III. DIP Lending and Cash Collateral Financings IV. Recovery of Vendor Claims: From Reclamation to Critical Vendor Programs V. Avoidance Powers: Fraudulent Transfer and Preference VI. Plan of Reorganization: Some Rules of the Road

Statutory/Judicial Framework: Bankruptcy System for Business Entities
US Has a National System of Bankruptcy Laws Provides a uniform set of laws (the Bankruptcy Code) and procedures (the Bankruptcy Rules) Even so, regional differences exist – e.g., critical vendor Who May be a Debtor under the Bankruptcy Code? Almost all business entities qualify (e.g., corporations; partnerships; individuals and sole proprietorships) Excludes entities subject to specialized regulatory schemes: Banks and insurance companies have separate regimes

Statutory/Judicial Framework: Bankruptcy System for Businesses
Other Eligibility Requirements are Modest: No requirement of insolvency: to encourage early resort to bankruptcy when reorganization is possible Good faith is required: Must suffer from financial problems justifying resort to bankruptcy laws Must have nexus to US – be a US entity; have assets or principal offices in US Commencement of the Case Voluntary: order for relief is automatic upon filing Involuntary by creditors: order for relief is only after court determines debtor is generally unable to pay its debts

Types of Bankruptcy Code Cases: Chapter 7: Governs Liquidation Proceedings Trustee is always appointed to liquidate assets and distribute proceeds to creditors in accordance with statutory priorities Chapter 11: Governs Reorganization Proceedings Goal is negotiation of a plan of reorganization Flexible process designed to preserve “going concern” value No automatic trustee appointment Chapter 9: Governs Reorganization Proceedings for Municipalities and other Governmental Entities Chapter 12: Governs Reorganization Proceedings for Farmers Chapter 15: Governs Foreign and Cross-Border Insolvency Cases

Federal Bankruptcy Court System Bankruptcy judges: Appointed to handle only bankruptcy matters; have special expertise Expansive jurisdiction to consolidate all matters involving the debtor and its property before the court Appeals go through the federal court system Venue Bankruptcy courts are in every state Favored venues for large cases: NY and Delaware

Initiation of Cases Voluntary: Commenced by filing of petition with the bankruptcy court by the debtor There is no insolvency or other financial conditions requirement Involuntary: Commenced by filing of petition by creditors against the debtor If the debtor has <12 creditors overall, only one creditor is required to sign the petition, who must hold noncontingent, undisputed, and unsecured claims that aggregate at least $15,325 If the debtor has >12 creditors, the petition must be signed by three creditors who hold noncontingent, undisputed, and unsecured claims that aggregate at least $15,325 An involuntary case may only be commenced under chapter 7 or chapter 11; a municipality cannot be the object of an involuntary petition in a chapter 9 case

Key Players Debtor in Possession: Curse or Blessing?
Pre-bankruptcy management remains in control in Chapter 11 cases – philosophy is that they can best maximize values Trustees can be appointed in cases of fraud, gross mismanagement or other cause Trustees are rarely appointed in Chapter 11 – even in cases of spectacular failures (Lehman and Enron)

Key Players Unsecured Creditors Committee – Chapter 11: Curse or Blessing II? Selected from largest unsecured creditors, unless adverse interest Active player on all major issues – DIP financing; assets sales; reorganization plans; litigation against other creditors Acts to protect interests of unsecured creditors as a whole Professionals of the UCC are paid by the estate

Key Players Secured Creditors Bankruptcy Judges
Often the key constituency – control access to financing Rarely have official committees for secureds Bankruptcy Judges No direct managerial involvement in debtor; rule on matters requiring court approval or adversary proceedings Rules prohibit “ex parte” communications; still, often perceived as having “pro-debtor” tendency

Key Players US Trustee: Intended as a Watchdog Governmental Appointees
Acts to protect the integrity of the bankruptcy system, but sometimes seen as inflexible Handles administration: Select trustees; Appoints committees

Key Concepts: Automatic Stay
Upon filing, creditors are stayed from collecting claims, from taking possession or control of property, or from taking setoffs Purpose is to protect the estate from dismemberment and to give DIP/Trustee a breathing spell Stay can be lifted for cause – e.g., to allow setoff or if collateral is not “adequately protected” A number of actions are exempt from the stay Swaps; repos; securities contracts can be closed out Exercise of police power – e.g., environmental laws are enforced

Key Concepts: Who Trumps Whom – Priority Scheme in Bankruptcy – Claims and Interests
Secured Creditors (DIP lenders and pre-bankruptcy lenders) – get highest priority but only to extent of the proceeds/value of collateral Administrative Expense Claims First to DIP lender with superpriority Second to post-bankruptcy claimants (vendors; professionals; obligations under assumed contracts) and to some pre-bankruptcy vendor claims But, then give priority to subsequent Chapter 7 creditors

Key Concepts: Who Trumps Whom – Priority Scheme in Bankruptcy
Pre-bankruptcy claims First, to priority claims (taxes; employees priority; deposits) Second, to general unsecured claims (trade; deficiency claims of secureds; rejection claims) Third, to subordinated creditors Fourth, to equity holders (together with any litigation claims based on equity)

II. Claims and Interests (cont’d)
Trading/Sale of Claims: Substantial market for trading of claims; particularly in large cases Validity/Enforceability Original Issue Discount Setoffs/Preferences Subordination Risks Warranties/Reps in Assignment/Sale Documents Disclosure Issues: Bankruptcy Rule 2019 may require certain disclosure of information

Key Concepts: Executory Contracts and Leases – a Brief Overview
DIP/Trustee has right to assume or reject contracts Decision is left to DIP/Trustee’s business judgment Some exceptions: e.g., agreements to make loans Pending decision, non-debtor must generally perform if paid currently for its performance Assumption, requires DIP/Trustee to cure all defaults, and give adequate assurance; and then must perform going forward Can also assume and assign Rejection relieves debtor from all obligation to perform, but gives non-debtor a claim for damages; special rules cap damage claims for leases

Key Concepts: Asset Sales Under Section 363 of the Bankruptcy Code
Section 363(b) of the Bankruptcy Code authorizes a debtor to sell property of the estate outside of the ordinary course of the debtor’s business with the prior approval of the bankruptcy court Sales or dispositions of property that are in the ordinary course do not require court approval 363 sales are increasingly common for various reasons, including the speed and finality with which they enable a debtor to monetize its business assets on a going concern basis and the fact that there are increasingly fewer successful reorganizations in Chapter 11

Overview of Asset Sales Under Section 363 of the Bankruptcy Code
363 sales provide important protections and related benefits to buyers that acquire assets Assets sold under Section 363 of the Bankruptcy Code are transferred “free and clear” of interests claimed by third parties Typically, claims or interests of third parties will attach to the proceeds of the sale, and the amount and relative priority of such claims and interests can be determined at a later date after the sale has closed

Ability to sell assets subject to third party claims and interests is not unlimited; sale must satisfy one or more of the following five requirements: Applicable non-bankruptcy law permits sale of such property free and clear of interests Entity claiming an interest consents to the sale free and clear of its interest or claim The claimed interest is a lien and the price to be obtained exceeds the aggregate of all liens against the property The claimed interest is subject to a bona fide dispute Entity claiming an interest can be compelled in a legal or equitable proceeding to accept money satisfaction of its interest

Case law is mixed whether Section 363(f) of the Bankruptcy Code authorizes bankruptcy court to order that a sale is free and clear of successor liability Better view is that the order cannot provide such protection, especially when the asserted claim bears no relationship to the subject assets However, where it can be established that the party asserting successor liability received notice of the sale and did not timely object or preserve its rights, party may be barred from seeking to impose successor liability under principles of res judicata

One of the benefits of acquiring assets under a 363 sale is that it eliminates any fraudulent transfer risk since Terms of the sale, including purchase price and other considerations, will be “blessed” by the sale order entered by the court No issue whether value paid is reasonably equivalent since assets were sold pursuant to court-approved process

Party objecting to proposed 363 sale must obtain stay pending an appeal in order to prevent consummation of a sale to a “good faith” purchaser Section 363(m) provides that reversal of sale order on appeal does not affect transfer of assets to a good faith purchaser; sale order should contain specific finding that buyer is entitled to protection of 363(m) In such circumstances, objecting party will need to post a bond, typically an amount equal to purchase price, to prevent consummation of sale pending its appeal Sale agreement should provide buyer with discretion to decide whether to close in the face of such an appeal

Summary overview of 363 sale process Absent extraordinary circumstances, proposed sale will be subject to competitive bidding process DIP/Trustee must demonstrate proposed sale is result of sound business judgment and in best interests of estate DIP/Trustee must demonstrate assets were effectively marketed and that the sale process will yield the “highest and best” value obtainable for the assets under the circumstances

In connection with a competitive bidding process, there often is a “stalking horse” bidder DIP/Trustee and its professionals typically will seek to negotiate an initial purchase agreement with a stalking horse bidder and then seek approval of the sale to that party or to a higher bidder pursuant to proposed bidding procedures Process can take many different forms Much of the actual due diligence, marketing and negotiations to determine the stalking horse may take place before a 363 sale motion is even filed, particularly in larger cases with sophisticated debtors

Advantages to Being a Stalking Horse Bidder: Provides timing advantage where extensive due diligence or regulatory approval is necessary since stalking horse bidder likely to have advantage over other potential competing bidders; ability to demonstrate certainty and ability to close provides advantage over competing bids Can shape the sale contract and potentially require other competing bidders to use its form of agreement Ability to negotiate bid protections, including, at least, expense reimbursement and typically some amount of a break-up fee; bid protections require bankruptcy court approval Influence bidding procedures, including minimum overbids, closing contingencies, right to credit-bid break-up fee, mechanism for valuing non-cash consideration, criteria for qualifying competing bids, and process of identifying higher and better bids at auction

Potential Disadvantages to Being a Stalking Horse Bidder Due diligence/negotiation expenses at risk until bid procedures, including, inter alia, expense reimbursement, are approved May over-price assets Potentially allows other bidders to utilize your due diligence efforts at less expense

363 Sales Usually Involve a Two-step Process Motion to approve bid procedures, including bid protections, Typically, this will be heard on fairly expedited basis, some period of due diligence may follow and, if qualified bids submitted, a sale auction will be held to determine highest and best bid Motion also will seek to schedule a hearing to approve the sale Includes proposed form of sale order; minimum 20 days’ notice required before sale hearing, which usually is scheduled as close to completion of auction as court’s calendar allows Also includes process of identifying executory contracts and unexpired leases to be assumed and assigned to winning bidder, including notice and cure procedures

DIP Financing / Cash Collateral Financings
Introduction “Offensive” DIP Lending “Defensive” DIP Lending Adequate protection “Bootstrapping” Cash Collateral Financings “Exit” Financing

Timeline for DIP Financing
Short Timeline to Finalize DIP Financing Limited Due Diligence Expense Agreement Documentation: Term Sheet; Credit Agreement and Order Approving DIP Financing Two-Step Court Approval Process

Timeline for DIP Financing
The Interim Hearing and Order “First Day” Motion; limited opportunity to object Capped Commitment – limit as necessary to prevent irreparable harm until the final hearing Finding of Good Faith: protects lender from reversal on appeal The Final Hearing and Order Schedule for the final hearing Re-trading the deal with creditor committee, US trustee/negotiating leverage Good faith lender still protected against appeals

Reasons to Engage in DIP Financing: Offensive
Profitable: Interest rates and fees are often higher than traditional lending Business Opportunity: DIP Loans may lead to exit loans and other post-confirmation business Bankruptcy Protections

Reasons to Engage in DIP Financing: Offensive
Court Order Provides Lien package Lien on free assets / junior lien on liened assets Priming lien / if “adequate protection” to existing lienholder Automatic perfection of collateral Given superpriority claim Clearer path to exercise remedies upon default Protection from appeals

Reasons to Engage in DIP Financing: Defensive
Leverage to Get “Adequate Protection” for Secured Loans Cardinal Rule: Adequate Protection Required for Secureds No use of cash collateral permitted without adequate protection Debtor’s use of collateral conditioned upon provision of adequate protection Stay must be lifted if adequate protection is not provided What is Required: Protect from Diminution in Collateral Values Numerous considerations taken into account (e.g., valuation; debtor’s financial performance)

Typical Forms of Adequate Protection Periodic cash payments Junior replacement lien on DIP lenders’ collateral package Junior superpriority claim – to extent protection is inadequate Additional “Defensive” Benefits Approval of budget process; financial reporting requirements Other performance covenants, e.g., requiring assets sales Secure waiver from debtor to challenge liens; limit time for creditors committee to bring challenges

“Bootstrapping” Strategies Bootstrapping – Cross-Collateralization Granting liens to “shore-up” existing loans is controversial Almost never approved if lender is not fully collateralized Purpose of adequate protection is protecting not improving position Sometimes approved if lender is fully secured and financing not otherwise available Bootstrapping – “Roll-up” Using DIP loan to pay out existing loans Also controversial: protects from “cramdown” and restructuring Some courts will approve if loans are fully secured and if successful reorganization is likely “Roll-over” – using collections to first pay down existing debt raises similar issues

“Cash Collateral” Financings
Form of Defensive Financing: Similar to DIP lending, except: No “new” $$ lending Recycles cash and collections Finances operations and preserves going concern values Way to obtain adequate protection – similar to DIP lending Similar Short Timeline to Negotiate Cash Collateral Financing Similar Two-Step Approval Process Avoids Litigation Risks in “Contested” Cash Collateral Hearing

Other DIP Lending / Cash Collateral Issues
Carve-Out Most courts require “carve-out” to pay professional fees Typical arrangement – “carve out” $$ amount from collateral Carve-out allows for wind-down Restrictions on use of carve-out: not to litigate with lenders Termination of DIP Loan / Cash Collateral Order Relief from stay; notice; bankruptcy court involvement Collateral Surcharge Recover from collateral cost of its preservation and sale Waiver provisions remain controversial

Potential Risks Associated with DIP Lending / Cash Collateral Financing
Limited Due Diligence Potential Creditor Challenges to Prepetition Claims and Liens Second Lien Disputes over Waivers of Adequate Protection and Related Rights Failure to Confirm Plan / Conversion to Chapter 7

Exit Financing Purpose of Exit Financing: Funds Emergence from Chapter 11 Benefits to Lenders Debtor has “deleveraged” balance sheet Defensive: releases and protections for existing lenders Special findings and decrees Potentially higher fees and interest rates

Recovery of Vendor Claims: From Reclamation to Critical Vendor Programs
Bankruptcy Code provides sellers of goods with certain additional protections that are not afforded to other creditors Whether creditor is a “seller of goods” (e.g., as opposed to, provider of services) may be subject to dispute Courts look to various definitions (e.g., Bankruptcy Code, Uniform Commercial Code, etc.) Seller may “reclaim” goods it has sold to the debtor, if goods were received by debtor within 45 days of petition date assuming debtor as already insolvent (subject to any priority rights of a secured creditor in same goods)

Recovery of Vendor Claims: From Reclamation to Critical Vendor Programs
Seller may also seek to recover unpaid prepetition amounts through “critical vendor” payment programs Not expressly authorized by statute and may be contrary to other payment/priority provisions of the Bankruptcy Code Debtor’s ability to obtain approval of such program may therefore depend on particular jurisdiction and particular judge

Avoidance Powers: Preferences
Elements of Preference, Bankruptcy Code § 547 Transfer made on account of preexisting debt Made while debtor is insolvent Made within 90 days of bankruptcy (1 year if insider) Allows creditor to recover more than in liquidation Limitation period for suit – 2 years Typical Examples: Grant of collateral to unsecured lenders; Payments made to creditors – lenders and suppliers

Avoidance Powers: Preferences
Key Defenses to Preferences Payment was made in the ordinary course of business New value: value given by creditor to debtor after an otherwise preferential payment Payments to a “fully secured” creditor – so that not receiving more than in a liquidation Contemporaneous exchange for new value – no antecedent debt

Avoidance Powers: Fraudulent Transfer
Fraudulent Transfers, Bankruptcy Code §§ 544, 548 DIP/Trustee Can Avoid Transfers and Obligations: If (1) debtor didn’t receive “reasonably equivalent” value, and (2) Debtor was insolvent or had unreasonably small capital Can also challenge based on debtor having had actual intent to defraud, delay or hinder creditors Highly Fact-Intensive Determinations Determinations are made as of the date of the transaction Battle of experts Limitations period for voiding transfers is 2 years under bankruptcy law, and extends to 4 to 6 years using state laws

Avoidance Powers: Fraudulent Transfer
Remedy for Fraudulent Transfer Recovery of the property transferred or its value Elimination of the obligation incurred If party was in “good faith,” then protected from avoidance to the extent of the value given Examples of Fraudulent Transfer Attacks Sales of assets (e.g., Calpine; Asarco) LBO transactions have also been subject to attack Dividends

Set Offs: An Overview Set off is Protected in Bankruptcy, except
It is subject to the Automatic Stay Cannot set off if no “mutuality” (same parties; same capacity) Cannot set off if claim owed to Debtor was incurred or acquired during the preference period for purpose of creating a setoff The pre-bankruptcy exercise of a setoff can be avoided to the extent the creditor got an improvement in its position during the 90-day preference period.

Protected Contracts: Safe Harbor Provisions
Swaps; Repos; Securities Contracts; and Forward and Commodity Contracts are Given Special Protections: They are exempt from the automatic stay and can be freely closed out based on the debtor’s bankruptcy Protections include the right to net out and set off collateral proceeds Pre-bankruptcy transfers made in connection with protected contracts are protected from avoidance – except when made with intent to defraud

Subordination Types of Subordination and Treatment in Bankruptcy
Contractual Subordination Where the subordinated creditors contractually agree to payment after the seniors Contractual subordination agreements are enforceable according to their terms in bankruptcy under section 510(a) of the Bankruptcy Code Structural Subordination Where the holding company creditor’s claim comes out behind claims based on debt extended to the operating company, to the extent the operating company has assets Generally, corporate formalities recognized in bankruptcy; however, risk of substantive consolidation (Owens Corning)

Plan of Reorganization: Some Rules of the Road
Ultimate Objective of a Chapter 11 Case is the Confirmation of a Plan of Reorganization Plan is, in essence, a new contract that reshapes and governs the prepetition debtor/creditor relationships and obligations Bankruptcy Code imposes strict requirements that must be met in order for the court to confirm a plan The requirements attempt to balance the sometimes competing goals of promoting successful reorganizations, assuring equality of treatment of similar claims, and protecting fundamental notions of due process Chapter 11 plan process does not always result in reorganization; case may also result in confirmation of a plan of liquidation

Only the debtor may file a plan within an exclusive period of time In small business cases (i.e., undisputed debts of less than $2 million), debtor has exclusive period to file that is 180 days from filing date; unless extended or decreased for cause, up to maximum extension of 20 months In any other business cases, period is 120 days from filing date, unless increased or decreased for cause, up to maximum exclusive period of 18 months Appointment of Chapter 11 trustee terminates exclusivity period At end of exclusivity period, any party in interest (e.g., banks, creditors’ committee, etc.) may file plan

A plan of reorganization must: classify all claims and interests specify any class that is not impaired describe the treatment to be accorded any impaired class; treat every claim or interest within a particular class identically establish adequate ways to implement the plan (e.g., raise new capital, sell assets, exit financing, selection of management)

A plan of reorganization may provide for: any class of claims or interests to be impaired or unimpaired the assumption, rejection, or assignment of executory contracts or unexpired leases the settlement of any claim or interest the liquidation of all or substantially all of the estate’s property the modification of the rights of secured and unsecured creditors any other appropriate measure

Plan Typically Contains Placement of creditors into various classes Administrative (e.g., expenses of the bankruptcy – post-petition trade credit, professional fees) Secured (debt secured by a perfected lien on assets) Priority unsecured (e.g., taxes, employee claims – up to $10,950) General unsecured claims (e.g., trade debt) Equity (e.g., common stock)

Treatment of Creditors (typically) Bankruptcy Code requires plan to provide for payment in full of administrative and non-tax priority claims Certain unsecured tax claims paid out in installments up to 5 years (with enough interest so deferred payments equals present value of tax claim) New note to secured lenders, secured by lien on same collateral Negotiate pro-rata distribution of cash and/or stock in reorganized entity to unsecured creditors No recovery for equity, existing shares cancelled

Implementation of Plan (typically) Raise new capital (issue new stock; exempt from registration under securities laws) Sell certain assets to raise funds to pay creditors Replace DIP financing with exit financing to provide additional liquidity upon emergence from Chapter 11 Change management Select new board of directors If plan provides for liquidation, appoint a plan administrator or liquidating trustee of trust

Plan Approval Process Typically a two step process in which plan proponents first obtain approval by the bankruptcy court of a “disclosure statement” Following approval of disclosure statement, proponents can proceed with solicitation of votes to accept plan, and if enough votes are received, can then proceed with hearing to seek confirmation of plan by the bankruptcy court In rare circumstances, generally involving single asset real estate or simple capital structure, court may combine disclosure statement and plan confirmation hearings

Acceptance of a plan is determined through votes cast for or against confirmation of the plan Some classes will be deemed to reject and, therefore, not be entitled to vote, if plan provides for no recovery (e.g. equity) Other classes will be deemed to accept and, therefore, not solicited if plan provides for full recovery (e.g. administrative claimants) Holders of impaired claims are entitled to vote and will be solicited (creditor may hold claims in more than one class and have more than one ballot to submit) Confirmation requires acceptance by at least one impaired class of creditors based on holders representing at least 2/3 in amount and more than 50% in number of all claims in class voting in favor of confirmation Claims may be estimated for voting purposes

Even if approved by creditors, plan still must be confirmed by the bankruptcy court, which will consider 16 factors, including: Feasibility; confirmation of plan will not be followed by liquidation of company; standard does not require guaranty of success but cannot impose too much risk of failure Best interests test; does plan provide each creditor with at least as much recovery as it would on account of its claim as it would receive in a straight liquidation Has at least one impaired, non-insider class voted in favor of confirmation

Through “cram down,” bankruptcy court may confirm plan over the objection of one or more classes as long as: All other confirmation requirements are satisfied AND Plan does not “discriminate unfairly” and is “fair and equitable” as to each such dissenting class of creditors Satisfaction of these cram down requirements differ depending on whether the dissenting class is comprised of secured, unsecured or equity interest holders “Unfair discrimination” means that similarly situated creditors must not receive substantially different treatment under the plan (e.g., court may find plan to be unfair if it provides payment in full of trade debt but no distribution to another class comprised of the Bank’s unsecured deficiency claim)

“Fair and equitable” treatment means different things for different classes of creditors Secured creditors are entitled to receive the “indubitable equivalent” value of their claim; With respect to the so-called “absolute priority rule,” unsecured creditors are entitled to be paid in full before equity receives any distributions on account of their prepetition equity interests, unless equity can successfully apply the “new value” exception to the absolute priority rule

Confirmation of Plan is Not the End of the Chapter 11 Case Plan must still become “effective” and be substantially consummated in order for debtor to emerge from Chapter 11 as a reorganized company Final determination of allowance of unsecured claims may not occur until long after plan has been confirmed; no statute of limitations for objecting to allowance of a claim May be many years before all distributions contemplated by a plan are finally made Effect of discharge, injunction and release under confirmed plan

Introduction I. Statutory Framework / Key Players and Concepts

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Introduction I. Statutory Framework / Key Players and Concepts

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