Balancing Creditor and Equity Interests Provides Incentive to Utilize Chapter 11 for Mutual Benefit

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Dec/Jan 2003

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Since its enactment in 1978 chapter 11 appears to have gradually evolved into a more creditor-oriented procedure.
The creditor orientation has certain appeal since it respects existing priorities between the various stakeholders.
However, this trend may have exacerbated what some might view as a flaw in the system. The problem is that
companies may not be opting to utilize chapter 11 as early as they should in order to help fix operational and/or
leverage problems.<a href="#3" name="3a">3</a> This disconnect is particularly pronounced with respect to closely held businesses. The
incorporation into chapter 11 proceedings of the absolute priority rule and the limited period of debtor exclusivity to
file a reorganization plan are designed to be beneficial to creditor constituencies, but are detrimental to the interests
of management and stockholders. Since management and stockholders are likely to be the very people who make the
decision of whether or not to file a chapter 11 proceeding, these provisions, among others, make chapter 11 less
attractive to the decision-makers. Ironically, in the long run this reticence about filing could impact creditor
recoveries negatively.

As a result, the use of chapter 11 as a business tool for fixing sick companies has diminished over time. In
many cases, because debtors have elected to delay filing, chapter 11 has become a substitute for foreclosure
proceedings for the benefit of creditors. Certainly, selling assets in a chapter 11 proceeding allows for sales as going
concerns and, therefore, should provide more benefit to creditors than liquidation by foreclosure. Because many
companies that could be otherwise restructured significantly delay filing chapter 11, this leads us to conclude that a
substantial loss in value to creditors and equity alike is prevalent. Put another way, the opportunity for creditors and
equity-holders to realize the going-concern value from a successful reorganization may all too often be squandered in
favor of "better-than-liquidation" value realized in §363 sales.

A professional approached to advise a debtor (including a closely held business) in financial difficulty is often faced
with moral and ethical dilemmas because of the current trends in chapter 11 cases favoring creditors. The
professional must harmonize his or her duty toward the fictional corporate entity, which may be at odds with the
interests of management and equity that are often focused on their own financial plight (notwithstanding their own
duties to all constituents). Creditor interests often differ from those of management and stockholders. The
developing corporate-law theory of applying an additional fiduciary duty to creditors when the zone of insolvency is
reached further complicates the decision-makers' conundrum.

<h3>Business Arrangements and Reorganizations Under the Bankruptcy Act</h3>

Prior to the passage of the Bankruptcy Code in 1978, there were essentially two choices available for
business debtors under the Bankruptcy Act—chapters X and XI.<a href="#4" name="4a">4</a> These were designed to reflect a distinction
between closely held businesses and large, public companies.<a href="#5" name="5a">5</a> That is, closely held businesses were expected to
restructure under chapter XI, while large, public companies were expected to look to chapter X. This distinction
reflected Congress's awareness that different debtor types required different frameworks for reorganization.

Under chapter XI, certain leverage was afforded to the debtor. For example, while under chapter XI, the
debtor, which typically remained in possession of its assets, was the plan only entity permitted to file a
reorganization plan and was not limited by an exclusive period for filing a plan. In addition, the absolute priority
rule did not apply. Creditor protections included an absence of a cramdown and, at least on the surface, the plan of
arrangement could not alter the debtors' secured debt. In practice, however, the imposition of the automatic stay
usually generated positive negotiations with secured creditors.

Chapter XI reflected a public policy favoring the ability of closely held businesses to reorganize. Because
chapter XI allowed value to flow to stockholders of closely held businesses, it naturally was less threatening to the
principals of the closely held business. Further, the closely held business debtor, as the exclusive plan proponent,
could propose to maintain its current management. This leverage, coupled with the absence of an absolute priority
rule, aided the closely held business in its reorganization efforts and provided an incentive for proposing a plan that
shared the going-concern value between the creditors and the stockholders.

While a successful reorganization was not certain, it was clear that the possibility of the business being
retained by equity interests was likely. With no limitation on the exclusivity period, the closely held business
debtor was given time to solve the operational and/or leverage problems that forced the debtor to reorganize in the
first place. In an arrangement under chapter XI, unsecured creditors would realize significantly greater value than
they would through a liquidation, and equity-holders were permitted to retain value.

As a matter of policy, many have argued that it is unfair for stockholders to retain any interest until
creditors are paid in full. On the other hand, a major purpose of a reorganization-based system (vs. a
liquidation-based system) is to produce more overall value for constituents. If a case is filed with sufficient time to
incorporate a business solution, then there should be more value to share between the various stakeholders than is
likely to be available to creditors alone when the reorganization is commenced too late to provide a higher level of
benefit to all of the debtor's constituents.

In chapter X cases, creditors' interests were paramount. Under chapter X, a trustee was automatically
appointed to exercise control over the administration of the estate and businesses operations; the absolute priority
rule was imposed and could not be waived. In addition, the likelihood that management would be replaced and
stockholders' interests would be eliminated was all but a foregone conclusion.

It does not take an economic genius to recognize that if chapter X was a likely disaster for the very people
deciding whether to file, few chapter X petitions would be filed. Of course, that is precisely what happened. In
addition, the creditors found chapter X cumbersome and too costly. Because the Bankruptcy Act did not specifically
define the type of debtor required to file under chapter X or XI, the choice of chapter XI over chapter X
predominated, even by large, public corporations. Today, the more chapter 11 appears to the corporate
decision-makers to resemble old chapter X, the less likely it is that corporations will file in a timely manner.

<h3>Obstacles to Reorganization Under the Bankruptcy Code</h3>

Under the Bankruptcy Code, no differentiation is made between closely held businesses and large, public
companies. Underlying policy considerations, however, may warrant different rules for different types of business
debtors. In drafting the current Bankruptcy Code, many provisions of chapters X and XI of the Bankruptcy Act were
merged into chapter 11. During Congress's debate over the adoption of the Bankruptcy Code, no significant
challenge was raised as to the application of the proposed "one-size-fits-all" chapter 11 system for closely held and
publicly held businesses. While the Bankruptcy Code distinguishes debtors in certain circumstances,<a href="#6" name="6a">6</a> most
business bankruptcies are required to file under chapter 11, which contains uniform provisions that do not allow for
differentiation based on debtor type.<a href="#7" name="7a">7</a>

The problems with the Bankruptcy Code's lack of differentiation between closely held businesses and
public companies stems from the classic corporate structure of these two entities. The construct of a corporation as a
separate entity was created as a legal fiction to enable entrepreneurs to invest in a business with little risk to their
personal wealth, other than to the extent of their own personal investments in the corporation. Closely held
businesses frequently have few stockholders, most of whom are involved in the day-to-day management of the
business and many of whom are likely to be guarantors of the company's bank debt. The shares of a closely held
business are not exchanged in a public market and are often subject to transfer restrictions.

When such a closely held business is contemplating chapter 11, usually the stockholders/managers initiate
a professional consultation (e.g., lawyer and/or investment banker). In this scenario, the stockholders likely are
concerned with their personal business problems as well as the problems of the business. The professional here has a
fiduciary duty to his or her client (i.e., the closely held business), but unless the business is reorganized and the
stockholders' interests survive, the professional has not truly achieved the objectives presented by the individuals
who consulted with him or her at the outset of the case.

The management and stockholders contacting the professionals will view the corporate fiction as a mere
instrumentality for their entrepreneurial endeavors. That is, of course, why we have corporations in the first place.
Corporations allow the entrepreneur to further his or her business interests while providing a fictional vehicle used
to protect the entrepreneur's assets. The growth of the American economy was due in no small part to this
development. It would be consistent with this protective philosophy to allow entrepreneurs an opportunity to
restructure their instrumentalities during difficult times. Such a policy choice was inherent under chapter XI of the
Bankruptcy Act, but not under chapter X.

The policies surrounding reorganization of public companies are somewhat different from those presented
by the closely held business. In public companies, stockholders are often separate from management. This results in
professional managers running the company and a diverse body of stockholders serving as absentee owners.
Generally, these stockholders are independent investors who, in purchasing the stock, assumed the risk of the
success or failure of a company. However, we would also observe that in order to preserve the flow of equity capital
to larger, public entities, stockholders must not have their investments eradicated because of a snapshot at a
particular point in time when a business has stumbled and enterprise valuation of a company may ebb at or below
the face amount of the debt for what may be a temporary period.

A creditor-oriented case can be made that it is appropriate to distribute value according to the priorities the
parties contracted for and what the non-bankruptcy law already dictates. While the result may or may not be fair and
appropriate on a case-by-case basis, the question is whether the reorganization system is working. Again, because
preservation of value for stockholders in chapter 11 may be viewed as problematic by the decision-makers, many
companies do not file until it is too late to preserve the optimum value of the business.

There are pre-packaged cases that work, where much of the reorganization is done prior to filing so as to
lessen the uncertainty inherent with chapter 11, but those cases typically provide balance-sheet fixes only. If a
company requires the protection of the automatic stay to undergo an operational fix, chapter 11 is less likely to
provide the time necessary to accomplish that goal and consequently will be less favorably viewed by the
constituency making the decision of whether to file.

Therefore, this problem is prevalent with respect to both public and closely held companies, but it may be
more pronounced with respect to closely held businesses. While it is beneficial that value is being realized for
creditors, the blood, sweat and tears of the owners are not being accorded the same consideration as under chapter XI
of the Bankruptcy Act. These facts seem to diminish the use of chapter 11 for traditional reorganizations,
particularly where operational remedies are required.

The difficulties faced by a closely held business in reorganization under chapter 11 often stem from the
debtor's limited exclusive period provided under §1121(b) to file a reorganization plan, and the application of the
absolute priority rule pursuant to §1129(b)(2)(B)(i) and (ii).

<h3>Exclusivity</h3>

As discussed above, chapter XI of the Bankruptcy Act did not have a defined exclusive period within
which the debtor must file a plan. Under chapter XI, the debtor retained exclusivity throughout the case. This gave
the debtor an opportunity to fix the business, not just to mend the balance sheet. Under chapter 11 of the
Bankruptcy Code, however, the debtor retains an exclusive period for only 120 days to propose a reorganization
plan.<a href="#8" name="8a">8</a> For many companies, this 120-day exclusive period is hardly sufficient to correct their balance sheets and is
not a sufficient amount of time in which to stabilize the business and fix the problems that forced the company to
file for relief in the first place. Often, a business needs an opportunity within chapter 11 to solve business problems
that cannot be adequately addressed without the benefit of the automatic stay. The mere hope of a court-allowed
extension of exclusivity (which is certainly to be expected in larger, public-company filings)<a href="#9" name="9a">9</a> can be perceived as
too risky to make chapter 11 an attractive option to management and stockholders—particularly in closely held
businesses.

Once exclusivity ends, the debtor loses much of its leverage, and the creditors are able to propose a plan
that likely would seek to oust current management and obtain ownership of the debtor. Another possible alternative
is that the creditors could propose a reorganization plan that calls for a sale of the business's assets, and the price
may not fetch enough to leave anything for equity interests of the closely held business. As a result, closely held
companies may not be encouraged to file a chapter 11 at the point in time where values are most likely to be
preserved.

<h3>Absolute Priority Rule</h3>

Under the Bankruptcy Act, a chapter X case was confirmed if found to be "fair and equitable." To be "fair
and equitable," a plan must respect the "role of full or absolute priority,"<a href="#10" name="10a">10</a> which means "to the extent of their
debts[,] creditors are entitled to priority over stockholders against all the property of the insolvent corporation."<a href="#11" name="11a">11</a>
The absolute-priority rule under chapter X was paramount and could not be avoided, even with consent. The
absolute-priority rule applied, not only between creditors and stockholders, but between different creditor classes as
well.

Conversely, chapter XI left the issue of fairness to be bargained for between the debtor and its creditors.
This bargaining often resulted in the sharing of the going-concern value of the debtor's assets between its creditors
and its stockholders. The absence of an absolute-priority rule under chapter XI of the Bankruptcy Act provided an
incentive for the management and stockholders of the business to pursue a timely chapter 11 filing rather than to
risk continued diminishment of the company.<a href="#12" name="12a">12</a>

Under chapter 11, unlike chapter XI of the Bankruptcy Act, the absolute-priority rule applies to every
business debtor type eligible for relief under chapter 11. Unlike chapter X, however, chapter 11 permits an affected
class to waive the absolute-priority rule upon consent of the affected class. Depending on the circumstances of a
given chapter 11 case, creditors and equity-holders may agree consensually to transfer value among the classes
outside of the normal priority scheme. It is becoming increasingly difficult, however, to obtain waivers of the
absolute-priority rule.

<h3>A Trend Toward Differentiation</h3>

During the 1980s, family farmers were hit hard due to severe economic deflation coinciding with reduced
exports.<a href="#13" name="13a">13</a> In response to the economic hardship facing family farmers, Congress enacted The Family Farmer
Bankruptcy Act of 1986, which was codified as chapter 12 of the Bankruptcy Code to address the unique interests
of the family farmer contemplating reorganization.<a href="#14" name="14a">14</a>

<blockquote><blockquote>
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The concern is that in seeking to provide "fairness" to creditors, there may be insufficient incentive for decision-makers to utilize the benefits of chapter 11.
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</blockquote></blockquote>

In addition, pursuant to the Bankruptcy Reform Act of 1994 (the "1994 Amendments"), Congress
attempted to ease the procedural requirements of a reorganization for small businesses, including a shortened
100-day exclusivity period to file a plan.<a href="#15" name="15a">15</a> In practice, however, few small-business debtors elect to be considered a
small business under chapter 11 because the provisions for small businesses are often worse for such debtors. A
reduced exclusivity period is rarely sufficient for management and stockholders to fix the underlying business
problems. The 1994 Amendments also added a new concept—the "single-asset real estate" case. The amendments
dealing with single-asset real estate cases were developed to address the primarily two-party disputes inherent in
these types of cases.

<h3>Conclusion</h3>

These recent changes represent a philosophical change that, under chapter 11, one size does not necessarily
fit all. This article raises the question of whether the Bankruptcy Code provides, or should provide, an appropriate
incentive and opportunity for reorganization of companies. The concern is that in seeking to provide "fairness" to
creditors, there may be insufficient incentive for decision-makers to utilize the benefits of chapter 11.

This reticence to file means that corporations that could be saved are not being "fixed" in time, and that
significant value for creditor constituencies is possibly being lost—not to mention opportunities for shareholders to
realize on their investments. In other words, while creditor value is currently being monetized at the point in time of
sale or balance-sheet fix, even greater value to creditors (and others) might be realized if reorganizations were
undertaken at an earlier time, before significant value is lost.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Richard E. Mikels is a shareholder in Mintz Levin's Boston office and chairman and manager of the Bankruptcy, Restructuring and Commercial Law Section. The authors are
grateful and appreciative to Adrienne K. Walker, an associate with the Boston office of Mintz Levin, for her assistance in the preparation of this article. <a href="#1a">Return to article</a>

<a name="2">2</a> Peter S. Kaufman is the head of Restructuring and Distressed M&A for the New York-based investment bank Gordian Group LLC. <a href="#2a">Return to article</a>

<a name="3">3</a> This concern was addressed more than 30 years ago in the 1973 report of the Commission on Bankruptcy Laws, when it recognized that "[i]nitiating relief should not be a death
knell. The process should encourage resort to it, by debtors and creditors, that cuts short the dissipation of assets and the accumulation of debts. Belated commencement of a
case may kill an opportunity for reorganization or arrangement." See Report on the Commission on the Bankruptcy Laws of the United States, H.R. Doc. No. 137, 93d Cong. 1st
Sess. (1973). <a href="#3a">Return to article</a>

<a name="4">4</a> The Bankruptcy Act, as amended from time to time, also had separate chapters for Agricultural Compositions (chapter VIII), Railroads (chapter VIII), Municipal Debt
Readjustment (chapter IX), Real Property Arrangements by Persons Other Than Corporations (chapter XII), Wage Earner Plans (chapter XIII) and Maritime Commission Liens
(chapter XIV). <a href="#4a">Return to article</a>

<a name="5">5</a> See H.R. Rep. No. 95-595, at 242-46 (1977); see, also, Posner, Eric A., "The Political Economy of the Bankruptcy Reform Act of 1978," 96 Mich. L. Rev. 47 (1997) (noting that
although the drafters intended chapter XI for closely held corporations and chapter X for public corporations, the wording of the statute did not actually reflect this requirement).
Because of this lack of clarity as discussed herein, most companies, large and small, preferred to file under chapter XI rather than chapter X. <a href="#5a">Return to article</a>

<a name="6">6</a> See subchapter III of chapter 7 (stockbroker liquidations), subchapter IV of chapter 7 (commodity broker liquidations), chapter 9 (municipalities), subchapter IV of chapter 11
(railroad reorganizations) and chapter 13 (individuals with regular income). <a href="#6a">Return to article</a>

<a name="7">7</a> The legislative history, however, reveals that the proposal by the Commission on the Bankruptcy Laws of the United States for a single, consolidated business reorganization
chapter differed significantly from what Congress ultimately enacted as chapter 11. See Peebles, Ralph E., "Staying In: Chapter 11, Close Corporations and the Absolute Priority
Rule," 63 Am. Bankr. L.J. 65 (1989) (summarizing the above differences, including a relaxed application of the absolute priority rule in the context of reorganizing close
corporations). <a href="#7a">Return to article</a>

<a name="8">8</a> 11 U.S.C. §1121(b). <a href="#8a">Return to article</a>

<a name="9">9</a> Extensions are often granted in smaller cases as well. It is the lack of assurance and the enormous change in leverage when extensions cease that make this issue paramount to
decision-makers. <a href="#9a">Return to article</a>

<a name="10">10</a> Case v. Los Angeles Lumber Products Co. Ltd., 308 U.S. 106, 112-114 (1939). <a href="#10a">Return to article</a>

<a name="11">11</a> Id. at 117. <a href="#11a">Return to article</a>

<a name="12">12</a> When the Bankruptcy Act was amended in 1952, it eliminated the fair and equitable test for chapter XI debtors. The congressional history suggests that the amendment was
necessary because, if the absolute priority rule was applied, "no individual debtor, and under chapter XI, no corporate debtor where the stock ownership is substantially identical
with management, could effectuate an arrangement except by payment of the claims of creditors in full." House Report No. 2320 on S. §2234, 82nd Cong., 2nd Sess. (1952). <a href="#12a">Return to article</a>

<a name="13">13</a> See H.R. Rep. No. 99-554, at 4 (1977) (statement of Hon. Quentin Burdick). <a href="#13a">Return to article</a>

<a name="14">14</a> Chapter 12 has yet to be adopted as a permanent chapter under the Bankruptcy Code. When enacted, chapter 12 included a seven-year sunset provision. This chapter has been
re-enacted several times, however, and is currently due to expire on Jan. 1, 2004. It is interesting to note that family farmers seem more sympathetic to Congress than family
businesses. <a href="#14a">Return to article</a>

<a name="15">15</a> See 11 U.S.C. §§101(51C), 1102, 1121 and 1125; see, also, Fed. R. Bankr. P. 1020 and 3017.1. <a href="#15a">Return to article</a>

Journal Authors

Richard E. Mikels

Journal Date

Monday, December 1, 2003 - 12:00

Bankruptcy Rule

2003