Rethinking the Concept of Success in Bankruptcy and Corporate Recovery

Journal Issue

May 1998

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In the past
few months, two important studies have been published highlighting
the prospects for achieving a successful reorganization. Both studies
indicate that the odds are still against most bankruptcy
petitioners, but shorter than previously thought. In view of these
findings, alternatives for the speedy resolution of creditor claims
against an estate should be explored and utilized if they will result
in increased creditor recoveries.

The definition of "success" in a bankruptcy proceeding is a
subject of much debate. In most studies, "success" appears to be
defined as the confirmation of a plan and the reorganization of the
entity. The definition of success can be broadened to include ceasing
the feeding frenzy over the debtor’s assets, maximizing the
recoveries to creditors and resolving the affairs of the
debtor’s estate. Defining success in this broader context is
difficult to empirically analyze, and the authors encourage the
submission of articles expanding the discussion. This examination of
"success" begins with an exploration of two recent empirical studies
and available non-judicial remedies.

EOUST Study

The February 1998 issue of the ABI Journal published the
findings by Gordon Bermant and Ed Flynn from data released by the Fee
Information and Collection System (FICS), run by the Executive Office
for the U.S. Trustee (EOUST). This data represents the most
comprehensive source of case statistics available for cases of all
sizes. Heretofore, the most comprehensive source of information on
national confirmation rates is a 1989 report by the Administrative
Office of the U.S. Courts (EOUST) on cases filed from 1979-1986 in 15
judicial districts. The EOUST study traced the outcomes of chapter 11
cases filed from 1989 through 1995. As of December 31, 1997, fewer
than 30 percent of these cases resulted in a confirmed plan of
reorganization. More than 70 percent were converted to liquidation or
dismissed as follows:

<center><table border="0">
<tbody><tr>
<td align="CENTER" width="110">
<center>Outcome No.</center>
</td><td align="CENTER" width="51">
Cases
</td><td align="CENTER" width="48">

Rate
</td></tr>
<tr>
<td align="CENTER" width="110">
<center>Confirmed</center>
</td><td align="CENTER" width="51">
33,879
</td><td align="CENTER" width="48">

25.8%
</td></tr>
<tr>
<td align="CENTER" width="110">
<center>Converted</center>
</td><td align="CENTER" width="51">
46,368
</td><td align="CENTER" width="48">
35.4%
</td></tr>

<tr>
<td align="CENTER" width="110">
<center>Dismissed</center>
</td><td align="CENTER" width="51">
46,241
</td><td align="CENTER" width="48">
35.3%
</td></tr>
<tr>

<td align="CENTER" width="110">
<center>Unknown/Still Open </center>
</td><td align="CENTER" width="51">
4,601
</td><td align="CENTER" width="48">
3.5%
</td></tr>

<tr>
<td align="CENTER" width="110">
<center>Total </center>
</td><td align="CENTER" width="51">
131,089
</td><td align="CENTER" width="48">
100.0%
</td></tr>
<tr>

<td colspan="3" align="CENTER" width="209">
<center>Source: FICS database, EOUST</center>
</td></tr>
</tbody></table></center>

While the confirmation rates for cases filed in 1995 (the most
recent data) achieved an all-time high of 29.5 percent versus cases
filed in preceding years, these statistics still indicate that the
odds are against most debtors successfully emerging from chapter 11.

Furthermore, the length of time typically experienced to
adjudicate cases continues to range from one to two years. In 1997,
50 percent of confirmed cases reached confirmation in 429 days or
less. The 1997 intervals from the filing date to outcome date for
confirmed, converted or dismissed cases are as shown in Table I.

Bankruptcy Research Database

Professor Lynn LoPucki recently published results from the
Bankruptcy Research Database in the March 10, 1998 issue of
Bankruptcy Court Decisions. LoPucki concluded that for large
public companies (assets greater than $100 million in 1980 dollars,
or $190 million in 1997 dollars), the average time in chapter 11
shortened dramatically from 1980 to 1994. Nevertheless, based on the
latest data for chapter 11 cases resolved in 1994, the interval from
the filing date to outcome date was approximately 21 months for all
cases excluding pre-packaged plans. When including pre-packaged
chapter 11s, the average duration for all cases dropped to 13 months.

<center><table border="0">
<tbody><tr>
<td colspan="4" width="213">
<center>TABLE I

Maximum Days from Filing

by Percentage of Cases</center>
</td></tr>
<tr>
<td width="90">
Outcome
</td><td width="42">
80%

</td><td width="44">
50%
</td><td width="37">
20%
</td></tr>
<tr>
<td width="90">
Confirmed
</td><td width="42">

696
</td><td width="44">
429
</td><td width="37">
275
</td></tr>
<tr>
<td width="90">
Converted
</td><td width="42">
573
</td><td width="44">

265
</td><td width="37">
120
</td></tr>
<tr>
<td width="90">
Dismissed
</td><td width="42">
462
</td><td width="44">
207
</td><td width="37">

77
</td></tr>
<tr>
<td colspan="4" width="213">
<center>Source: FICS database, EOUST </center>
</td></tr>
</tbody></table></center>

Alternatives to Filing Bankruptcy

In evaluating "success," a study of alternatives to filing
bankruptcy is crucial. Many creditors are unaware that alternatives
to bankruptcy exist when dealing with an insolvent business. Other
options such as assignments for the benefit of creditors, state court
receiverships, federal equity receiverships, and the use of
out-of-court workouts and agreements are alternatives that need to be
discussed and analyzed. This is particularly important with the
release of the new data on bankruptcy filings and case resolution.

Assignments for the Benefit of Creditors

Although governed by state law, assignments are generally
out-of-court proceedings used to consolidate and liquidate a
debtor’s property for the sole purpose of repaying creditor
claims. Under an assignment, the debtor (or "assignor") voluntarily
transfers title of all assets through a trust agreement to a trustee
(or "assignee") who liquidates the assets and distributes the
proceeds on a pro rata basis among the creditors. While the trust
agreement is not necessarily recorded with the state court, the
assignment may be recorded in the county where it was executed.

Some states regulate the assignment. Most, however, operate under
common law precedent to determine the standards of performance for an
assignee. Generally, the assignee’s duties include the
following:

•Controlling the debtor’s cash, accounts receivable,
inventory, real property and other assets;

•Identifying fraudulent transactions that can be prosecuted
under state statutes;

•Liquidating the debtor’s assets by selling assets
through the ordinary course of operations, going concern sales of
businesses, private sales and/or public auctions; and

•Distributing proceeds from the liquidation to creditors.

Although creditors are the beneficiaries of the trust, their
consent is not required to validate the trust. Lack of creditor
support is often a difficult problem that can impede the use of
assignments. Most states do not require formal acceptance by the
creditors, and creditors are not necessarily asked for their consent;
however, creditors must refrain from filing an involuntary bankruptcy
petition for an assignment to be effective. Asset turnover provisions
§§543(c)(3) and 543(d)(2) generally limit this action to
within 120 days after the execution of the assignment. Generally, if
no creditor has taken action within 120 days, the assignment is
considered binding. If, however, the debtor is unable to obtain
support of all significant creditors, it will be impossible to
proceed with an effective and binding assignment.

Assignments may be faster, simpler and less expensive than
bankruptcy cases. They essentially only involve execution of the
trust agreement and do not include the forms, schedules, hearings and
other activities necessary to commence a bankruptcy case. Although
assignments vary in length, they generally conclude faster than
chapter 11 or chapter 7 liquidations, lasting between six weeks and
eight months. Finally, assignments do not involve the litigation of
bankruptcy proceedings and are less expensive. On the other hand,
assignments may be viewed by the creditor body as an attempt to
conceal transactions or avoid liability. In addition, many states do
not allow assignments without judicial supervision.

State Court Receiverships

State court receiverships provide more supervision over the case
through the appointment of the receiver, the selection of other
professionals, the conduct of the liquidation and the distribution of
the proceeds to creditors. The receiver is appointed at the state
court’s discretion as a fiduciary to preserve assets pending the
liquidation of the debtor’s business operations. Requests for
appointments of receivers typically occur when a secured creditor
with a mortgage in the debtor’s real property commences a
foreclosure action on the mortgage. The receiver is appointed in the
county where the foreclosure action was brought. The receiver is
generally appointed if the following conditions are met:

•The property is in danger of being lost, removed or
materially injured;

•The property may not be sufficient to discharge the
mortgaged debt;

•The secured creditor has requested the appointment of a
receiver;

•All or a portion of the property is leased;

•Rents or profits in controversy are in danger of being lost,
removed or materially injured; or

•The corporation is insolvent, in danger of being dissolved,
or has otherwise forfeited its corporate rights.

The receiver is empowered to bring and defend actions with respect
to the property, to take possession of the property, to receive
rents, collect debts and perform all other acts with respect to the
property that the court authorizes to ensure that adequate security
is maintained for the mortgagor. As such, the receiver is required to
provide an accounting to the court of the assets and liabilities
involved, and any use of the assets must be approved by the court.
The receiver is not permitted to sell property without the consent of
the secured lender and the court, since the receiver is appointed to
preserve and protect the property from loss or destruction. The
debtor’s consent to a property sale also may be required unless
a successful foreclosure has been achieved by the secured lender.

In the event a bankruptcy is filed, §543(b) requires that the
receiver turn over control of the property to the bankruptcy trustee.
If the debtor is in control of its own assets, the receiver must turn
over control of the property to the debtor for the purpose of
preserving the debtor’s right to propose a plan of
reorganization while controlling its assets. If the debtor is not
likely to reorganize, has no long-term interest in preserving the
assets and the prospect for reorganization is remote, then the
bankruptcy court may permit the receiver to continue controlling and
operating the assets under §543(d). A bankruptcy trustee may be
appointed to administer claims and pursue preference and fraudulent
conveyance actions during the pending sale of the debtor’s
property.

Benefits of receivership primarily include: (i) court supervision
of the property, (ii) assets are sold or disposed more quickly, and
the secured lender’s collateral is more quickly adjudicated,
(iii) notification of creditors is simplified, (iv) the lender has
greater control over the disposition of assets and management of the
case since the lender compensates the receiver, (v) distributions to
secured creditors generally proceed faster since subordinate classes
of creditors typically receive no distribution, (vi) the lender is
shielded from liability to third parties for negligence resulting
from possession and (vii) time required to eject a borrower is
shortened under a receivership versus a foreclosure action.

Federal Equity Receiverships

The scope of federal equity receiverships has diminished with the
expansion of federal bankruptcy and state receivership statutes.
Today, federal receivers are most often utilized in connection with
stockholder derivative suits or at the request of government
officials regarding specific legislation such as the Securities and
Exchange Commission or prosecutions of federal racketeering cases.
Federal receivers are also used in businesses such as interstate
motor carriers, railroads or pipelines where the debtor’s fixed
property extends into different states. Cases where the United States
is a property holder or lien claimant also may qualify for federal
receivership. As in state court receiverships, any creditor
demonstrating an existing interest in the property, such as secured
creditors, lien holders and mortgagees filing a foreclosure action,
may request the appointment of a federal receiver in federal district
court to administer the property. Tests employed to determine whether
a receivership is appropriate include: (i) the debtor has engaged in
fraudulent conduct, (ii) property is in imminent danger of being lost
or diminished, (iii) available legal remedies are inadequate, (iv)
plaintiffs have a probability of success in related legal actions,
and (v) the possibility exists of irreparable injury to the
creditor’s interests in the property.

Federal equity receiverships are governed by the Federal Rules of
Civil Procedure Rule 66. As such, federal rules apply in all matters
except the actual administration of the receivership estate. Local
rules exist in less than half the districts, but virtually all local
rules provide that the receiver shall administer the estate similar
to a bankruptcy case. The receiver can bring actions in the district
court regarding the property, provide the court with an accounting of
the assets, and perform all other tasks and activities necessary to
protect and preserve the property. In practice, federal receiverships
resemble bankruptcy proceedings, but have none of the formal
requirements and procedures that make bankruptcy a more costly
alternative.

Appointment of a federal receiver is considered an extraordinary
remedy. Although notice of the appointment is generally given to
parties that may be affected by the appointment, notice is not
specifically required. Since federal receivers are appointed to
preserve and protect the property in question, the receiver’s
fees and expenses, to the extent that they were incurred for the
benefit of the estate, are charged against the parties requesting the
receivership and for whom the receiver was appointed.

To summarize, the benefits of federal receivership are similar to
the benefits of state court receivership. In addition, federal
receivership permits the administration of fixed property in multiple
states in the interests of preserving uniformity and continuity in
the administration of the estate. However, as mentioned above,
federal receiverships are an extraordinary measure.

Out-of-court Workouts

Compositions, extensions, standby agreements, combinations and
other out-of-court workouts and agreements can be made between the
debtor and creditors’ committees, trustees and individual
creditors without incurring the time and expense of a courtroom
proceeding. Out-of-court workout agreements are used to reorganize a
debtor by preserving and continuing to operate the debtor’s
business. They are often appropriate when reorganizing a debtor
after the occurrence of a non-repeating event, where the interests of
all parties are best served by continuing an otherwise viable
business.

A composition agreement is a contractual agreement between the
debtor and its creditors whereby the creditors discharge a portion or
all of their claims against the debtor in exchange for payment of a
lesser amount than what is actually owed. In contrast, under an
extension agreement, only the payment terms are revised, thereby
permitting the debtor to repay its obligations for a negotiated
period of time. Other types of agreements such as standby, moratorium
or stand still agreements preserve the status quo by delaying
repayment of the debtor’s outstanding obligations for defined
periods without interest or penalties.

Use of out-of-court agreements is advantageous because they permit
the continuation of the business without incurring the time and
expense of a legal proceeding. They also can be directed to apply to
specific issues rather than calling all business transactions,
relationships and the overall viability of the business into
question. Since these agreements are governed by contract law, the
application of the agreement will generally be uniform among most
states.

<center><big>...while bankruptcy may not be viewed as an initial
option, its strengths as a system should be kept in mind along with
its inherent limitations and attendant cost.</big></center>

The major disadvantage of these agreements is the inability to
bind all creditors to the terms of the agreement. Non-consenting
creditors are not bound by the agreement and are not prohibited from
using other means to assert their claims against the debtor.
Therefore, these agreements are most appropriate when a key secured
creditor holds the vast majority of the security interests in the
debtor and where that creditor’s claims negatively impact the
recoveries of the other creditors in the event the agreement is not
consummated.

Advantages of Alternatives Over Bankruptcy

Often out-of-court or state court proceedings have the advantage
of being faster, simpler and less expensive than bankruptcy court
proceedings. Specific advantages are as follows:

•Out-of-court workouts are generally simpler to consummate
than bankruptcy cases since they typically only involve the execution
of a negotiated agreement. Bankruptcy involves court supervision,
numerous forms, schedules and procedures that require substantial
time, effort and cost to prepare, affecting management’s ability
to remain focused on stabilizing the business. This will not be
possible if a large number of disparate interests exist in the
creditor body.

•State court assignments and receiverships and federal equity
receiverships generally conclude faster than chapter 11
reorganizations or chapter 7 liquidations since the acts of the
assignee or receiver are not subject to stringent bankruptcy court
supervision. Although assignments and receiverships will vary in
length, they usually last between six weeks and eight months in
duration, whereas an average bankruptcy may last two years.

•Bankruptcy can be a much more expensive alternative than
either state court actions or out-of-court workouts. The additional
costs of bankruptcy stem from professional fees associated with
litigating cash collateral orders, chapter 11 plans of reorganization
or chapter 7 liquidation issues. A key benefit of bankruptcy is the
ability to control and resolve disputes in an ordered, procedural and
adjudicated format.

Debtors will usually prefer either an out-of-court or state court
approach since the debtor will typically have the ability to
influence the selection of an assignee or receiver or will retain
greater control of the business. In contrast, the U.S. Trustee
selects and appoints the creditors’ committee and/or the trustee
for each case under the authority of the bankruptcy court. State
court actions will often involve less adverse publicity than
bankruptcy. Finally, the debtor’s principals may be able to
reduce certain personal tax liabilities through payment of tax claims
on a priority basis before general unsecured debt.

Creditors may prefer non-bankruptcy alternatives primarily because
they receive larger distributions in a shorter period of time. In
addition, the creditors can control isolated hostile creditors whose
interests may be adverse to all other creditors by purchasing their
claims.

Finally, assignments or receiverships can be an effective means of
selling a company’s assets to a third party since the assignee
or receiver can continue operating the business so that it can be
sold as a going concern, whereas a chapter 7 trustee generally
terminates business operations and liquidates the assets. Without an
assignment or receivership, potential purchasers may be reluctant to
acquire assets which may not be free and clear of creditor claims.

Advantages of Bankruptcy

Bankruptcy offers many advantages, including increased powers for
the court to investigate the business and its conduct, the bankruptcy
court’s ability to void preferential transfers and fraudulent
conveyances, supervision of professional fees, and the court’s
ability to discharge the debtor from its debts.

•Creditors and/or debtors may prefer to file under chapter 11
of the Bankruptcy Code seeking time to facilitate a reorganization
process or to litigate the liquidation decision. The underlying
premise of assignments and receiverships is that the business is not
reorganizable and must be liquidated or sold. In addition, court
authorization of debtor-in-possession financing may enable the debtor
to obtain badly needed working capital over the objections of
creditors, thus buying time for the reorganization decision to be
adjudicated.

•Although non-bankruptcy approaches may be expeditious,
economic and sensible, out-of-court workouts, state court actions and
other non-bankruptcy alternatives can be inappropriate in cases
involving alleged fraud or cases requiring extensive investigation.
The authority of the bankruptcy court will be necessary to pursue and
collect preferential payments and fraudulent conveyances. Debtors may
favor the automatic stay provisions to prevent commencement,
continuation or enforcement of actions against them. In addition, the
bankruptcy court provides a single forum for negotiating, litigating
and resolving creditor disputes.

•Although non-bankruptcy alternatives typically involve lower
legal fees than bankruptcy, they are not subject to the strict court
supervision of professional fees, including those of lawyers,
consultants, auctioneers, brokers, etc. The bankruptcy court may
disallow fees and expenses as it deems appropriate. State courts
generally possess no such mechanisms.

•State laws do not discharge debts, and the automatic
restraining provisions of §362 are not applicable. In addition,
a debtor cannot be discharged from its debts through a state action
unless individual creditors elect to accept the distribution as full
payment toward their outstanding claims. A debtor must file a
bankruptcy petition in order to obtain a full discharge and be
relieved from its debts or to assume or reject disadvantageous leases
or executory contracts.

•Time and money may be wasted on non-judicial reorganization
attempts where only a bankruptcy filing would resolve creditor or
inter-creditor disputes. The chances of non-judicial "success" should
be carefully analyzed at the onset of negotiations with the debtor.

Conclusion

Some new and interesting statistics regarding chapter 11
bankruptcy filings and the "success" of case outcomes may be creating
a different view of judicially supervised proceedings. This data
comes on the heels of the National Bankruptcy Review
Commission’s study and report on the bankruptcy system, which
itself engendered a thorough analysis of bankruptcy law. The emerging
data suggests a far greater chance of "success," as narrowly defined
by chapter 11 confirmations, than was suggested in previous studies.

The authors believe that a broader definition of "success" could
yield even brighter statistics. A review of available alternatives to
court supervised proceedings and a cost/benefit analysis of each
would seem appropriate at this juncture. This article was not
intended to discuss all the alternatives to bankruptcy. Options such
as the use of replevin actions, bulk sales of assets, deeds in lieu
of foreclosure, exchange offers, mediation, arbitration, and other
methods exist. Yet, while bankruptcy may not be viewed as an initial
option, its strengths as a system should be kept in mind along with
its inherent limitations and attendant cost. Again, the authors
invite additional discussion regarding successful resolution of a
troubled business’ affairs, how to define "success" and how to
empirically measure its achievement.

Journal Authors

David P. Bart

Scott P. Peltz

Journal Date

Friday, May 1, 1998 - 12:00