The Liquidating Chapter 11 in State Court

<p>There is no question that many insolvency professionals are busier now than at any time during the last
eight years. "Shakeouts" are going on in a number of industries. Lenders seem to have more and more
troubled loans. And bankruptcy lawyers are a "hot" hire once again. But there is reason to doubt that
increased business insolvencies will produce the bankruptcy boom some commentators are predicting.

</p><p>For example, when it comes to the liquidation of small and mid-sized companies in a number of
jurisdictions, it has become far more likely that the assets of those companies will be sold in state
receivership court than in federal bankruptcy court. Indeed, insolvency professionals have already seen
something of a receivership renaissance nationwide. This column will discuss some of the reasons that
smaller liquidating companies, needing protection from their creditors, are choosing a state, rather than a
federal, remedy.

</p><h3>The Bankruptcy Disadvantage</h3>

<p>The impression is widespread that federal bankruptcy court has been less effective in recent years as
a tool for maximizing net-asset values, particularly when it comes to situations requiring the expeditious
sale of a small business as a going concern. Chapter 7 trustees certainly know how to sell assets. But for
various reasons, including the risks inherent in operating businesses they have no opportunity to get to
know ahead of time, panel trustees rarely agree to continue operations pending a sale, even for a short
period of time.

</p><p>Chapter 11, on the other hand, generally permits the debtor's management to remain in place, and, many
commentators believe, implicitly authorizes going-concern sales in §1123(a)(5)(D). But in many
jurisdictions, chapter 11 has become too expensive for small businesses as financial reporting and
procedural requirements have proliferated. In some jurisdictions, the sale of substantially all the assets of
a chapter 11 debtor, pursuant to §363, requires almost as much time and effort as a sale pursuant to a
confirmed liquidating plan. Furthermore, in some quarters, chapter 11 asset sales are disfavored as a matter
of policy and will be met with motions to convert or dismiss the case.

</p><p>While there are no doubt valid reasons for close scrutiny of asset sales in chapter 11, some companies
simply cannot afford the high transaction costs and delays associated with a bankruptcy sale process. Often,
these companies will be closely held businesses whose assets are subject to a general business security
interest in favor of an asset-based lender. The business is losing money, it has already been refinanced and
the lender of last-resort has had enough. No additional equity financing is available. However, the business
might be sold for enough to pay the lender in full and even to generate a dividend for unsecured creditors,
if transaction costs can be kept to a minimum. In such instances, state receivership may provide a
cost-effective alternative to bankruptcy.

</p><h3>The Receivership Alternative</h3>

<p>Many states permit a debtor company to commence a voluntary receivership by means of a "general
assignment" or "assignment for the benefit of creditors." Such assignments of all the company's assets are
typically made to a turnaround specialist or insolvency practitioner who has participated in the development
of a strategy for selling the business in a manner designed to maximize the net recovery for creditors. The
assignment document will then be filed in state court, together with motions for an order appointing the
assignee as the receiver for the debtor, enjoining creditor collection action and, generally, setting parameters
for the receiver's liquidation of the company's assets.

</p><p>Once the receivership is commenced, the receiver will function in many ways as would a chapter 7
trustee, but with one important difference: The receiver, typically, will operate the business prior to its sale.
State court receivers are accustomed to operating businesses over which they are appointed (often in
court-supervised supplementary proceedings). The receiver may be pre-selected as someone familiar with
the debtor's industry. Typically, the receiver—or technically, the "assignee" prior to his or her appointment
as receiver—also will have some time to become familiar with the debtor's operations before commencing
the case. And most importantly, the receiver will often permit the debtor's management team to remain in
place, subject to the receiver's supervision.

</p><p>The early stages of a small business receivership may resemble a chapter 11 case in other respects.
There may be first-day motions for authorization to obtain bank financing, to pay pre-petition wages and
"stay" bonuses, and for approval of a sale process. The receiver may apply for authority to employ attorneys
and accountants. Notice of commencement of the receivership and of a deadline to file claims will be sent
to all creditors.

</p><p>Many receivership statutes also contain provisions for (i) filing schedules of assets and claims, (ii)
recovery of preferences, (iii) the priority status of administrative, wage and tax claims, and (iv) a claims
objection and allowance process. Upon completing the liquidation of assets, the receiver will typically be
required to file an accounting with the court and obtain authority to distribute net proceeds in conformity
with the claim priorities set forth in the statute.

</p><p>The need for a quick and cost-effective sale of assets is probably the most important reason that small
and mid-size businesses resort to receivership filings. Receivership statutes sometimes include or refer to
the Uniform Act Governing Secured Creditors Dividends in Liquidation Proceedings, which specifically
provides for the receiver's sale of a secured creditor's collateral (if the creditor consents). Assets may be
sold by public or private sale. Typically, the receiver will file what is in effect a §363 motion requesting
court approval of the sale, free and clear of liens, claims and encumbrances. As in a bankruptcy case, the
validity of that order depends, to a great extent, on the adequacy of the notice provided to creditors of the
terms and conditions of sale.

</p><h3>Receivership's Disadvantages</h3>

<p>This brings us to the disadvantages of state court receivership for liquidating businesses. A bankruptcy
trustee can use collateral, even cash collateral, over the objection of a secured creditor if that creditor's interests
are adequately protected under §§361 and 363. There is no comparable power under state receivership law.
If the secured creditor in a receivership wants to take its ball and go home, the game is over.

</p><p>Similarly, while there may be a division of authority as to whether a bankruptcy court can authorize the
sale of assets under §363(f) over the objection of a secured creditor, there is no question that a receiver's
ability to sell collateral depends on the secured creditor's consent. Utilities, landlords and parties to
executory contracts also have more leverage against a receiver than they would have against a trustee or
debtor-in-possession. Only a few states have statutory provisions modifying the rights of landlords or other
executory contract parties in favor of state court receivers. Thus, <i>ipso facto</i> provisions, prohibitions on
non-consensual assignments, contractual waivers and forfeitures of the kind that the Bankruptcy Code, by
virtue of the Supremacy Clause, overrides, are all presumptively valid in a state receivership.

</p><p>Another problem is that most state receivership statutes are vague. Many date from the 19th century and
have been subject to few amendments. Many state judges are only vaguely familiar with receivership law
because it has been so little used. This, of course, presents opportunities as well as pitfalls to the
practitioner. To some extent, bankruptcy precedent can be brought to bear on unresolved issues of statutory
construction because many receivership statutes contain provisions lifted from the Bankruptcy Act in effect
at the time the state statute was drafted.

</p><p>Finally, the pendancy of a receivership does not prevent unsecured creditors from filing an involuntary
bankruptcy petition against the debtor. The question, of course, then becomes whether the bankruptcy court
will abstain from exercising jurisdiction under §305. The bankruptcy court should dismiss an involuntary
petition where the interest of creditors would be better served by the continuation of the state receivership.
In small business receivership cases, absent a showing of fraud or defalcation, creditors most often will be
better served by dismissal of the bankruptcy petition.

</p><p>A final "on the edge" point pertains to reorganization. Receivership statutes provide a framework for
orderly liquidation, not reorganization. Indeed, receivership statutes have been invalidated on federal
pre-emption grounds to the extent that such statutes have contained a discharge provision, a key element
of a reorganization.

</p><p>Nevertheless, it may be possible to use a receivership to pave the way for a chapter 11 reorganization.
If the company turns around financially during the receivership, unsecured creditors may benefit more from
a payment plan than from a liquidation. The receiver may then be able to negotiate a plan acceptable to
creditors, at which point a pre-packaged chapter 11 plan can be prepared, acceptances solicited and, if all
goes well, that rarity of rarities achieved—a quick and inexpensive chapter 11 small business case
successfully concluded.

</p>