Remembering Chapter 7

Journal Issue

May 2004

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One benefit of reading the advance sheets is that we are forced to reflect whether we are teaching the law of
bankruptcy as it currently functions. Recently, we've thought about our standard introduction that says, "There are
two corporate chapters: chapter 7 for liquidation and chapter 11 for reorganization," followed by the caveat,
"although chapter 11 is sometimes used for liquidation also." Is that statement becoming educational malpractice?

Should we instead begin with the explanation, "There are two corporate chapters: chapter 7 for liquidating small
businesses no one wants to fool with any more, and chapter 11 for all the rest?" With the large and apparently
increasing number of liquidating plans in chapter 11, it may now be rare for a business of any size to liquidate in
chapter 7.<a href="#1" name="1a">1</a> We will soon publish additional data from our large empirical study, the Business Bankruptcy Project,
that suggests that a substantial percentage of confirmed chapter 11 cases have liquidating plans. A recent sample of
high-tech bankruptcies found that the great majority of confirmed plans were liquidating plans.<a href="#2" name="2a">2</a> The question we
pose is this: Given that the Code authorizes liquidating plans in chapter 11, when should a business be liquidated
in chapter 7 and when in chapter 11?

The Code is silent on this issue. Section 1123(a)(5) broadly authorizes plans that include the transfer, sale or merger
of all or any part of the estate, making the more-often cited §1123(b)(4), which permits plans that provide for the
sale of all of the debtor's property, seem largely redundant. No standards are provided there or elsewhere telling us
when it is appropriate to use chapter 11 for this purpose. Both chapter 7 and chapter 11 begin in media res with no
introduction to tell us their purposes or limitations, other than a few quite specific requirements of particular
provisions.

The standard reply to our question is that chapter 11 plans are used for the sale of the business as a going concern.
But the statute is not so limited, and it appears to us that chapter 11 plans often include provisions for sales of
assets as well as sales of operating businesses, directly or through a liquidating plan.<a href="#3" name="3a">3</a> Why aren't those cases being
liquidated under the congressionally mandated rules in chapter 7? Increasingly, we seem to see plans in which there
is little monitoring or control, with unsupervised "plan trustees" free to do pretty much as they like, except perhaps
for watchdog committees made up of a small number of powerful creditors. These plans permit the avoidance of
most, if not all, of the Code's rules. But if Congress wanted liquidations to proceed without rules, in whatever way
a majority of creditors thought right, why didn't it make all the chapter 7 rules subject to a creditor vote?

Notwithstanding the "end run" aspect of liquidating plans, there seem to be two primary rationales for liquidating
chapter 11s. The first is flexibility. Sale of all or part of a modern business requires more time and less rigid
procedures than those found in chapter 7. Although we realize that our views are subject to the limits of what we
observe and read about, that rationale doesn't seem very persuasive to us. Is the use of chapter 11 necessary to
continue operating the business? Sections 363 and 721 give broad authority to the trustee to continue in business,
and §364 provides for post-petition financing regardless of chapter. It is sometimes said that chapter 11 gives more
time for the sale of assets or the business itself, but we don't see anything in the statute or rules that compels that
conclusion. Chapter 7 would seem to give the trustee as much time as necessary to market the business or its
assets.<a href="#4" name="4a">4</a> It is true that reports would have to be filed on a regular basis and that sort of thing, but why is that bad? If
there should be different reports for the chapter 7 liquidation of a large business over time, why not so provide in
the rules? If there is pressure under Administrative Office guidelines to close chapter 7 cases, perhaps because the
idea of liquidating large cases in chapter 11 has been built into the workload formulas, then the formulas could be
changed. We have trouble identifying the missing flexibility in chapter 7 that requires liquidations to be done in
chapter 11 with fewer creditor protections.

The other rationale has more bite. It is said that preexisting management is a better liquidator than a trustee under
chapter 11 or chapter 7. Actually, the notion should be refined to say that the DIP is a better operator-liquidator,
because often the business must be operated for a while in order to get the best price for it. The argument that the
DIP makes a better manager than a trustee was the central one in the elimination of the old chapter X trustee in favor
of the DIP in reorganization cases. Further, the DIP might be a better liquidator as well, using knowledge of the
industry to get the best prices. To evaluate these arguments, it is necessary first to separate the DIP's
operator-liquidator role from the other rationale for the DIP, the idea that the DIP would represent equity. Equity
representation will usually make little sense when a liquidating plan is the right answer.

In cases in which representation of equity can be ignored, the decision about whether to use chapter 11 liquidation
by a DIP really becomes a choice of choice-mechanisms. That is, the argument for chapter 11 DIP liquidation must
be that a choice of an operator-liquidator by the debtor's board of directors, and those who might influence the
board, is better than the choice that would be made by a majority of creditors. It isn't self-evident to us that the
board of a distressed company is a better chooser in this situation, while it is clear to us that a backstage chooser,
exercising behind-the-scenes influence over the board, is a bad idea.

If a creditor majority will often be the best way to choose a liquidator, then why don't we do that in chapter 7? The
response might be that often the creditors don't bother to vote for a trustee in chapter 7, but in those cases, will they
vote on a chapter 11 plan? The provisions of chapter 7 are designed to protect all creditors, including those who do
not actively participate. Why would we want to avoid the application of such protective rules? We don't know all
the answers to these and many related questions, but we think someone should be asking them.

There is a third rationale we've heard: Liquidating in chapter 11 saves the trustee's fees in chapter 7. At a time when
the fees in Enron are around $.5 billion, it seems unlikely that there is much to be saved by using chapter 11. If the
chapter 7 fee schedule is too generous in big cases, then it would surely be possible to adjust chapter 7 fees, scaling
down to reflect the enormous sums involved in the largest cases.

As things stand today, courts routinely permit liquidating chapter 11 plans. We think there should be a standard to
decide when chapter 11 liquidation should be used and when not. The de facto rule seems to be that a chapter 11
liquidating plan is fine whenever creditors will approve it, even if only by a minority-majority vote under §1125.<a href="#5" name="5a">5</a>

To compound the ironies, we note that such plans are often approved, it seems, even when the only assets to be
administered after confirmation are non-operating assets, including lawsuits, where the need for specialized managers
may not be apparent.

Three cases have made us think again about these issues, although they do not reflect all the problems in this area.
One was In re Beyond.com Corp., 289 B.R. 138 (Bankr. N.D. Cal. 2003), which is the exception that proves the
rule because the bankruptcy court refused to approve the disclosure statement. The court turned down the plan
because it made the pre-bankruptcy CEO the plan's liquidation manager, with full power to spend as he liked,
employ professionals and others as he liked, disclose little, give notice rarely and modify the plan almost at will.
The only supervision of his work would come from a committee representing five of the largest creditors. The CEO
given these broad powers was the same one who had presided over a very impressive $300 million operating loss.
There were also provisions to limit liability for insiders and authorize substantial compensation for the CEO.

Judge Morgan puts teeth into the Code's rules, especially the rules under §1129(a)(4). She points out that:

<ol>
<li>Payments for expenses and services are supposed to be approved by the court or by a procedure established
for future approval.
</li><li>The assets of this failed dot.com seem to consist largely of lawsuits, but the manager has broad discretion as
to which to pursue and which not.
</li><li>The plan contemplates little or no notice of dispositions, settlements and other significant events for which
notice is normally required by the Code.
</li></ol>

Finally, Judge Morgan strongly suggests that approval of the plan will require a finding by her that management is
not too incompetent or conflicted to carry out the plan.

While applauding Judge Morgan's analysis, we wonder if the rule shouldn't go further: Approval of a liquidating
plan should require a finding that the nature of the liquidation task in the case requires the specialized expertise or
knowledge of the proposed managers and that this benefit outweighs the benefit of appointing a neutral liquidator.

A case that went in the opposite direction was In re Communications Options, 299 B.R. 481 (Bankr. S.D. Ohio
2003). The case permits management to come close to complete privatization of chapter 11 control while retaining
the benefit of the law's coercive force. After finding that the debtor has obfuscated and delayed for three years, the
court appoints, over objection, a "responsible person...to act on behalf of" the DIP. So the DIP no longer has any
connection, apparently, with the old debtor. We are puzzled. Why shouldn't the "responsible person" be a chapter 11
trustee? Will the "responsible person" now administer the case with minimum supervision and propose a plan that
largely ignores the creditor protections built into the Code? Why use the vague and often tenuous powers granted by
§105, as the court did in Communications Options, rather than the solid power of §1104(a), in a case in which the
stiff standards for appointment of a chapter 11 trustee seem easily met on the judge's findings? Indeed, why not
convert to chapter 7? We are very conscious of the fact that there may have been factors in the case we can't see in
the opinion, but we are troubled by the approach.

A third case that made us think chapter 7 should perhaps be revived was In re Lacy, 297 B.R. 786 (Bankr. D. Colo.
2003). The central financial problem in the case was the failure of the debtor's movie, Love Stinks. Apparently, the
movie did too. The case was a classic liquidating-plan nightmare. The confirmed plan provided for sale of the
debtor's ranch, artwork, etc., and 100 percent payment to creditors, but following confirmation somehow it just
didn't happen. Even when sales did take place, the proceeds were used by the debtor or paid to family and friends,
but not to a $5 million creditor, with whom it had been involved in major litigation. The court granted the
creditor's motion to convert the case to chapter 7. It rejected the debtor's argument that confirmation vests the assets
of the estate in the debtor, so the court no longer has jurisdiction. It holds that in a liquidating plan property does
not fully re-vest in the debtor, at least not unconditionally, and therefore the assets remain property of the estate.
Closely related is the point that the lack of asset sales in this case means there was not substantial consummation
of the plan. Finally, the plan provides for retention of jurisdiction (watch that boilerplate!).

What is especially striking about this case is that such a liquidating plan was approved, presumably over the
objection, formal or informal, of a major creditor, and the debtor was able to use and abuse his assets for almost
three years free of most of the rules in the Code designed to provide transparency and to protect creditors.

Perhaps there are so many good results from freeing liquidation from the rules of chapter 7 that it misses the point
to discuss the bad results and the risks. But if that is true, shouldn't there be new rules that reflect that new reality,
while also providing some concrete protections addressed directly to the circumstance of a liquidating plan? What
those rules should be and how the use of chapter 7 fits into a larger view of bankruptcy law is a law review-type of
article, but maybe we should all start thinking about it now.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> See Warren, Elizabeth and Westbrook, Jay L., "Financial Characteristics of Businesses in Bankruptcy," 73 Am. Bankr. L.J. 499, 523, 525 (1999). <a href="#1a">Return to article</a>

<a name="2">2</a> Mann, Ronald J., "To File or Not to File: An Empirical Investigation of Bankruptcy Choices of Failed High-tech Firms" (unpublished paper on file with authors). <a href="#2a">Return to article</a>

<a name="3">3</a> Following the demise of Lionel, §363 sales are serving as a second important substitute for chapter 7 liquidation, another subject for another day. <a href="#3a">Return to article</a>

<a name="4">4</a> Section 721 does restrict the trustee to operations "for a limited period," but that phrase obviously gives the court considerable discretion to determine what period of operation
is necessary to maximize value. <a href="#4a">Return to article</a>

<a name="5">5</a> Section 1126(c) requires approval by the specified percentages of those who vote, so that a minority of qualified creditors can approve a plan. <a href="#5a">Return to article</a>

<hr>

Journal Authors

Elizabeth Warren

Jay L. Westbrook

Journal Date

Saturday, May 1, 2004 - 12:00

Bankruptcy Rule

2004