Control the Denominator to Enhance Creditor Recoveries

<p><The focus in many
bankruptcy cases tends to be on maximizing the value of the assets (the
numerator), while the claims against those assets (the denominator) often
get out of control. Unsecured creditors typically find that the ultimate
"cents-on-the-dollar" return is less than expected because
little or ineffective attention was paid to addressing asserted claims.
Controlling this "denominator" can often significantly enhance
the percentage return to the rightful creditors.

</p><p>For example, assume that there is $500 million of
asset value to distribute among creditors, and that the reorganization plan
provides for payment in full of all priority claims before any funds are
distributed to general unsecured creditors. Further assume that the claims
asserted by the creditors are as presented in the table below:

</p><p><table cellpadding="10" width="300"><tbody><tr><td><b>Asserted Claims</b></td><th></th><th></th></tr>

<tr><td><i>(millions)</i></td>
<td><i>Claims</i></td>
<td><i>Payout</i></td>
<td><i>Return</i></td></tr>

<tr><td>Secured Debt</td>
<td>$200</td>
<td>$200</td>
<td>100%</td></tr>

<tr><td>Priority Debt</td>
<td>$50</td>
<td>$50</td>
<td>100%</td></tr>

<tr><td>Reclamation and Cures</td>
<td>$100</td>
<td>$100</td>
<td>100%</td></tr>

<tr><td>General Unsecured Claims</td>
<td>$1,000</td>
<td>$150</td>
<td>15%</td></tr></tbody></table>

</p><p>After paying $350 million to priority creditors, there
is only $150 million available to pay $0.15 on the dollar to general
unsecured creditors based on asserted unsecured claims of $1 billion.
Appropriate strategies and processes for addressing these various
categories of claims can improve the return to creditors by minimizing
claims in all classes.

</p><h4>Secured Claims</h4>

<p>In addition to secured-lender claims, secured claims
often include lien assertions, claims made by lessors for value of
equipment and claims for which there is no basis to assert a security
interest. Lien assertions should be scrutinized, as these asserted liens
might not have been properly or timely perfected or filed. Secured claims
asserted by equipment lessors can be avoided simply by returning the
equipment. Where, as is often the case, the debtors cannot locate the
equipment, the lessor's assertion of the fair market value of the
equipment should be challenged, as these values are usually overstated.

</p><h4>Priority Claims</h4>

<p>Priority claims usually consist of claims by taxing
authorities and employees. In sum, tax claims are typically overstated, and
most employee priority claims are paid through first-day orders and filed
in excess of the statutory priority amount. Any other type of creditor
asserting a priority claim should be questioned in most cases. Reviewing
priority claims to identify the types of creditors and bases for claims of
priority assertions will quickly reveal many asserted claims that simply do
not qualify for priority status.

</p><p>Taxing authorities are notorious for filing
"jeopardy assessment" claims that are substantially overstated.
Commonly, taxing authorities have not fully evaluated any liabilities of
the debtor at the time of the claims bar date. As a result, taxing
authorities often file claims seeking the maximum amount potentially
due. Moreover, taxing authorities often include claims from many years
past, even though priority status is generally accorded only to tax debts
arising within three years prior to the petition date. Thus, tax claims
should be thoroughly investigated with the tax department, and attempts
should be made to expedite tax audits in order to resolve these claims.

</p><p>Employees are entitled to priority claims to the
extent that the liability arose during the 90 days prior to the petition
date. Moreover, the priority amounts of an employee cannot exceed $4,925
(pursuant to 11 U.S.C. §104, effective for all cases filed on or after
April 1, 2004). Proper analyses of pre-petition amounts owed to employees
often reveal that amounts owed to employees, if any, were earned over time.
Most or all amounts that arose during the 90 days prior to the petition
date are paid in connection with first-day orders allowing for payment of
employee obligations.

</p><h4>Reclamation and Executory Contract Cure Claims</h4>

<p>Spending adequate time evaluating and challenging
reclamation claims and cure costs will substantially reduce these claims.
Claims asserted by vendors for goods shipped during the reclamation period
and asserted executory contract cure costs are typically gross amounts that
are significantly overstated. A thorough understanding of the
debtor's accounting systems and detailed calculations are necessary
to perform these analyses.

</p><p>Vendors that assert reclamation claims usually do not
properly consider the applicable time period for reclamation shipments and,
more importantly, the amount of goods that were shipped during the
reclamation period that remain on hand at the time of the reclamation
demand. In general, vendors are entitled to reclamation claims to the
extent that the goods were received during the 10 days prior to the
petition date, and these same goods were on hand at the time of the
reclamation demand.

</p><p>Any product that has been sold or consumed by the
time of the reclamation demand does not qualify for inclusion in a valid
reclamation claim. Analyses of the shipment detail of asserted reclamation
claims may also reveal other causes for reducing asserted reclamation
claims.

</p><p>Executory contract cure costs can also be
significantly reduced through proper analyses. It is common to find that
parties to assumed executory contracts expect the cure amount to include
all amounts that are owed by the debtor, including liabilities that are not
associated with contracts that are being assumed.

</p><p>Recent telecom cases have provided good examples of
overstated cure cost assertions in connection with circuits. Although some
of the circuits are associated with master service agreements that have
created many complexities regarding attempts to "cherry pick"
circuits and calculate cure costs, many of the circuits are not associated
with master service agreements.

</p><p>For example, assume that a circuit vendor provides
the debtor access to 500 circuits for which the debtor only assumes 300
circuits and the circuit vendor has an outstanding claim of $50,000. It is
common that the circuit vendor will assert a $50,000 cure claim. Moreover,
logic may suggest that three-fifths of the circuits are being assumed and
that the cure cost would be $30,000 (3/5 multiplied by $50,000).

</p><p>However, analyzing the circuit-level billing detail
will reveal the proper amounts of these claims. Through a thorough
understanding of the debtor's accounting records, analyses can be
performed to determine the exact amounts owed on a circuit-by-circuit basis
to determine the amounts owed for each circuit that is being assumed. This
concept can be applied in calculations of cure costs with all types of
executory contracts. In general, the liabilities need to be traced
specifically to the contracts being assumed.

</p><h4>General Unsecured Claims</h4>

<p>The process for evaluating general unsecured claims
in large bankruptcy cases can initially appear to be overwhelming. Certain
initial steps will, however, create a manageable process. The first useful
step is to identify and focus on the primary reconciling claims that make
up the bulk of the overall reconciling difference, which I refer to as the
"needle movers."

</p><p>Another useful step is to categorize the reconciling
claims by type of claim. Although there are many types of general unsecured
creditors in large bankruptcy cases, there are four common types: (1)
unsecured debt claims, (2) trade claims, (3) executory contract rejection
claims and (4) litigation claims. Upon categorizing reconciling claims
based on claim type, processes can be established to evaluate and resolve
these claims.

</p><p>Unsecured debt claims are typically few in count and
fairly simple to evaluate. In general, the unpaid principal and interest
amounts as of the petition date should be determined.

</p><p>Trade claims are best reconciled through computerized
methods to identify the reconciling invoices that are included in the
creditor's claim, but not included as unpaid items in the
debtor's accounts payable records. These reconciling invoices can be
researched through additional computerized methods to determine
conclusions.

</p><p>Executory contract rejection claims are often filed
at gross amounts, and are thus often greatly overstated. Most bankruptcy
professionals are familiar with the rejection damage-claim limitations for
real property lessors per §502(b)(6) of the Bankruptcy Code (the
greater of one year or 15 percent of the lease, not to exceed three years).
Despite this limitation, landlords often file claims that assert the entire
amount of the remaining lease as contract rejection damages. In addition,
for all rejected contracts, rejection damages are subject to reduction
based on state law mitigation obligations.

</p><p>Litigation claims are often difficult to analyze in
any systematic fashion and can be time-consuming to resolve, since
litigation of the unique underlying issues through discovery and trial may
be necessary. However, alternative dispute resolution processes have proven
to be an effective process for expeditiously reaching resolution of
litigation claims more quickly and inexpensively than the standard
claims-objection process. In addition, in cases where the projected
percentage recovery for unsecured creditors is fairly low, many litigation
claimants are willing to negotiate settlements in lieu of incurring the
legal costs attendant to litigation over the claim.

</p><p>In addition to reconciling and resolving unsecured
claims based on their merits, preference claims can serve as strong
leverage for additional claim reductions. The evaluation of preference
claims can tend to be very subjective (especially with respect to the
ordinary-course-of-business defense), and the parties tend to have
disparate views on the merits. This uncertainty can often facilitate claim
reductions based on waivers of preference claims.

</p><p>Using the hypothetical distribution chart on p. 68,
assume that proper claim-resolution methods such as those described above
are employed, and the following claim reductions are achieved: secured debt
reduction of 5 percent, priority claim reduction of 30 percent, reclamation
and cure reductions of 30 percent and general unsecured claim reductions of
40 percent. The table below summarizes the significantly better result for
general unsecured creditors:

</p><p><table cellpadding="10" width="300"><tbody><tr><td><b>Final Resolution of Claims</b></td><td></td><td></td><td></td></tr>

<tr><td>&nbsp;</td>
<td><i>Claims</i></td>
<td><i>Payout</i></td>
<td><i>Return</i></td>
</tr>

<tr><td>Secured Debt</td>
<td>$190</td>
<td>$190</td>
<td>100%</td></tr>

<tr><td>Priority Debt</td>
<td>$35</td>
<td>$35</td>
<td>100%</td></tr>

<tr><td>Reclamation and Cures</td>
<td>$70</td>
<td>$70</td>
<td>100%</td></tr>

<tr><td>General Unsecured Claims</td>
<td>$600</td>
<td>$205</td>
<td>34%</td>
</tr></tbody></table>

</p><p>The result is a substantial cent-on-the-dollar
increase to general unsecured creditors, where the return increased from 15
to 34 percent.

</p><p>In conclusion, while many focus on maximizing the
value of assets in a bankruptcy, that is only part of the equation. The
proper management of liabilities as well can significantly improve the
percentage of return to creditors.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} Meade
Monger is a principal with AlixPartners LLC in Dallas, where he leads
AlixPartners's case-management services practice, which primarily
assists bankrupt companies with case management, reorganization and/or
liquidation initiatives. He has significant experience in many industries
and has worked on many of the nation's largest bankruptcy cases,
including <i>Kmart</i> and <i>WorldCom.</i> <a href="#1a">Return to article</a>