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    Locke Lord QuickStudy: The Use of Chapter 11 of the Bankruptcy Code to Address Business Disruption Resulting From COVID-19

    Locke Lord Publications

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    The COVID-19 pandemic has already caused widespread business shutdowns and layoffs as a result of stay at home orders, social distancing, and resulting business interruption.  Many businesses are unprepared to deal with the expected economic fallout of these unprecedented actions.  The potential benefits and protections of chapter 11 of the United States Bankruptcy Code may be more important than ever in helping these companies navigate the current crisis.   

    A company facing these unprecedented challenges can use chapter 11 of the Bankruptcy Code to maximize the value of the company and its assets, preserve key employees and other jobs, and maintain operations throughout the duration of this crisis. While in bankruptcy, the company can continue to operate its business and maintain its leadership and management structure throughout the case.  Perhaps most valuable, the bankruptcy filing triggers an immediate injunction, called the “automatic stay,” which protects companies from creditor demands and enforcement actions, allowing management to focus on a restructuring plan to preserve value and jobs without having to fend off creditor pressures that can disrupt the business as a going concern.  The bankruptcy process may give companies additional leverage and space to reach a consensual reorganization plan with creditors and other interested parties for the benefit of all involved.  

    The current crisis is forcing many companies to confront unique challenges and pressures.  More than just a pause button, a bankruptcy case can enable companies to reorganize and plan a long term strategy that ultimately benefits all interested parties. 

    Tools and Benefits of Chapter 11
    The filing of a bankruptcy petition stays all attempts to collect on pre-bankruptcy debts and affords a debtor many additional benefits, including the possibility for immediate relief from the bankruptcy court to allow for a seamless entry into bankruptcy, an opportunity for new financing, the ability to reject contracts and leases that are burdensome or no longer of value to the company, and provide for a process to sell assets free and clear of all liens and claims. 

    A. The Imposition of the Automatic Stay
    A primary benefit of bankruptcy is the immediate imposition of the “automatic stay.”  Under section 362 of the Bankruptcy Code, an automatic stay is imposed, without the need for application or hearing, upon the filing of the chapter 11 petition.  The automatic stay bars the commencement or continuation of any judicial, administrative, or other action or proceeding against a debtor that could have been commenced before the chapter 11 case, or the recovery on a claim against the debtor that arose before commencement of the case.  In addition, the automatic stay prohibits the exercise of any remedies or attempts to gain control over any property of the estate.  Thus, with certain exceptions, all litigation is stayed or barred from commencing.  

    The stay provides management with a pause from fending off creditors in order to focus on continuing day to day operations, maximizing the company’s value, examining the company’s options for reorganization and/or restructuring of debts, and negotiating a potentially consensual plan with creditors.  In addition, section 1121 of the Bankruptcy Code provides that a debtor has the exclusive right to propose a plan of reorganization for a period of 120 days and the exclusive right (for 180 days) to solicit acceptances of the plan.  Along with the automatic stay, this exclusivity period empowers management to maintain control of the business and direct the reorganization process without the constant commencement of enforcement actions by creditors.   Moreover, this exclusivity period forces creditors and other parties in interest to negotiate with the debtor directly a potentially consensual resolution of disputes and a reorganization plan.  The debtor is thus able to guide the direction of the bankruptcy case, at least during this initial period, without fear that creditors might seek to propose a plan without guidance or input from the debtor. 

    B. Immediate Relief and “First Day” Motions 
    Within days of a chapter 11 filing, the bankruptcy court will schedule a “first day” expedited hearing to address the emergency needs of the debtor.  The debtor typically files emergency motions on the same day as the filing of the bankruptcy petition seeking various forms of immediate relief, including court permission to pay employee wages and to retain bankruptcy and other financial professionals, approval of additional financing (either a DIP loan, which is discussed below, or the use of cash collateral), permission to use and retain present cash management systems, and permission to pay utility bills and other critical vendors in order to assure smooth business operations.  

    At the first day hearing, the debtor will describe the circumstances that lead to the chapter 11 filing, discuss the company’s plan for a successful emergence from bankruptcy, and seek the relief requested in the emergency motions.  Many bankruptcy courts have already announced that they will allow these hearings to be conducted telephonically during the COVID-19 crisis.

    C. Post Bankruptcy Financing 
    Obtaining credit, or “DIP financing,” after the filing of a chapter 11 case is often a critical part of the relief a debtor seeks at the beginning of the case, especially if the debtor is short of liquidity during a crisis.  Pursuant to section 364 of the Bankruptcy Code, a debtor may obtain credit on an unsecured basis in the ordinary course, or on a secured basis with court approval.  A debtor may grant liens on assets not otherwise encumbered or may grant junior liens on assets already encumbered.  The bankruptcy court may also authorize pari passu or senior (“priming”) liens but only if the debtor is unable to obtain credit otherwise and provides adequate protection to other lien holders.  

    Lenders often seek super-priority status and waivers of defenses to pre-petition loan obligations as a condition to their lending agreement, and are often provided attractive interest rates and other protections in the bankruptcy case.  In addition, if a DIP lender is also the debtor’s prepetition lender, the bankruptcy court may permit the lender to “roll up” its prepetition debt with its post-petition DIP loans.  Another route is that the debtor may seek to use a prepetition lender’s cash collateral as long as the debtor provides the lender with “adequate protection” of its lien, typically in the form of periodic payments at the nondefault interest rate. 

    Thus, while traditional sources of financing may be scarce, the added incentives of serving as a DIP lender afford debtors a unique opportunity to obtain credit on an expedited basis once a chapter 11 case has been filed.  Indeed, traditional lenders may even require that companies show concrete chapter 11 planning in order to receive extensions on debt payments or other forms of forbearance.  Thus, planning for chapter 11 and securing postpetition financing can offer a distressed company much needed liquidity during a crisis.  

    D. Rejecting Burdensome Contracts and Leases 
    In times of recession, companies often find themselves burdened by uneconomical contracts.  In bankruptcy, obligations arising from “executory” contracts, i.e., contracts under which all parties have ongoing and incomplete obligations, as well as unexpired leases, can be shed or restructured.  More specifically, a debtor may “reject” executory contracts and unexpired leases.  The rejection of burdensome contracts and overmarket leases is a powerful mechanism for the debtor’s restructuring efforts.  Bankruptcy courts are often deferential in permitting the debtor to pick and choose which contracts to “assume” (i.e. continue performing) or “reject.”  Thus, bankruptcy courts typically allow a rejection if it accords with the debtor’s reasoned “business judgment,” a lenient standard.  If the debtor is a tenant, then it has 120 days to assume leases, but this period may be extended.  Often, an assumption and assignment of such a contract takes place in the context of a sale of related assets.  While the debtor is deciding whether to assume or reject an executory contract, the nondebtor counterparty is obligated to perform its obligations.  The debtor is thus afforded additional space in which to make these decisions without facing the pressure of a contract counterparty refusing to perform. 

    E. “Free and Clear” Sales of Assets
    A debtor may dispose of specific assets, business segments, or the entire business in a chapter 11 case.  These sales, pursuant to section 363 of the Bankruptcy Code, may be made “free and clear” of all liens, claims, and encumbrances.  In addition, a debtor may conduct such a sale pursuant to a plan of reorganization. Sales of major (or substantially all) assets are generally subject to a competitive marketing process and auction procedures.  These procedures may include a potential leading purchaser or a “stalking-horse bidder” being granted certain bid protections.  In addition to these buyer incentives, the bankruptcy court order approving a sale often precludes successor liability claims against the purchaser and insulates the sale approval from many forms of appellate attack.  

    In addition, purchasers often assume executory contracts that are related to the assets they are purchasing and thus become obligated for future performance.  It is important to note, however, that certain courts require that the sale or transfer of executory contracts be subject to the rights of certain nondebtor counterparties, notably IP licensees and tenants.  Thus, while the debtor may sell most assets “free and clear,” including executory contracts, the purchasers may be required to assume the assets subject to a licensee’s rights to certain IP or a tenant’s possessory rights to certain premises.

    F. A Chapter 11 Reorganization Plan 
    The plan approval process channels all disputes and all negotiations over claims and liabilities to a single forum, the bankruptcy court.  This channeling promotes a global resolution of all claims and efficient negotiations with all creditors.  Typically, a plan of reorganization provides for the post-bankruptcy control of current management and directors.  In addition, a chapter 11 plan often contains releases and injunctions in favor of the debtor’s management, including officers and directors who remained with the debtor throughout the chapter 11 case and continue post-reorganization.  Thus, a chapter 11 plan provides substantial protections and benefits and need not be accepted by all creditors in order to be binding upon them.  However, in a typical chapter 11 case, an “impaired” class of creditors must accept the plan.  A debtor must work to convince such a group of creditors that the plan is in their best interests even when they won’t receive a full recovery on their claims.  In sum, the bankruptcy plan typically results in the discharge of substantial unsecured debt obligations without unanimous creditor support, an outcome that would be difficult to achieve outside of bankruptcy.  

    Conclusion
    While the current crisis may be daunting, companies can use the Bankruptcy Code to stay in business and continue operations while providing a period of time to formulate and confirm a plan of reorganization.  The chapter 11 filing affords companies a pause in order to gather themselves and come back to the market on a footing that is stronger for the long term.  The powerful tools and benefits of a chapter 11 filing enable the debtor to negotiate a global resolution with creditors and other interested parties.  These are just some of the benefits that filing for chapter 11 can provide during this crisis.

    Visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19.

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