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Business Bankruptcy Issues The Financially Troubled Company

DIP Financing: How Chapter 11’s Bankruptcy Loan Rules Can Be Used To Help A Business Access Liquidity

Cash Is King. An army may march on its stomach, but for companies, it’s liquidity that keeps the business going. For many companies, typical sources of liquidity, beyond cash flow from sales or other revenue, are (1) financing from banks or other secured lenders, (2) credit from vendors that can reduce immediate liquidity needs, and (3) when needed, loans from owners, investors, or other insiders.

When A Liquidity Crisis Hits. Companies in financial distress often find that their need for liquidity goes up just as the availability of traditional financing goes down. The borrowing base may shrink, the ability to get further advances may be cut off, and loans may go into default. Worse, new lenders may be unwilling to make loans given the distress. For many distressed businesses, revenues may also be declining and insufficient to cover expenses without additional financing. A liquidity crunch can quickly snowball into a liquidity crisis.

Insider Loans. Even if an owner, investor, or other insider might be open to making a loan, the company’s distress may raise a red flag because of the extra scrutiny often given to insider loans to a distressed company. Insiders may be concerned that if they make the loan, creditors or a bankruptcy trustee could later challenge it (and any security interest granted) in an attempt to recharacterize the loan as an equity contribution or have the debt equitably subordinated — and therefore never repaid — in a bankruptcy. 

A Potential Solution: DIP Financing. A company in financial distress is probably already looking at a workout, restructuring, or sale of the business. Out-of-court workouts should be considered and may succeed. However, in the right situation a Chapter 11 bankruptcy can provide powerful options, including the ability to facilitate financing. If a company needs a loan but a potential lender is unwilling to make it, including because of concern about a legal challenge, the Bankruptcy Code offers a way to give the lender comfort that the loan will not be challenged, even if the lender is an insider or a potential purchaser.

  • To explore this further, we first need to review a little bankruptcy terminology. When a company files a Chapter 11 bankruptcy, the company’s management and board of directors remain in possession of its business (unless a trustee is later appointed). For that reason, the company in Chapter 11 is called a "debtor in possession" or a "DIP" for short. The special Chapter 11 bankruptcy financing is known by this acronym: DIP financing.
  • When the debtor company has lined up a lender, it files a motion seeking Bankruptcy Court approval of the DIP financing. Typical DIP financing terms include a first priority security interest, a market or even premium interest rate, an approved budget, and other lender protections. Creditors have a right to object to the DIP loan, and may do so if the proposed lender is an insider, and the Bankruptcy Court will ultimately decide whether to approve it.
  • If the company already has secured debt, to borrow funds secured by a lien equal or senior to the existing lender (often called "priming" the existing lender), the company either will need the existing lender to consent or will have to convince the Bankruptcy Court that the existing lender’s lien position will be "adequately protected" (essentially meaning that the existing lender will not be worse off if the DIP loan is approved).
  • An existing lender itself may be willing to make a DIP loan, even if it has refused to make further advances outside of bankruptcy. In fact, when DIP loans are made they often come from a company’s existing lender. That lender may have its own reasons to use the DIP financing process, for instance, to finance a sale process on specific timelines or otherwise to enhance its position.
  • Unlike a loan outside of bankruptcy, if the Bankruptcy Court gives final approval to a DIP loan and finds that the loan was made in good faith, the new DIP loan will no longer be subject to legal challenge. Put differently, with that approval in hand, a loan that could have been challenged outside of bankruptcy will not be subject to challenge inside of bankruptcy. That’s true even if the lender is an insider or a "stalking horse purchaser" seeking to buy the company’s assets. 
  • The takeaway is that while it isn’t easy, in the right case a distressed company may be able to use Chapter 11 bankruptcy’s DIP financing procedures to get the liquidity it needs, to run a sale process or finance a formal Chapter 11 restructuring, even if it could not get a new loan outside of bankruptcy.

Why Chapter 11? One of the key reasons companies file for Chapter 11 bankruptcy is because of the special legal protections it provides. For the company, those include the automatic stay and, in the right case, the ability to restructure its debts through a Chapter 11 plan of reorganization. Chapter 11’s protections for purchasers of assets can sometimes allow the seller to achieve through Chapter 11 a sale price that it never could have realized without bankruptcy. Likewise, Chapter 11’s DIP financing process for lenders may help the company generate liquidity — including from an existing lender, investor, or stalking horse purchaser — even if it could not do so outside of bankruptcy. 

Conclusion.  A company facing a liquidity crisis should get legal advice from an experienced restructuring and bankruptcy attorney to make sure it considers all options. A workout or other out-of-court restructuring may be able to solve the problem and get the business back on track. However, there are times when a Chapter 11 bankruptcy filing, despite its costs and disruptions, is the best tool in the toolkit. That’s especially true if Chapter 11’s DIP financing rules help a business access liquidity that it could not get outside of bankruptcy.

Business Bankruptcy Issues The Financially Troubled Company

Forced Into Bankruptcy: The Involuntary Bankruptcy Process

When a company is facing financial distress, the question often comes up whether creditors can "force" the company into bankruptcy. Although the answer is more complicated than it may seem, this post aims to sort out what being "forced into bankruptcy" really means (hint: there are two different ways this can happen) and why it matters to companies and creditors.

Forced But Voluntary Bankruptcy. When a company is "forced" into bankruptcy, often what actually has happened is that the company filed a voluntary bankruptcy petition under Chapter 11 (reorganization) or Chapter 7 (liquidation) of the U.S. Bankruptcy Code in response to creditor actions. For example, a secured lender may have declared a default under its loan documents and commenced foreclosure proceedings, or an unsecured creditor may have filed a lawsuit or obtained a judgment against the company. In response, the company filed bankruptcy.

While it may be fair to describe the company as having been "forced" into bankruptcy, technically the company’s board of directors made a voluntary decision to file bankruptcy given the company’s financial circumstances or creditor actions. The distinction is important because a voluntary bankruptcy filing puts the company in bankruptcy immediately, making it subject to the Bankruptcy Code’s provisions and the bankruptcy court’s supervision. In contrast, the other kind of bankruptcy — an involuntary bankruptcy filing — does not. 

A Truly Involuntary Bankruptcy. This begs the question: if the company does not consent, can creditors literally force a company into bankruptcy anyway? The answer is yes, under certain circumstances, and subject to meeting the requirements for filing an involuntary bankruptcy petition. The major requirements, discussed below, are found in Section 303 of the Bankruptcy Code.

  • Required number of creditors. The Bankruptcy Code specifies the minimum number of creditors and amount of their claims: 
    • If a company has 12 or more creditors, an involuntary bankruptcy petition requires (a) three or more creditors whose claims are not contingent as to liability or subject to a bona fide dispute as to either liability or amount to file the petition, and (b) those qualifying claims must total, in the aggregate, at least $14,425 if unsecured or $14,425 more than the value of any liens securing those claims if any are secured.
    • If the company has fewer than 12 creditors, it only takes one qualifying creditor to file an involuntary petition.
    • Additional creditors can join the petition later, and if only one creditor files and it turns out that the company has more than 12 creditors, the bankruptcy court will give other creditors an opportunity to join.
    • The $14,425 amount is adjusted every three years, with the next adjustment due in April 2013.
  • Generally Not Paying Debts. If the company timely objects to the involuntary filing, for the company to be placed in bankruptcy, the company also must: 
    • generally not be paying its debts as they become due unless those debts are subject to a bona fide dispute as to liability or amount, or
    • have had a custodian appointed within the past 120 days to take possession or control of substantially all of its assets.
  • Choosing The Chapter. In the involuntary petition, the petitioning creditors must designate which bankruptcy chapter (Chapter 7 or 11) into which they seek to force the company.

How Is An Involuntary Different? When an involuntary petition is filed, the automatic stay of bankruptcy kicks in immediately to prevent creditor actions, but that’s where the similarities with voluntary bankruptcy end.

  • Unlike a voluntary bankruptcy filing, when an involuntary bankruptcy petition is filed, a company is not immediately placed into bankruptcy and the company may continue to operate its business and use, acquire, or dispose of its property as if an involuntary bankruptcy case had not been filed.
  • Instead, an involuntary bankruptcy petition functions more like a complaint asking the court to declare that the company should be put into bankruptcy. Like a complaint, the involuntary petition must be served together with a summons.
  • Although the bankruptcy court has the authority to appoint an interim trustee or order other restrictions on the company, those do not automatically apply, have to be sought by motion, and may be denied by the bankruptcy court.
  • The company can consent to the involuntary bankruptcy filing. When an involuntary Chapter 7 filing is made, the company can also respond with its own voluntary Chapter 11 filing and take control over the case as a debtor in possession.
  • To contest an involuntary petition, the company must do so within the time allotted by the Federal Rules of Bankruptcy Procedure, currently 21 days after service of the summons. Typically that involves filing an answer or a motion to dismiss.
  • Litigation over whether the requirements discussed above have been met, and thus whether the company should be put in bankruptcy, can involve various pleadings, document and deposition discovery, status conferences, motions for summary judgment, and/or an evidentiary hearing or trial. 
  • If the bankruptcy court ultimately rules in favor of the petitioning creditors, an "order for relief" is entered and the company is officially placed into bankruptcy. At that point, the company is subject to the Bankruptcy Code’s provisions and supervision by the bankruptcy court.

What If The Involuntary Fails? Filing an involuntary bankruptcy petition against a company is, of course, serious business, and the consequences of failing are equally serious.

  • Once filed, an involuntary petition cannot be dismissed without a notice and an opportunity for a hearing, even if the petitioning creditors and the company agree.
  • If the involuntary petition is dismissed, the petitioning creditors can be liable for costs and attorney’s fees of the company.
  • If the bankruptcy court determines that the involuntary petition was filed in bad faith, the petitioning creditors can be liable as well for damages caused by the involuntary filing and even for punitive damages.

When Do Creditors Typically File An Involuntary? The prospect of creditor liability for costs, attorney’s fees, damages, and possibly punitive damages makes involuntary petitions one of the lesser-used creditor tools. Involuntary bankruptcy is most often used when unsecured creditors suspect fraud on the part of a company, such as when a Ponzi scheme is discovered, or for some other extraordinary reason. Otherwise, creditors will typically pursue collection of their own claims directly, including through litigation in state or federal court. That might end up "forcing" the company into bankruptcy, but technically it would be a bankruptcy of the voluntary kind.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Real Estate Workouts: Are Pre-Bankruptcy Waivers Of The Automatic Stay Enforceable?

This post examines a new decision from the Bankruptcy Court for the Southern District of Florida involving the enforceability of a pre-bankruptcy waiver of the automatic stay. Let’s first set the stage by taking a look at a not so uncommon fact pattern involving a real estate project in financial trouble.

The Real Estate Workout: Forbearance With A Price. The owner of a troubled real estate development is about to default on a loan secured by the real property. On the eve of foreclosure, the lender agrees to forbear from foreclosing for two months to give the developer time to refinance and save the project.  However, in exchange the lender insists that the developer agree that, in the event of bankruptcy, the lender would have relief from the automatic stay to foreclose. The developer agrees and the forbearance agreement is executed.

The Bankruptcy Aftermath. Unfortunately, the hoped-for financing falls through and the developer files a Chapter 11 bankruptcy for the project just before the rescheduled foreclosure sale. The lender quickly files a motion for relief from stay, asking the bankruptcy court to enforce the pre-bankruptcy relief from stay waiver included in the forbearance agreement. The motion is opposed by the developer, now a Chapter 11 debtor in possession, as well as the official committee of unsecured creditors and junior lienholders.

Is The Waiver Of The Automatic Stay Enforceable? This was the question answered by Bankruptcy Judge John K. Olson in an 18-page decision, issued on February 12, 2008, in the In re Bryan Road, LLC Chapter 11 bankruptcy case. The facts were essentially as described above, but a few additional details help put the issue in context.

  • The real estate project involved a 210 unit "dry stack" boat storage facility in Dania Beach, Florida.
  • The lender, which commenced a judicial foreclosure proceeding against the 191 units still owned by the debtor, had been awarded final judgment setting a foreclosure sale.
  • On the morning of the foreclosure sale, the debtor and the lender entered into a forbearance agreement that was approved by the court in the foreclosure proceeding. The forbearance agreement provided for a two-month continuance of the foreclosure sale in exchange for the debtor’s agreement that the lender would have relief from the automatic stay to foreclose in the event of a bankruptcy.
  • The day before the continued foreclosure sale was to take place, the debtor filed its bankruptcy petition.

The Bankruptcy Court’s Analysis. In his decision on the lender’s stay relief motion, Judge Olson first noted that prepetition waivers of the stay will be given "no particular effect as part of initial loan documents" but the "greatest effect if entered into during the course of prior (and subsequently aborted) chapter 11 proceedings." After concluding that a confirmed chapter 11 plan was not required, the Bankruptcy Court looked to four non-exclusive factors, drawn from In re Desai, 282 B.R. 527 (Bankr. S.D. Ga. 2002), in considering whether stay relief should be granted based on the prepetition waiver:

(1) the sophistication of the party making the waiver; (2) the consideration for the waiver, including the creditor’s risk and the length of time the waiver covers; (3) whether other parties are affected including unsecured creditors and junior lienholders; and (4) the feasibility of the debtor’s plan.

As to the first two factors, the Bankruptcy Court found that the debtor’s counsel was very sophisticated and, although the forbearance period was short, it was sufficient consideration. On the third and fourth factors, the Bankruptcy Court first noted the existence of junior lienholders and approximately $1 million of disputed unsecured claims. However, the Bankruptcy Court then engaged in a detailed analysis leading to the conclusion that the debtor’s plan simply was not feasible. As such, there likely was no value for unsecured creditors in the boat storage project beyond the secured debt and the junior lienholders could protect their own interests under state law. Putting these factors together, the Bankruptcy Court concluded that the forbearance agreement — including the waiver of the automatic stay — should be enforced and the stay was lifted.

A Few Key Take-Aways. With economic conditions continuing to strain a variety of real estate developments, workouts in the shadow of foreclosure may become more common. The In re Bryan Road, LLC decision highlights that in the right case a bankruptcy court may be willing to enforce prepetition stay relief agreements if a bankruptcy is later filed.

  • This is particularly true when the debtor is a single asset real estate entity, it signs an agreement on the eve of foreclosure, and it has few unsecured creditors. In fact, the more the bankruptcy appears to be just a two-party dispute between the debtor and lender, the more likely the prepetition automatic stay waiver will be enforced.
  • On the other hand, when a troubled real estate project has a real chance of reorganizing, and substantial unsecured creditor claims are involved, these agreements more likely will be rejected in favor of traditional relief from stay analysis under Section 362 of the Bankruptcy Code.

Conclusion. Prepetition stay relief agreements involve complex issues. As with most bankruptcy questions, real estate owners and lenders should get advice from bankruptcy counsel on their specific situation when considering whether to include such a waiver of the automatic stay in any forbearance agreement.

Business Bankruptcy Issues

Automatic Stay Of Bankruptcy

One of the most fundamental protections for companies or individuals filing for bankruptcy is the automatic stay.  In fact, when someone says a company has sought "bankruptcy protection" they usually are referring to the "protection" of the automatic stay.  The automatic stay arises the instant a bankruptcy petition is filed.  It doesn’t matter whether the petition is a voluntary one filed by the company itself or an involuntary one filed by creditors seeking to force the company into bankruptcy. 

The automatic stay operates as a stay — really a statutory injunction — against almost all collection actions by creditors against a debtor and its property based on debts existing before the bankruptcy petition was filed.  It is called the automatic stay because this stay arises automatically when the petition is filed without the need for any court order.  Among the actions stayed are:

  • Lawsuits 
  • Repossessions of assets
  • Foreclosure sales
  • Collection calls and notices, and
  • The making of setoffs.

Creditors should make every effort to avoid a violation of the automatic stay.  Violating the automatic stay is serious business (even when the government does it).  This is especially true if the debtor is an individual.  Not only are actions in violation of the stay generally held to be void, but in some cases creditors can expose themselves to a claim for damages or even punitive damages.  

Creditors can ask the bankruptcy court for relief from the automatic stay, for example to allow a lawsuit to continue or a foreclosure sale to take place.  While such "relief from stay" is occasionally granted, more often the request is denied to give the debtor more breathing room to reorganize its business.  In any event, seek assistance from a bankruptcy attorney if you have questions about or need relief from the automatic stay.