Restructuring and insolvency in United States: overview
A Q&A guide to restructuring and insolvency law in the United States.
The Q&A gives a high level overview of the most common forms of security granted over immovable and movable property; creditors' and shareholders' ranking on a company's insolvency; mechanisms to secure unpaid debts; mandatory set-off of mutual debts on insolvency; state support for distressed businesses; rescue and insolvency procedures; stakeholders' roles; liability for an insolvent company's debts; setting aside an insolvent company's pre-insolvency transactions; carrying on business during insolvency; additional finance; multinational cases; and proposals for reform.
To compare answers across multiple jurisdictions, visit the Restructuring and Insolvency Country Q&A tool.
This Q&A is part of the multi-jurisdictional guide to restructuring and insolvency law. For a full list of jurisdictional Q&As visit www.practicallaw.com/restructure-mjg.
Forms of security
In the United States, when a creditor lends money to a debtor, the creditor often insists on some form of security to ensure, or at least significantly reduce, the risk of non-payment on its loan. In order to create an effective security interest in movable or immovable property, and to enforce that interest against subsequent creditors of the debtor, certain formalities must be adhered to. In all jurisdictions in the United States, a creditor must put the public on notice of its interest in the debtor's property, whether movable or immovable, in order for that interest to be effective against third parties. A failure to put the public on notice of the creditor's interest, or otherwise comply with the formalities described below, can render the creditor's security unenforceable, leaving the creditor unsecured and reducing the likelihood of full repayment on the creditor's loan in the event the debtor defaults or files for bankruptcy.
Common forms of security. The most common forms of security granted over immovable property (that is, real property) are a mortgage or deed of trust. Both a mortgage and deed of trust secure the repayment of a loan by placing a lien on the real property. With a mortgage, depending on state law, either the borrower or lender can hold actual title to the real property. With a deed of trust, neither the borrower nor the lender hold title to the property, but a third-party trustee holds title for the benefit of the lender. A mortgage and deed of trust also differ in the rights a lender has following a default by the borrower. With a mortgage, the lender must obtain court authority to seize the collateral (that is, a judicial foreclosure). With a deed of trust, the trustee has the authority to foreclose on the property through a non-judicial sale.
A debtor's property can also be subject to certain non-consensual liens, such as judicial liens, tax liens or mechanics' liens.
Formalities. The creation and enforcement of a security interest in immovable property is governed by state law. Secured creditors must put the public on notice in order for the creditor to have lien priority over subsequent creditors. Notice can be accomplished by actual notice, constructive notice (a third-party reasonably should know about the lien based on the circumstances), or record notice. The real property mortgage system, where the security instrument must be duly recorded, is divided into separate counties and the security instrument must be filed at the local county courthouse or recorder's office where the property is physically located.
A security interest in a fixture (something attached as a permanent appendage, apparatus, or appliance) should also be filed in the real property recording system; a UCC-1 financing statement with respect to a fixture is unnecessary and ineffective.
Under the "first to file" rule, the first creditor to properly file its security instrument will have the highest priority lien on that real property.
Effect of non-compliance. A failure to comply with the required formalities can result in the security interest being deemed invalid or unenforceable and leave the creditor's lien unsecured or subordinated to other creditors. In the event of a bankruptcy proceeding, a failure to comply with the required formalities may result in the avoidance of the security interest and leave the creditor with a claim reduced to unsecured priority status.
Common forms of security. The most common form of security granted over movable property (that is, personal property) is a security interest or lien in the debtor's property. Article 9 of the Uniform Commercial Code (UCC), a version of which has been enacted in some variation in all 50 states, the District of Columbia and Puerto Rico, governs the creation and enforcement of security interests in movable property.
Formalities. In order for a security interest to be enforceable the security interest must "attach" to the collateral. Attachment requires satisfaction of the following three conditions:
Value has been given.
The debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party.
The debtor has authenticated a security agreement that provides a description of the collateral.
In order for a security interest to be effective against third parties, the UCC requires the secured creditor to take some affirmative action to put the public on notice of its security interest, a concept referred to as "perfection" of the security interest. The UCC prescribes the ways that a secured creditor can perfect its security interest, which varies based on the nature of the collateral. The most common form of perfection is to file a proof of the security interest, known as a UCC-1 financing statement. The financing statement must include:
The debtor's name and address.
The creditor's name and address.
A description of the encumbered property in terms sufficient to give third parties inquiry notice of the security interest.
The financing statement must also be filed with the office of the state secretary of state in the state where the debtor is located.
A security interest can also be perfected, absent the filing of a financing statement, if the secured creditor takes possession of the collateral.
In order to perfect a security interest in a deposit account, a creditor must "control" the account. The most common way for a secured creditor to gain control, and perfect its security interest, is to enter a control agreement with the debtor and the applicable bank. Under the control agreement, the bank agrees to comply with instructions originated by the secured creditor directing disposition of the funds in the account without debtor's further consent.
Under the "first to file" rule, if a secured creditor is the first to perfect its security interest in the movable property, that secured creditor will have a first priority lien over that collateral, subject to certain exceptions for mechanics' liens and certain tax liens.
Effect of non-compliance. If the creditor's security interest has attached to the collateral, but the creditor has failed to perfect its interest, the secured creditor's interest will be subordinated to a perfected security interest in that collateral and/or to any lien creditor that comes into existence prior to the secured creditor perfecting. In the event of a bankruptcy proceeding, a failure to comply with the required formalities may result in the avoidance of the security interest, leaving the creditor with an unsecured claim against the debtor's estate.
Creditor and contributory ranking
Chapter 7 of the United States Bankruptcy Code (which governs the process of liquidation) and Chapter 11 of the United States Bankruptcy Code (which governs a reorganisation) generally follow the same priority of distribution scheme. However, in Chapter 11, the court-approved plan of reorganisation will dictate the distribution to creditors and interest holders, and a negotiated plan of reorganisation may, in certain circumstances, modify the priority of distribution strictly adhered to in all Chapter 7 cases.
In a Chapter 11 proceeding the doctrine known as the absolute priority rule, applicable when a class of impaired unsecured creditors objects to a plan of reorganisation, can prevent equity holders from retaining their equity interest unless all creditors are paid in full, subject to certain caveats. Specifically, when the absolute priority rule is invoked, in order to confirm a reorganisation plan the court must find that the plan is "fair and equitable", which can only be established if one of the following two conditions are satisfied:
The allowed value of the dissenting class of claims is paid in full under the plan.
If the holder of any claim or interest that is junior to the dissenting creditors will not receive or retain any property under the plan on account of such junior claim or interest.
Some jurisdictions recognise limited exceptions to the absolute priority rule, such as the new value doctrine. The new value doctrine allows for equity holders to make a substantial and essential contribution in exchange for the retention of their equity interest in circumstances where the absolute priority rule would otherwise be violated. To be substantial, most courts require that the contribution directly relate to the success of a reorganisation plan and be a present contribution, freely tradable in the market, and constitute money or money's worth.
Bankruptcy Code's priority scheme
The United States Bankruptcy Code provides the following general order of priority for creditors and equity interest holders.
Secured creditors. A creditor with a valid and perfected security interest in property of the bankruptcy estate as of the date the bankruptcy petition is filed will have a first priority lien over that property. A secured creditor is entitled to accrue interest on its claim during the bankruptcy proceeding if the creditor is "oversecured", meaning the collateral securing that claim is greater than the amount of the claim. A secured creditor may also be entitled to adequate protection payments to compensate the creditor for any diminution in the value of the creditor's collateral during the bankruptcy case. To the extent that a secured creditor's claim for principal, accrued interest and other fees and expenses due under the applicable agreements exceeds the fair market value of its collateral, the secured creditor will have an unsecured claim for the deficiency.
"Super priority" claims. In certain circumstances, a debtor-in-possession (DIP) lender (a financial institution or fund/investor that loans money to a debtor during the course of a bankruptcy proceeding) may be granted a "super priority" interest in property of the estate for the amount of the financing. Super priority status effectively means that a secured creditor's claim, to the extent it was unsecured or became unsecured during a bankruptcy case (or lends money during the case and because of the declining value of its collateral becomes undersecured), will have a claim that is senior to all allowed claims against the bankruptcy estate, subject to certain limited caveats. In order to obtain financing on these terms, the debtor-in-possession or trustee must establish that it could not obtain financing from another lender on less onerous terms.
Administrative expenses. Under the United States Bankruptcy Code the expenses associated with a bankruptcy proceeding are paid first before other unsecured creditors' claims. Administrative expenses generally arise only after the bankruptcy petition is filed and are the actual, necessary costs and expenses of preserving the estate. These expenses include, among other things:
Professional fees, such as the fees for the debtor and official committees' advisors, and fees associated with an examiner or trustee.
A debtor can also borrow money and incur debt during a bankruptcy proceeding, with the lender receiving administrative expense priority.
Priority unsecured claims. The Bankruptcy Code includes a list of certain types of unsecured claims that are granted priority treatment over general unsecured claims. These include, among others:
Claims for certain domestic support obligations.
Employee salary and wage claims.
Certain pre-petition tax claims.
General unsecured claims. General unsecured claims are claims that are neither secured by property of the estate nor entitled to priority treatment. General unsecured claims do not accrue interest during a bankruptcy proceeding unless the estate is solvent.
Subordinated claims. Creditors who hold claims that have been subordinated, either by a court order or by a voluntary agreement entered among creditors, are generally (but not always) paid after the satisfaction of general unsecured claims and prior to equity interest holders.
Equity interest holders. The estate's equity claimants are the last in line to be paid in a bankruptcy proceeding, and will often receive no recovery from the debtor's estate.
Unpaid debts and recovery
Critical vendor payments
If a trade creditor is deemed a "critical vendor", some jurisdictions will allow the debtor to pay the vendor for pre-petition claims on, or close to, the first day of a bankruptcy proceeding. The purpose of critical vendor payments are to ensure that the critical vendor will not cease conducting business with the debtor during the bankruptcy proceeding and disrupt the debtor's prospects of reorganising. Over the last several years, largely as a result of the US Court of Appeals for the Seventh Circuit's high-profile disallowance of critical vendor payments in Kmart's bankruptcy, many courts have been more reluctant to authorise critical vendor payments. Certain jurisdictions are unwilling to liberally approve critical vendor payments because these payments effectively guarantee payment to certain vendors ahead of other creditors of equal rank in contravention of the priority and distribution provisions set out in the Bankruptcy Code. Nevertheless, a trade creditor may still secure payment on its pre-petition debt if the debtor can demonstrate that the following two circumstances are present:
The critical vendor will stop deliveries if pre-petition arrears are not paid.
Paying the critical vendor will preserve a reorganisation that will provide all creditors with at least the recovery they would have received if the debtor had not paid the critical vendor and liquidated.
Administrative expense treatment
The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), passed by Congress in 2005, provides suppliers of goods to the debtor with an administrative expense claim equal to the value of any goods that the debtor received in the ordinary course of business within 20 days prior to the debtor's bankruptcy filing. These claims have priority over any other unsecured claims in a bankruptcy proceeding and such administrative expenses must be paid in full in cash on the effective date of any Chapter 11 plan.
Reclaim delivered goods
Under the Bankruptcy Code, a creditor may reclaim, upon written demand, any goods sold to the debtor in the ordinary course of the creditor's business if the debtor received the goods while insolvent, within 45 days before the date of the commencement of the debtor's bankruptcy case. The creditor must prove the debtor's insolvency at the time of its reclamation demand based on a balance sheet test of liabilities exceeding assets. The creditor must also demand in writing reclamation of the goods either:
Not later than 45 days after the date of receipt of such goods by the debtor.
Not later than 20 days after the date of commencement of the debtor's case, if the 45-day period expires after the commencement of the case.
Although there is no mandatory set-off obligation in bankruptcy, the Bankruptcy Code preserves the right to set-off mutual debts arising under non-bankruptcy law. In order to effect a set-off post-petition, a creditor must gain relief from the automatic stay. However, where all the elements of a valid set-off claim are satisfied (meaning, that the debts are mutual between the creditor and the actual debtor entity, and the debt arose pre-petition), it is unlikely that a bankruptcy court would deny a creditor the right to exercise this remedy. Therefore, a creditor is generally deemed a secured creditor to the extent its set-off rights can be enforced.
A creditor is entitled to set-off mutual debts pre-petition, but certain set-offs effected within 90 days of the petition date can potentially be recovered in whole or in part by the bankruptcy estate. Whether a pre-petition set-off is subject to avoidance depends on whether the creditor improved its position in the bankruptcy case by virtue of the set-off. In other words, the set-off is subject to avoidance to the extent that the "insufficiency" (the amount that the debt owed by the debtor exceeds the debt owed to the debtor) measured on the date of the set-off is less than the insufficiency on the later date that is either:
90 days before the filing.
The first day that there is an insufficiency during the 90 days preceding the petition date.
In certain circumstances a creditor can invoke the doctrine of recoupment. Although there is no specific provision of the Bankruptcy Code authorising a creditor's right of recoupment, bankruptcy courts have sanctioned the exercise of this equitable remedy. Where applicable, recoupment allows a creditor to avoid payments owed to a debtor to the extent that a creditor holds a claim against the debtor that arises from the same transaction. Unlike set-off, a creditor's recoupment rights are not subject to the automatic stay or the improvement-in-position test. Recoupment can therefore serve as a powerful remedy, allowing a creditor's claim to be offset against debt owed without the specific restrictions stated in the Bankruptcy Code.
Prior to the filing of a bankruptcy case, creditors can bring actions in state court to seek a judgment on their unsecured debt. The following forms of relief, among others, are available:
Attachment. A legal procedure where a court designates specific property owned by the debtor to be transferred to the creditor, or sold for the benefit of the creditor.
Garnishment. A legal procedure where a court designates specific property in the possession of a third party to be transferred to the creditor, or sold for the benefit of the creditor.
Receivership. A court order where the property subject to dispute is placed under the control of an independent person known as a receiver.
In the United States, government support in a bankruptcy proceeding is unusual, but not unprecedented. The high-profile bankruptcy proceedings of General Motors and Chrysler Corporation are examples of the rare instance where the federal government will intervene to support the restructuring efforts of a Chapter 11 debtor. The federal government only agreed to provide financial assistance to General Motors and Chrysler, however, based on the theory that the automobile manufacturing industry was a critical sector of the United States' economy, and that a failure to rehabilitate these corporations would be extremely detrimental to the domestic and global economy. During the course of these proceedings, the United States loaned billions of dollars to not only General Motors and Chrysler, but other key players in the automotive industry, the majority of which has since been paid back well ahead of schedule.
Although the restructuring of General Motors and Chrysler arguably show how government support can be effective in a bankruptcy proceeding, especially where debtor-in-possession financing may otherwise be unavailable, it is very rare to see any level of government support in a typical Chapter 11 case.
Rescue and insolvency procedures
Chapter 11 reorganisation
Objective. A Chapter 11 reorganisation is used primarily by a corporation, sole proprietorship, or partnership that seeks to continue operating a business and repay creditors concurrently through a court-approved plan of reorganisation. The purpose of Chapter 11 is to preserve the debtor's business as a going concern though restructuring its debt and equity.
Initiation. A Chapter 11 case is commenced by the filing of a petition for relief with the bankruptcy court where the debtor has a domicile or residence. The proceeding can be commenced either voluntarily by the debtor, or involuntarily by the debtor's creditors provided the court finds that the debtor is generally not paying its debts as they become due and certain other conditions precedent are satisfied. Unless the court orders otherwise, in addition to filing the petition, the debtor must also file:
A schedule of assets and liabilities.
A schedule of current income and expenditures.
A schedule of executory contracts and unexpired leases.
A statement of financial affairs.
Substantive tests. There is no per se substantive test to initiate a Chapter 11 proceeding. Corporations, partnerships, limited liability companies, business trusts, unincorporated associations and individuals are eligible to file under Chapter 11. A debtor need not be insolvent or even unable to pay its debts when due in order to file for Chapter 11. Although there is no "good faith" requirement for the filing of a Chapter 11 petition, several jurisdictions in the United Sates have concluded that the filing of a petition in "bad faith" constitutes grounds for dismissal or conversion of the case to a Chapter 7 proceeding.
Consent and approvals. During the first 120 days after the petition is filed, the debtor has the exclusive right to file a plan of reorganisation (this period can be extended by the court for at most 18 months from the petition date). In order for a plan to be confirmed it must include certain information, including:
How claims and interests are classified.
Whether such classes are impaired under the plan.
How impaired classes will be treated under the plan.
To confirm a plan, all impaired creditors or interest holders (meaning those whose contractual rights are to be modified or who will be paid less than the full value of their claims under a plan) that are entitled to vote must approve the plan. A class of claims is considered to have accepted a plan when more than one-half in number and at least two-thirds in dollar amount of the claims which actually voted, voted in favour of the plan. A class of interests is considered to have accepted a plan when at least two-thirds in amount of such class which actually voted, voted to accept the plan.
In order for a plan to be confirmed the bankruptcy court must find, among other things, that:
The plan was proposed in good faith and not by any means forbidden by law.
The proponent of the plan made certain required disclosures.
The plan is feasible.
Where one or more classes of claims or interests has not accepted the plan, the court can still confirm the plan, and "cram down" the plan on a dissenting class, provided that the plan does not discriminate unfairly and is fair and equitable with respect to each impaired non-accepting class. A plan is fair and equitable if, among other things, it satisfies the "absolute priority rule" (see Question 2).
Supervision and control. During a Chapter 11 case, the debtor and existing management typically remain in control as a debtor-in-possession. The debtor-in-possession is a fiduciary with the rights and powers of a Chapter 11 trustee (see Question 11).
The bankruptcy court oversees the bankruptcy case and the US trustee monitors the progress of the Chapter 11 case and supervises its administration.
Protection from creditors. The filing of a bankruptcy proceeding automatically triggers the automatic stay, which prohibits any party from taking any action that affects the debtor or its property, including suspending all collection activities, set-offs, foreclosures and repossessions of property. Certain limited types of actions are exempt from the automatic stay, such as the commencement of a criminal action against the debtor. The automatic stay remains in effect during the duration of the bankruptcy proceeding, although a secured creditor can in some instances obtain relief from the stay. For example, bankruptcy courts will often lift the automatic stay for a secured creditor to foreclose on estate property if the debtor has no equity in the property and the property is not necessary for an effective reorganisation.
Length of procedure. The length of the typical Chapter 11 case, sometimes referred to as a "free fall", varies greatly depending on the size of the case and the complexity of the legal issues. In a "free fall" the debtor enters bankruptcy due to a shortage of capital and without a restructuring arrangement with its major stakeholders. These cases are generally the longest in duration.
The shortest type of Chapter 11 case is a "pre-packaged" case, in which, prior to filing bankruptcy, the debtor has proposed a plan of reorganisation to its creditors, and the creditors have voted in favour of the plan. A "pre-packaged" case is much shorter than the typical "free fall" case, and can be completed in as short as a few months.
A "pre-arranged" or "pre-negotiated" plan is a hybrid of a "free fall" and "pre-packaged" case. In a "pre-arranged" case, the debtor files for bankruptcy after negotiating the terms of a restructuring with its major stakeholders, often resulting in certain stakeholders entering into a plan support agreement setting forth the material terms of the proposed restructuring. Shortly after commencing the bankruptcy case, the debtor will solicit acceptances of the plan.
Conclusion. The confirmation of a plan of reorganisation discharges a debtor from any debt that arose prior to the date of confirmation. Following confirmation, the debtor is bound by the provisions of the plan and is required to make payments under that plan. A final decree closing the case is entered after the estate has been fully administered.
Chapter 7 liquidation
Objective. The objective of Chapter 7 is to achieve an orderly, court-supervised procedure in which a court-appointed trustee can:
Take over the debtor's assets.
Expeditiously reduce the assets to cash.
Make distributions to creditors, subject to the debtor's right to retain certain exempt property.
Initiation. The process for initiating a Chapter 7 case is the same as a Chapter 11 case. Namely, the filing of a petition voluntarily by a debtor, or involuntarily by the debtor's creditors.
Substantive tests. One of the most significant amendments made to the Bankruptcy Code by the enactment of BAPCPA was the adoption of the "means test", which is aimed at curbing perceived abuses of the Chapter 7 process. Now, if a debtor's current monthly income is more than the state median, the "means test" is applied to determine whether the filing is presumptively abusive. Abuse is presumed if the debtor's aggregate current monthly income over five years, net of certain statutorily allowed expenses, is more than US$11,725 or 25% of the debtor's non-priority unsecured debt (as long as that amount is at least US$7,025). The debtor may rebut a presumption of abuse by showing special circumstances that justify additional expenses or adjustments of current monthly income. If the debtor is unable to overcome the presumption, the proceeding will be converted to Chapter 13 (if the debtor consents), or will be dismissed.
Supervision and control. The bankruptcy court oversees the bankruptcy case and the US trustee monitors the progress of the Chapter 7 case and supervises its administration. When a Chapter 7 petition is filed, the US trustee appoints (or in some cases the creditors elect) an impartial Chapter 7 trustee to administer the case and liquidate the debtor's non-exempt assets, and the debtor's management and personnel are generally displaced (see Question 11).
Protection from creditors. The automatic stay protects a debtor from any attempts by its creditors to collect debts or enforce liens in the same manner as in a Chapter 11 case (see above, Chapter 11 reorganisation: Protection from creditors).
Length of procedure. The typical Chapter 7 case moves relatively quickly, and often is completed within three to six months from the petition date. However, a Chapter 7 case cannot close until the trustee completes its collection efforts and claims administration process, the length of which will depend on the size of the debtor's assets and liabilities and the complexity of the issues involved.
Conclusion. In most Chapter 7 cases, if the debtor is an individual, he receives a discharge that releases him from personal liability for certain dischargeable debts. Corporations and partnerships are not entitled to a discharge under Chapter 7, and a liquidated corporate debtor must dissolve in accordance with applicable state law following a completion of its bankruptcy. A final decree closing the case is not entered until the trustee has reported that all of the assets have been administered and the money recovered has been paid to creditors who filed proof of claims.
The stakeholders with the most significant role in a bankruptcy proceeding generally include the following.
The debtor-in-possession or the Chapter 7 or 11 trustee. The debtor-in-possession or the Chapter 7 or 11 trustee control the day-to-day operations of a debtor's business and arguably have the most significant role in the outcome of the bankruptcy case (see Question 11).
Creditors' committee. The official creditors' committee helps to ensure that unsecured creditors are adequately represented in a bankruptcy case. A creditors' committee is appointed by the US trustee, and generally consists of the creditors who hold the largest unsecured claims against the debtor that are willing to serve on the committee. The creditors' committee, among other things, may perform the following functions:
Monitor the proceedings and assert the interests of the unsecured creditors, either by moving for specific relief or challenging the actions of other parties.
Confer with the debtor on the administration of the case, and participate in the formulation of a plan of reorganisation.
Investigate the debtor's conduct.
Secured creditors. Secured creditors also have some level of control over a restructuring proceeding because a debtor generally cannot use, sell or lease the creditor's collateral, outside of the ordinary court of business, without the creditor's consent or where the court, after notice and a hearing, authorises such use, sale or lease. Furthermore, the debtor must provide the secured creditor with adequate protection for any diminution in value of a secured creditor's lien during the bankruptcy proceeding.
Post-petition lenders. Debtor-in-possession financing agreements are sometimes used by lenders to gain significant leverage and control of a debtor's reorganisation. For example, debtor-in-possession financing agreements may require the debtor to hire new management or a Chief Restructuring Officer subject to the lender's approval, or require the debtor to file a plan of reorganisation on a specified date or face a sale of substantially all of its assets.
Although directors and officers will generally be protected from liability by the business judgment rule for decisions that were made in good faith and with reasonable skill and prudence, the following doctrines provide some authority for a court to hold a director, partner or parent entity liable for a debtor's obligations.
Piercing the corporate veil
Piercing the corporate veil refers to the judicial act of imposing personal liability on the owners, shareholders, members or directors of a corporate entity. Although the law varies by state, most courts impose a presumption against piercing the corporate veil unless serious fraud or misconduct has occurred. The party seeking to pierce the corporate veil carries the high burden of proof to establish the grounds for veil piercing, and courts will typically look to the following factors, among others:
Disregard of corporate formalities.
Overlapping ownership, officers and directors.
Intermingling of funds.
Shared bank accounts, office space and other property.
Whether dealings between the separate entities were at arm's length.
Courts assess the totality of the circumstances, with no one factor being determinative. Therefore, whether a court will pierce the corporate veil and hold a director, partner or parent entity liable for an insolvent debtor's debts is based on a fact intensive inquiry, but courts will typically only grant such relief in exceptional cases where an entity's corporate separateness has been so ignored that the entity is effectively an alter ego.
A related concept in American bankruptcy jurisprudence is substantive consolidation. The application of this doctrine results in the assets and liabilities of one or more separate legal entities being combined and treated for purposes of the Chapter 11 proceeding as a single consolidated enterprise. A court may be inclined to substantively consolidate legally separate entities if one of the following circumstances exist:
The creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit.
The affairs of the debtors are so entangled that consolidation will benefit all creditors.
Although substantive consolidation is not uncommon, the unanimous consensus among bankruptcy courts is that the remedy should only be invoked in narrow circumstances given the potential to prejudice creditors of the bankruptcy estate.
Setting aside transactions
Who prosecutes avoidance actions?
Although it is typical for a bankruptcy trustee or a debtor-in-possession to prosecute avoidance actions, the Bankruptcy Code provides that avoidance actions can also be pursued by a representative of the estate appointed for such purpose. The primary test for whether a party qualifies as a representative of the estate is whether a successful recovery by the appointed representative would benefit the debtor's estate, particularly the debtor's unsecured creditors.
The Bankruptcy Code allows a pre-petition transaction to be avoided as a preferential transfer if the transfer occurred within 90 days of the bankruptcy filing to a non-insider, or within one-year to a corporate insider. In order to be avoided as a preference, in addition to occurring in the foregoing time period, the following elements must all be shown:
The debtor was insolvent at the time of the transfer.
The payment was on account of antecedent debt.
The payment enabled the creditor to receive more than it would have received on the debt in a liquidation if the payment sought to be avoided had never been made.
The Bankruptcy Code sets out certain transfers that are exempt from avoidance as preferences including, among other transactions:
Transfers that were intended as, and in fact were, a contemporaneous exchange for new value.
Transactions made in the ordinary course of the debtor and transferee's business.
Pre-petition transfers can be avoided as fraudulent transfers under a theory of actual fraud or constructive fraud. A transfer is deemed "constructively" fraudulent if the following elements can be shown:
The debtor received less than reasonably equivalent value.
The debtor was insolvent at the time of the transfer (or rendered insolvent on account of the transfer), was engaged in business for which the debtor had unreasonably small capital, initially incurred debts beyond the debtor's ability to pay, or made the transfer to for the benefit of an insider.
Under federal bankruptcy law, a constructively fraudulent transfer can only be avoided if the transfer was made within two years of the petition date.
A transfer can also be avoided under the theory of actual fraud if a creditor can show that the debtor made the transfer with the "actual intent to hinder, delay, or defraud". Actual fraudulent conveyance actions are also subject to a two-year look back period.
A trustee or debtor-in-possession can also bring fraudulent avoidance actions under applicable state law. Every state has adopted a statute which enables a party to avoid fraudulent conveyances, and often these statues have a four or six year look back period.
Strong arm powers
The Bankruptcy Code has a "strong arm" statute that enables the trustee or debtor-in-possession to avoid certain pre-bankruptcy transfers by the debtor that could have been avoided by a judgment lienholder, an unsatisfied lien creditor, or a bona fide purchaser, whether or not any such party actually exists. For example, if a bank had failed to properly perfect its security interest with respect to a lien on estate property, the debtor-in-possession or trustee can assert its "strong arm" power to avoid the bank's security interest, leaving the bank with an unsecured claim.
Third parties' rights
If the trustee has established the authority to avoid a transfer, either as a preference or fraudulent conveyance, the trustee is entitled to recover the transfer from the entity that received the transfer, referred to as the initial transferee, or from subsequent transferees who received the transfer from either the initial transferee or from another subsequent transferee.
The estate cannot recover from a subsequent transferee that takes for value in good faith and without knowledge of the voidability of the transfer avoided, referred to as the good faith transferee, or any immediate or mediate transferee of this good faith transferee.
A cause of action to recover against a transferee must be brought within one year of the avoidance of the transfer on account of which recovery is sought.
Carrying on business during insolvency
Upon commencement of a bankruptcy case, an estate is created consisting of the debtor's assets and all of its rights and entitlements. Generally in Chapter 11 cases, the debtor continues to operate its business in the ordinary course, subject to oversight by the bankruptcy court, and is charged with the powers and duties of a trustee. This is known as a "debtor-in-possession". Chapter 11 is designed so that the debtor's board of directors generally remain in place and are not supplanted by a trustee unless exceptional circumstances, such as fraud, gross mismanagement, or creditor mistrust, are demonstrated. This is due to the fact that current management is generally most familiar with the debtor's business and is best suited to orchestrate the process of rehabilitation for the benefit of creditors and other interests of the debtor's estate.
In every Chapter 7 case, and occasionally in a Chapter 11 case, an impartial bankruptcy trustee will be appointed. In a Chapter 7 case, the trustee is charged with managing the affairs of the debtor's estate, including the collection and sale of the estate's assets. A Chapter 7 trustee may also continue to operate the debtor's business for a brief period of time, but this is usually short as a Chapter 7 trustee typically liquidates the estate's assets relatively quickly.
The bankruptcy court can appoint an independent trustee in a Chapter 11 case upon finding that the debtor's management is guilty of fraud, dishonesty, incompetence, gross mismanagement, or other bad acts. Courts uniformly hold that appointment of a Chapter 11 trustee is an extraordinary remedy and there is a strong presumption for existing management to remain in control of the business. Therefore, it is unusual (particularly early in a Chapter 11 case and even more so in a complex case involving a large debtor) for the court to remove existing management through the appointment of a trustee. In contrast to a Chapter 7 trustee, a Chapter 11 trustee will generally continue to operate the debtor's business and will work to develop a plan of reorganisation.
Sometimes creditors are able to replace incumbent management, particularly if they are united in their desire to replace management. For instance, pre-petition lenders that agree to provide post-petition financing often have the leverage to require the appointment of a Chief Restructuring Officer (CRO) as a condition to providing financing (see Question 8). Generally, appointment of a CRO will require compliance with the guidelines set out in the J. Alix Protocol, which is enforced by New York and Delaware courts. Under this protocol, approval of a CRO will need the express approval of the debtor's board of directors and the CRO will act under the direction, control and guidance of the board.
When a company files for bankruptcy it will likely need cash at the beginning of the case in order to continue to operate its business. Although the debtor-in-possession or trustee may obtain unsecured credit in the ordinary course of business, financial institutions will generally by unwilling to lend on an unsecured basis to an entity in Chapter 11 proceedings. In the likely instance that a debtor cannot obtain financing on an unsecured basis, a court can authorise the debtor to obtain secured financing, often referred to as debtor-in-possession financing.
Debtor-in-possession financing is a robust business in the United States and many lending institutions in fact compete to extend credit to bankrupt corporations because of the protections that a post-petition lender can obtain in bankruptcy. Specifically, the Bankruptcy Code provides that, with bankruptcy court approval, the debtor-in-possession lender can obtain the following forms of special treatment in connection with providing post-petition financing:
Priority over all other administrative expenses (see Question 2).
A lien on property of the estate not otherwise encumbered.
A junior lien on encumbered property.
A senior or equal lien on encumbered property (a "priming lien").
Frequently, debtor-in-possession lenders will insist on a first-priority priming lien on the debtor's most valuable assets, including its cash and inventory. However, bankruptcy courts can only grant such relief if the court finds that the secured creditor whose lien is being primed is adequately protected or the secured creditor consents to the lien. Secured creditors will often consent in exchange for the inclusion of additional protections in the court order approving the financing terms, such as cash interest payments or a second lien on unencumbered property.
In 1997, in an effort to harmonise cross-border bankruptcy proceeding, the United Nations Commission on International Trade Law (UNCINTRAL) adopted the UNCITRAL Model Law on Cross-Border Insolvency 1997 (UNCITRAL Model Insolvency Law). Chapter 15 of the United States Bankruptcy Code incorporates the majority of the provisions of the UNCITRAL Model Insolvency Law. The stated objectives of Chapter 15 include:
Promote co-operation between the United States courts and parties of interest and the courts and other competent authorities of foreign countries involved in cross-border insolvency cases.
Establish greater legal certainty for trade and investment.
Provide for the fair and efficient administration of cross-border insolvencies that protects the interests of all creditors and other interested entities, including the debtor.
Afford protection and maximisation of the value of the debtor's assets.
Facilitate the rescue of financially troubled businesses, thereby protecting investment and preserving employment.
A Chapter 15 case is generally ancillary to a primary proceeding brought in another country, typically the debtor's home country. An ancillary case is commenced under Chapter 15 by a "foreign representative" (meaning a duly authorised representative of the foreign proceeding) filing a petition for recognition of a foreign proceeding. In order to obtain the rights and benefits of Chapter 15, including the automatic stay, a foreign representative must obtain recognition of the foreign main proceeding.
Under Chapter 15, a court can recognise two forms of proceedings pending in other countries: "foreign main proceedings" and "foreign non-main proceedings". Typically, after the petition is filed, the bankruptcy court will hold a recognition hearing to determine whether the foreign proceeding is a foreign main or non-main proceeding. The classification as a main or non-main proceeding determines the extent to which certain relief can be granted and the extent of rights granted to the foreign representative. For example, the automatic stay is automatically triggered (with limited exceptions) with respect to the foreign debtor's US assets upon the recognition of a foreign main proceeding. In a foreign non-main proceeding the petitioning party must affirmatively request the imposition of the automatic stay, and the court determines whether to grant such relief. In determining whether the proceeding is a foreign main proceeding, the bankruptcy court focuses on whether the proceeding is pending in the country where the debtor has its "centre of main interests".
Once a foreign proceeding is recognised in the United States, the foreign representative may file a case under Chapter 11 and Chapter 7 if the debtor has assets in the United States, subject to the same general filing requirements imposed on all domestic debtors. A foreign representative may decide to commence a plenary proceeding in order to take advantage of the United States bankruptcy court's worldwide jurisdiction and the greater relief afforded in a plenary case. However, if recognition of a foreign main proceeding occurs before the Chapter 7 or Chapter 11 proceeding is commenced, the subsequent plenary case will be limited to the administration of the debtor's assets that are located within the United States, subject to certain exceptions.
A court must grant consistent relief in a concurrent proceeding, which means that the commencement of a plenary case can, in some instances, impact the relief available under Chapter 15. For example, if a plenary proceeding is commenced after recognition of a foreign proceeding, any relief granted under Chapter 15 must be modified to the extent it is inconsistent with the Chapter 7 or Chapter 11 case.
The Bankruptcy Code provides that foreign creditors have the same rights regarding the commencement of, and participation in, a case under Chapter 15 as domestic creditors, and expressly provides that that the claim of a foreign creditor will not be given a lower priority than that of general unsecured claims solely because the holder of such claim is a foreign creditor.
Recently, the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 (the Commission) was created. The stated purpose of the Commission is the following: "In light of the expansion of the use of secured credit, the growth of distressed-debt markets and other externalities that have affected the effectiveness of the current Bankruptcy Code, the Commission will study and propose reforms to Chapter 11 and related statutory provisions that will better balance the goals of effectuating the effective reorganisation of business debtors - with the attendant preservation and expansion of jobs - and the maximisation and realisation of asset values for all creditors and stakeholders."
The Commission includes 13 advisory committees charged with studying and assessing the following areas of American bankruptcy law:
Administrative claims, critical vendors and other pressures on liquidity.
Bankruptcy remote entities, bankruptcy-proofing and public policy.
Distributional issues under plans.
Executory contracts and leases.
Financial contracts and derivatives and safe harbours.
Financing Chapter 11 proceedings.
Governance and supervision of Chapter 11 cases and companies.
Labour and benefit issues.
Multiple enterprise cases/issues.
Plan issues: procedure and structure.
Role of valuation in Chapter 11 cases.
Sale of substantially all of the debtor's assets, including going concern sales.
The Commission is currently in the process of conducting expert hearings regarding potential reforms, but there are no significant proposals from the Commission, or otherwise, to report at this time.
Legal Information Institute
Description. Legal Information Institute's website, housed at Cornell University, containing up-to-date versions of the Uniform Commercial Code and the Bankruptcy Code. Up-to-date versions of the US Bankruptcy Code can also be accessed here at: www.law.cornell.edu/uscode/text/11.
United States Court
Description. United States Court website, providing an overview of American bankruptcy law.
John Rapisardi, Co-Chair of Global Restructuring
O'Melveny & Myers LLP
Professional qualifications. Admitted to practice in New York State
Areas of practice. Domestic and international restructuring experience across a variety of industries, including automotive, casinos, chemical, healthcare, retail, real estate, satellite, sports franchises, textile and telecommunications.
- LyondellBaseell Industries in its Chapter 11 cases.
- The United States Department of Treasury and the Presidential Task Force with respect to the restructuring of Chrysler, General Motors and Delphi.
- Icahn Associates and certain of its affiliates, as the largest prepetition and post-petition lender, and auction participant in Blockbuster Inc's Chapter 11 cases.
- The senior secured noteholders in Black Gaming LLC's pre-packaged bankruptcy filing in Las Vegas, Nevada.
- Barclays as agent to the senior lenders in the pre-packaged bankruptcy of CHL, Ltd and its affiliates.
- Caribbean Petroleum in its Chapter 11 cases.
- Portland Trailblazers in workout negotiations with its bondholders.
- Saint Vincent's Medical Center in its Chapter 11 case.
- West Point Stevens in its Chapter 11 case and related UK subsidiaries in insolvency proceedings.
Publications. Regular contributor to the New York Law Journal.
Diana Perez, Counsel
O'Melveny & Myers LLP
Professional qualifications. Admitted to practice in New York State
Areas of practice. Domestic and international restructuring experience across a variety of industries, including airline, shipping, chemical, energy, financial, retail, and textile companies.
- Northwest Airlines Corporation.
- Fred Leighton Holding, Inc.
- Lyondell Chemical Company.
- Blockbuster Inc.
- Xerium Technologies, Inc.
- Marco Polo Seatrade.
- Dynegy Holdings, LLC.
- Contec, LLC.
- Midwest Generation, LLC.
- Vertis Communications, Inc.
Matthew Kremer, Associate
O'Melveny & Myers LLP
Professional qualifications. Admitted to practice in New York State
Area of Practice. Represents creditors in Chapter 11 proceedings across a variety of industries, including telecommunications, energy, and insurance and financial companies.
Publications. A Narrow Interpretation of Section 546(e), Law360 (April 2013).