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Debtor pressures

Recent turmoil in the credit and subprime mortgage markets has negatively affected a number of private equity deals. Less publicized has been the effect of the turmoil on companies. To that end, we revisit amendments to the US Bankruptcy Code and outline what they mean for private equity sponsors and their distressed portfolio companies.

Levitin is a partner and the chair of the international bankruptcy/ corporate recovery and insolvency practice in the New York office of law firm Dechert. Hall is an associate in the group. They can be contacted at joel.levithin@dechert.com and davin.hall@dechert.com, respectively.

The most publicized provisions of the relatively recent amendments to the Bankruptcy Code in the US relate to individual consumer bankruptcy cases, but there were also several changes that affect the rights and obligations of companies operating in Chapter 11. We provide a brief background on certain bankruptcy principles and provisions to establish the context for our discussion of the relevant changes to the law that are important to private equity sponsors and their distressed portfolio companies.

Bankruptcy background
The primary goal of corporate bankruptcy law in the US is to give debtors an opportunity to restructure their business operations, as well as their capital structures. During the course of their bankruptcy cases, debtors have the benefit of the ?automatic stay,? which is a statutory right to be free from actions to collect debts that arose prior to the petition date that goes into effect immediately upon the filing of a bankruptcy petition. This automatic stay is, of course, subject to certain exceptions, including permitting certain government enforcement actions, and the stay can be lifted ?for cause? by order of the bankruptcy court.

Unlike Chapter 7, the liquidation provisions of the Bankruptcy Code, wherein a trustee is appointed to collect, administer, and distribute the debtor's assets, in Chapter 11 cases, debtors generally remain in control of their assets and continue to operate in the ordinary course of their business, with their own management and corporate governance intact. Accordingly, Chapter 11 debtors are known as a ?debtors-in-possession.?

Debtors are responsible for paying all ordinary course post-petition obligations as they become due on a going-forward basis. Such post-petition obligations have priority of payment as ?administrative expenses? over most pre-petition obligations of the debtor. Perfected secured creditors retain their rights over debtors' collateral during bankruptcy, although the automatic stay prohibits them from exercising their rights in the collateral absent court approval, so long as they are ?adequately protected,? or the collateral is not declining in value without appropriate consideration.

Debtors also have special rights with respect to ?executory contracts? and unexpired leases. ?Executory contracts? are contracts in which there are mutual, material obligations that are remaining to be performed by the debtor and by the non-debtor counterparty. Debtors in Chapter 11 have the right to assume, to assign (i.e., sell) or to reject most executory contracts. In order to assume such contracts or to assign them, debtors must generally cure all existing defaults and provide adequate assurance of future performance of obligations thereunder. If they elect to reject an executory contract, rejection damages will typically be treated as pre-petition claims.

To fund their operations, debtors may make use of secured lenders' cash collateral, so long as such lenders are provided with ?adequate protection? (typically in the form of replacement liens). If debtors need additional working capital, they can obtain post-petition financing (known as ?DIP financing?). This type of financing is unique to bankruptcy in that DIP lenders may obtain significant court-approved protections, including priority over preexisting liens, if debtors provide ?adequate protection? to the prior lienholders.

Emergence from Chapter 11 may be accomplished through bankruptcy court confirmation of a plan of reorganization, pursuant to which the debtors' obligations are restructured. To be confirmed, the plan must be: feasible (not likely to be followed by another bankruptcy case); in the best interests of creditors (i.e., it provides for the payment to creditors of more than they would receive under a Chapter 7 liquidation); and accepted by each class of creditors (or, if it is accepted by at least one such class that is impaired under the plan, is ?fair and equitable? and does not ?discriminate unfairly? with respect to the other classes). Importantly, debtors have the exclusive right to file and seek confirmation of a plan of reorganization for a certain amount of time.

An exit from bankruptcy can also be accomplished following a court-approved sale of assets under Bankruptcy Code section 363. Buyers in bankruptcy typically get the benefit of obtaining debtors' assets free and clear of most liens, claims, and encumbrances, thereby limiting their exposure to potential successor liability and other claims. Debtors generally conduct a ?363 auction sale,? sometimes with the backing of a ?stalking horse? bidder who commits to an initial bid in exchange for certain ?break-up? fees and other protections in the event it is not the successful bidder.

Timing and control, and cash flow
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (?BAPCPA?) was signed into law on April 20, 2005, and most provisions became effective in cases that were filed on or after October 17, 2005. The provisions most relevant to distressed portfolio company bankruptcy cases can be broken down into two categories: (1) those affecting timing and control, and (2) those affecting cash flow.

1. Timing and control
Plan exclusivity. As indicated above, debtors have the initial exclusive right to file a plan of reorganization without having to compete with potential plans that could be filed by other parties-in-interest. This is a major leverage point for debtors (and equity sponsors) to gain creditor concessions. Specifically, debtors have the exclusive right for 120 days from the petition date to file a proposed plan and 180 days to gain acceptance of that plan. Prior to BAPCPA, debtors could move for endless extensions of exclusivity, as long as they showed ?cause.? Under BAPCPA, however, a bankruptcy court may not extend the filing exclusivity period to a date that is longer than 18 months after the petition date. The limit on the acceptance exclusivity period is 20 months after the petition date.

Real property lease assumption and rejection. Prior to the amendments, an unexpired lease of non-residential real property that was not assumed or rejected within 60 days of the petition date would be deemed rejected, unless the debtor obtained an extension for ?cause,? and there was no outside date. Under BAPCPA, the 60-day period was extended to 120 days, but debtors can move for an extension of no more than 90 additional days without the consent of the landlord.

New grounds for conversion and dismissal of a bankruptcy case. Before the amendments, bankruptcy judges had broad discretion to determine if there was cause to dismiss or convert a Chapter 11 case.

The amendments attempt to provide a more stringent standard, potentially providing creditors with improved leverage over debtors. Limitations on key employee retention programs. It had become relatively common practice in Chapter 11 cases for debtors to seek approval of ?key employee retention programs,? providing payment of retention and other bonuses to management and other key employees, if they simply showed that such payments were an exercise of their sound business judgment (a fairly easy standard to meet). BAPCPA generally prohibits the payment of retention bonuses to ?insiders? unless debtors show that employees have bona fide job offers from other companies and that their services are essential to the debtors' business. There are also significant limitations on the amount that debtors can pay the insiders, including relative to lower level employees.

Notwithstanding these hurdles, debtors have been successful in obtaining court approval for bonus payments to senior management, where those payments are legitimately considered incentivebased, rather than merely related to staying for a period of time. For example, courts have authorized bonuses related to meeting certain sales or earnings targets.

2. Cash flow
Administrative priority status to certain sellers. Although creditors formerly had certain reclamation rights against debtors that in some limited cases gave them special priority for goods shipped immediately prior to a bankruptcy filing, BAPCPA provides that the value of any goods received by a debtor within 20 days prior to the petition date that were sold in the ordinary course of business are entitled to administrative priority of payment over other general unsecured pre-petition claims.

Enhanced rights to utility providers. In bankruptcy, debtors are protected from unilateral termination of utility service if they provide ?adequate assurance of payment? of post-petition obligations to utility providers. Prior to the amendments, debtors often obtained court orders in which the grant of administrative priority to the post-petition claims of utility providers would be deemed to be adequate assurance of payment. Under the amendments, however, debtors are instead required to give adequate assurance in the form of cash deposits, letters of credit, bonds, prepayments of service, or other similar consideration.

Enhanced rights of taxing authorities to receive payments. Prior to BAPCPA, debtors could provide in a plan of reorganization for holders of allowed tax claims to receive deferred cash payments, over a six-year period from the date of assessment of the claim, of the amount of the tax claim. Now, plans must provide regular installment payments of cash, over five years from the petition date, of a total value (as of the effective date of the plan) equal to the allowed amount of the claim, and they must be made in a manner not less favorable than the most favored nonpriority unsecured claim under the plan.

Conclusions
The impact of the bankruptcy law amendments on distressed portfolio companies is significant. The amendments increase pressure on debtors to make progress toward restructuring with creditors and other groups prior to filing because debtors have less time and flexibility once they are in bankruptcy. Moreover, under the new regime, debtors have greater cash needs during their cases and in connection with emergence. Additionally, given the increased leverage of creditor groups, there may be increased pressure on debtors to sell their assets, rather than to attempt to effectuate a more traditional restructuring. Pre-filing negotiations and cash management and other planning are increasingly important to avoid getting unduly squeezed. On the other side, from the investor perspective, potential new investment opportunities abound!