An Introduction to Chapter 11 Transactions
An Introduction to Chapter 11 Transactions
Although many companies first evaluate out of court alternatives, Chapter 11 remains as one of the primary venues in which distressed companies can find respite and a structured path to reorganization and, ultimately, rehabilitation. The bankruptcy code is detailed and no two situations are the same. That said, almost every company that files Chapter 11 shares the same objective: execute a plan to exit Chapter 11.
A company filing for Chapter 11 protection and becoming a “debtor” can exit chapter 11 in two basic ways. First, the debtor can design a plan of restructuring (a “Plan”) that designates how the debtor’s operations and balance sheet will be restructured and who the owners of the business will be upon exiting Chapter 11. The second Chapter 11 path is a sale conducted via a public auction (a 363 sale).
Exiting via a Plan of Reorganization
A Plan is usually, though not always, a pre-baked strategy to which relevant stakeholders have agreed before the company files for Chapter 11 protection. The company may have been in breach of financial covenants for extended periods of time with little hope for a return to historical levels of profitability. Or, the company may have unrefinanceable maturities due to permanently impaired earnings power or unfavorable capital market conditions (or both). The company may also have a “liability overhang,” common jargon to reference liabilities which may not be fully quantified in the present moment, or which have other contingent qualities to them, which prevent lenders from extending credit. Asbestos liabilities, large awarded judgments, environmental remediation obligations, and pension obligations are all examples of liability overhangs.
Whatever the cause of the Chapter 11 process, the company and its fulcrum lenders¹ will negotiate an appropriate recapitalization of the balance sheet based on the company’s projected future earnings stream. The two parties will then discuss how the value of the company will be allocated and to which creditor classes. This process is all publicly signaled via key documents posted to the bankruptcy docket:
- Disclosure Statement: The disclosure statement provides a detailed narrative of the debtor’s history, business model, capitalization, and the course of events that brought it to the precipice of a bankruptcy filing. The document further discloses information essential to stakeholders’ ability to evaluate a plan and vote to accept or reject it. That information includes:
- Liquidation analysis – a study of the valuation that could be realized via a quick liquidation of the debtor’s assets all netted against the costs to conduct the liquidation process
- Financial projections – summary level financial projections to include income statement profitability on an unlevered basis, typically will provide indications of unlevered free cash flow, and occasionally will show a pro-forma balance sheet
- Valuation – a valuation analysis performed by the debtor’s investment banker on the basis of the debtor’s financial projections
- Plan of Reorganization: The Plan divides stakeholders of the business into discrete classes based on their lien and payment priorities, describes the consideration that each class is to receive under the plan, and indicates which classes may vote for the plan. Classes which are deemed to be unimpaired under the Plan are assumed to accept the Plan while impaired classes may vote to reject the plan. To confirm a Plan, the debtor must:
- Have the support of 2/3 in value and 1/2 in number of stakeholders within one impaired class
- Satisfy the best interests test by showing that no class is worse off under the Plan than it would be in a liquidation (hence the liquidation analysis mentioned above)
- Satisfy the feasibility test by demonstrating the debtor’s ability to meet obligations as they come due upon exit (hence the financial projections)
- Pay all administrative claims in cash at exit
363 Auction Processes
Depending on the investment mandate of the impaired creditor class, there may be no desire for a Plan that gives a significant equity stake in the business to existing lenders. In these instances, lenders may prefer to exit their exposure to the debtor entirely, regardless of the recovery they receive on their investment. A 363 auction process effectively allows for the company to market its assets for sale in a public, value-maximizing auction process that effectively converts lender collateral into (typically) cash proceeds.
As in a Chapter 11 filing initiated with a Plan, 363 auctions frequently are announced with a stalking horse bid. The stalking horse is a party that agrees to be bound to acquire the assets of the debtors on agreeable terms and in return may receive certain benefits including breakup fees if the stalking horse bid is eventually topped at auction. The stalking horse’s bid and all relevant details including the assets to be acquired (and those left behind), liabilities to be assumed (and those left behind), and purchase price are all made public in an asset purchase agreement (“APA”).
The debtors will propose a calendar for the auction process marked by an acceptable marketing and diligence period for the assets so that any interested party can evaluate whether it desires to make a bid for the debtor’s assets. By a date certain, “Qualified Bids” will be due and are so designated based on reasonable criteria at the discretion of the debtor and its advisors. Should no qualified bids emerge, the auction is cancelled and the stalking horse acquires the assets pursuant to its APA with the debtors. If a Qualified Bid rivaling that of the stalking horse emerges, then an auction is conducted with the best bid winning. It’s worth noting that “best” does not necessarily mean “highest.” A bid with maximum certainty of closing, that proposes to maintain employment levels, and assume certain contracts and liabilities may be a better offer than one with a slightly higher purchase price, but which guts existing contracts and liabilities, giving rise to large unsecured claims in the process.
Proper Prior Planning
A consistent feature of Chapter 11 filings – at least the more successful filings – is a significant amount of planning prior to the filing itself. Pre-negotiating the key terms and outlining the preferred transaction paves the road to the eventual exit from Chapter 11. Absent that planning, Chapter 11 filings can sometimes languish in bankruptcy court, incurring significant professional fees and risking damaged commercial relationships and further impairment to enterprise value. Both a Plan and a 363 sale can be significantly developed prior to filing Chapter 11, reducing the risks and expense of the Chapter 11 process.
- The “fulcrum” security or class of investors is the point at which there is no more enterprise value to satisfy claims. For example, if a company has a $100 first lien loan and the valuation published in the disclosure statement estimates value at $50, then those first lien lenders are the “fulcrum” because there is not enough value to satisfy their entire claim.