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Chris Haffenden

This is the second in a series explaining restructuring processes in different jurisdictions.

In this 9fin Educational we look at the largest, and most-used globally, US Chapter 11. The report is divided into the following:

Finally, there is an Annex for those looking for more detail.

Our first report, Staying Local — UK Restructuring Processes is available here.

US Chapter 11 is very different from many other processes, as unlike many European jurisdictions it is a court-led process with substantial transparency and a raft of documentation available.

The goal of the process is to provide maximum return to creditors (and if possible shareholders). It aims to reorganise rather than liquidate, the intention is to preserve employment and realise the ‘going concern surplus’ over liquidation value

The case begins with a filing of a petition — either voluntary by the company, or on an involuntary basis (for the company) by creditors making their own filing. The debtor also files schedules of assets and liabilities, current income and expenditures, contracts and unexpired leases, and a statement of financial affairs

Upon filing, there is an automatic stay on enforcement, with the US courts claiming worldwide effect. Even though this is not automatically recognised in other jurisdictions, in practice many foreign company executives will adhere, worried about being in contempt of the US courts

The worldwide stay makes the process attractive for foreign firms, most notably those with long-term contracts such as shipping and airlines. There is a low jurisdictional threshold, you can have limited property in the US — just having cash in a US bank account can qualify

It is a debtor-in-possession managed reorganisation or liquidation process. It can convert into a trustee-administered liquidation (Chapter 7, see Annex) or going concern sale (a 363 sale) if it fails

A key element of Chapter 11, is debtor-in-possession (DIP) financing. This covers immediate liquidity needs and finances the business throughout the bankruptcy process. It is one of the more unique features of Chapter 11 and can have super priority over existing lending, and offer attractive returns to third-party providers. Often the provider of the DIP financing will ‘drive’ the restructuring process. Existing creditors can offer a roll-up DIP which effectively pays off their pre-petition secured debt

Under Chapter 11 directors and management remain in control, and the debtor has the exclusive right to propose a plan of reorganisation (POR) within the first 120-days. This can be extended up to 18-months if certain criteria are met. After this period of exclusivity, creditors can also propose their own POR or liquidation plan to the court. Generally, these are rare, with unsatisfied creditors often asking the court to dismiss or convert the case into Chapter 7 to sell assets to satisfy their claims

In conjunction with the POR filing, the company will seek to obtain an exit financing commitment from existing creditors or third-parties (see Annex) to enable it take out its pre and post-petition debt such as DIP Financing (as stated under the POR)

Alongside the POR is a disclosure statement containing all material information about the debtor, a classification of its claims and how each creditor class is treated under the POR

Creditors and their claims are categorised by class and seniority level, the so-called absolute priority rule — with their claims being paid out via the waterfall

The court solicits feedback, objections or motions from creditors at a creditor meeting before putting the proposal out to a vote. The creditor meeting should be held within 20-40 days of filing

Creditors in unimpaired classes and those with first priority claims are not eligible to vote. The debtor has a 180-day limit to obtain acceptance of its plan, unless otherwise extended

Creditors whose rights are affected vote on the plan. The plan is confirmed if it secures the required votes and satisfies certain legal requirements. For those creditors that do vote, the company must secure two-thirds in value and a majority in number for any given class

There is also the ability to cram-down dissenting creditors as long as the absolute priority rule is observed

The court will confirm the plan at a confirmation hearing. It must be satisfied that it is feasible, proposed in good faith and complies with the applicable provisions of the US Bankruptcy Code.

The judge then files the bankruptcy’s final decree and the debtor will ‘emerge’ from Chapter 11.

The length of a Chapter 11 will depend on the complexity of the restructuring and whether some or all of the terms have been agreed prior to filing with all or a majority of its creditors.

A pre-pack Chapter 11 can take as little as 1-2 months given most if not all of the terms have already been pre-agreed by stakeholders. Whereas a ‘free-fall’ filing (such as Cineworld) is likely to be much more chaotic and therefore can take 12-months or more to conclude.

Many deals fall somewhere in the middle, some being pre-negotiated where the debtor seeks to reach agreement with as many creditors as possible prior to filing — leading to a Plan Support Agreement. Some pre-negotiated deals have concluded in as little as three months.

The case begins with a filing of a petition — voluntary by the company, or involuntary by creditors. There is no specific insolvency test requirement.

At this time, the debtor also files schedule of assets and liabilities, current income and expenditures, contracts and unexpired leases, and a statement of financial affairs.

A First Day Hearing typically takes place within days of a petition filing. A number of first day motions can be submitted, for example to make payments to essential unsecured creditors. It is typically when an application is made to use cash collateral and/or obtain DIP financing.

The US Trustee will form an official committee of unsecured creditors. This committee will retain financial and legal advisors (if not already represented).

A Creditor Meeting typically takes place 20-40 days from the filing date.

A Plan of Reorganisation must be submitted within 120-days. But this timeframe can be extended by the court by up to 18-months.

There is a 180-day limit for a debtor to obtain acceptance of a POR.

Once voted upon and approved, the court will confirm the plan at a confirmation hearing.

For creditors seeking to appeal against the plan, they have 14-days to do so following the entry of the confirmation order.

Chapter 11 has been used as the template for many improvements to insolvency processes across the globe in recent years.

In its favour are greater certainty, and the power of having the automatic (and global) stay alongside other protections such as safe harbour treatment. It is particularly useful for companies with operations across the globe, as a primary proceeding.

The costs of Chapter 11 are very high compared to say the UK. Top restructuring lawyers can charge up to $2,000 per hour, and their associates up to $1,000. The US process can invite challenges and cases can often become highly litigious and lengthy, affecting creditor recoveries.

A key attraction for debtors is the ability to cram down creditors. However, this feature is now being adopted in many jurisdictions — coming into force in the UK in 2020, and will be a feature of most European processes after its inclusion in the EU minimum standards legislation. Outside the UK, there are few precedents to see if these cram down processes will work as envisaged.

The voting threshold is also lower, at two-thirds, compared to 75% in the UK and Germany. The Netherlands and France, however, also have two-thirds voting thresholds.

Similar to the UK, in the US there are number of dedicated experienced judges to hear cases. But according to White & Case in the US, the judges have a very hands-on role in directing the course of the restructuring and managing competing interests of creditors and stakeholders.

In Europe, professionalism of judges varies, many processes are very new and with little case law, and with many creditors more familiar with UK and US processes, these will prevail for some time yet.

The ability of debtors to forum shop across the US, has led to accusations of abuse of process, with companies able to scour the country to find favourable courts and judges. This is due to the Bankruptcy Code allowing a lot of flexibility where to file within the US under the venue statute, and the law leaves many issues open for courts to decide such as severance payments.

The Southern District of New York and District of Delaware are two de facto specialised national bankruptcy courts, but others such as Texas (for Oil & Gas initially) are actively chasing business.

In 2022, the debate intensified following a number of cases where the process had been used to avoid litigation and damages payouts, with Johnson & Johnson seen as the most egregious. The pharma group had used a Texas law that allows liabilities (in J&J’s case billions in baby powder litigation — it contained asbestos) to be separated from assets into a new entity — also known as a “Texas two-step” bankruptcy. The new entity then files for Chapter 11, meaning tort liabilities will need to be resolved via the bankruptcy process, without any recourse to the original company. In J&J’s case it put $2bn in a trust to deal with the claims, limiting payouts and protecting itself against future claims.

For those looking for more detail on various aspects of Chapter 11, an A-Z Annex follows:

Absent class consent, creditors with higher priority must be paid in full before creditors of lower priority. (NB this is absent in UK Restructuring Plan’s, thereby allowing the possibility of a cram-up in the UK). Therefore secured claims must be paid in full, prior to unsecured creditors receiving recoveries. Equity holders cannot receive any distribution until all financial creditors have been paid in full.

One of the most important aspects of the Bankruptcy Code is the statutory injunction which comes into effect when a filing is made for a Chapter 11 case. It has a very broad scope.

The Automatic Stay stops most creditors from pursuing actions or exercising remedies to recover against a debtor’s property. It provides breathing room to assess and assemble all the property of the estate. One important exception is the netting out or termination of ‘financial contracts’ such as forward sales, commodities contracts, derivatives, etc — also known as Safe Harbours (more on this below), which can still be paid out (under certain circumstances) in Chapter 11 and are not subject to a moratorium.

These prevent a pre-bankruptcy transfer of property from the bankruptcy estate. By ‘avoiding’ a particular transfer of property, the debtor can cancel the transaction and force the return or "disgorgement" of the payments or property, which then are available to pay all creditors during the Chapter 11 process.

An insolvent debtor can avoid or recover payments made to creditors 90-days prior to filing, or up to one year for payments made to insiders. Fraudulent transfers can be ‘avoided’, debtors can recover transfers subsequently deemed fraudulent or which were made while the company was insolvent and done for less than ‘reasonably equivalent value’. (NB This could give rise to challenges for drop down financings and/or transfers to unrestricted subsidiaries). There is avoidance of unperfected security interests, not perfected prior to the case’s commencement.

This process is more common for individuals, and is also known as a ‘liquidation bankruptcy.’

Under Chapter 7 the debtors property is liquidated by a court appointed trustee to pay down outstanding debt. In Chapter 11 the debtor negotiates with creditors to reorganise its debt.

Business owners and management are not in control of the business which is often wound-up. Disgruntled creditors in Chapter 11 can push for a Chapter 7 to realise asset sales to gain full or partial repayment of their claims.

Chapter 15 a mechanism for the US and foreign courts to coordinate and collaborate when assets and creditors are spread across multiple jurisdictions.

Based on UNCITRAL Model Law on cross-border insolvency

Can only exist as an ancillary proceeding — the debtor must have already commenced a proceeding outside the US

Mostly used as a recognition tool. Recognises that the foreign proceeding is the main proceeding having commenced in the debtors Center of Main Interest (COMI)

Can provide creditors some comfort that US norms of due process are protected, but in turn the US courts have limited powers to interfere with foreign proceedings

Creditors must file their proof of claim by the ‘bar date’ — which is set by the court.

Creditor committees are formed based on their rights and interests, including the source of their debt and security in collateral. At least one impaired class must approve a POR.

The U.S. Bankruptcy Code allows claims and/or interests to be classified together only if such claims and/or interests are substantially similar. According to Akin Gump “allegations of artificial impairment or allegedly improper classification of claims and accusations that a debtor has “gerrymandered” classes or “manufactured” an impaired, consenting class in order to more easily satisfy the cram-down requirements are often brought before the bankruptcy court.”

Akin Gump adds that “Courts typically defer to a debtor’s proposed classification of claims and interests and thus require clear evidence of class manipulation to find in an objector’s favor.”

Creditors are normally categorised as Secured Creditors; Priority Unsecured Creditors; General Unsecured Creditors and Equity Security holders.

If a class is receiving 100% recovery it is deemed to have accepted the plan, and conversely, a class with no recovery may be deemed to reject the plan.

The ability to bind dissenting creditors without shareholder consent.

Cross-class cram down is possible if (i) at least one impaired (non-insider) class votes in favour, (ii) the plan does not discriminate unfairly toward each impaired class that has voted against it, and (iii) the plan is fair and equitable to the non-consenting class.

DIP financing is only available under the Chapter 11 process, and can override existing provisions within bond and loan agreements regarding additional debt capacity.

It covers immediate liquidity needs and finances the business throughout the bankruptcy process. Can be via debt or equity. The latter is often done via a backstopped rights offering.

DIP financing offers the ability for third-parties and existing creditors to generate returns from the bankruptcy process. (See also Roll-up Financing, and Exit Financing). Providers of DIP financing can often influence the restructuring process. Within this process hedge funds providers of the DIP may be more willing to convert their claims into equity to boost their IRRs via the exit financing.

The Code also grants the lenders of such DIP financing super-priority status, so long as the court is satisfied that the company cannot obtain such financing on less burdensome terms, and non-consenting pre-petition secured lenders that are being primed are ‘adequately protected’.

The Disclosure Statement aims to give Creditors, Shareholders and other Stakeholders adequate information to make an informed decision whether to accept or reject a Chapter 11 plan.

It includes the history of the debtor; circumstances leading to the filing; summary of the reorganisation plan; description and value of assets and liabilities; any tax issues; plan confirmation procedures; feasibility of the plan; and comparison with Chapter 7 (see above) liquidation.

Once filed, the court will hold a hearing to approve or reject the Disclosure Statement.

The availability of adequate exit financing is often a condition to the confirmation of a plan of reorganisation. The exit financing pays creditor (pre-petition and DIP) claims as agreed under the Plan of Reorganisation and also funds the debtors ongoing operations post bankruptcy. The exit financing can be via debt or equity.

The latter are often structured as backstopped rights offerings, allowing investors to reinvest in post-restructured equity — often at a discount, to the Plan value.

The POR details outlines how the debtor will pay back its creditors over time. It defines each class of creditors and how they will be treated. It identifies which classes are impaired and their voting rights.

It outlines changes in payment terms, assumption or rejection of contracts; sale of real estate assets, settlement or adjustment of claims against the estate such as turnover of property or avoidance claims.

The POR can be modified at any time before the Plan confirmation. A hearing will determine whether the modification negatively impacts any creditors who have not accepted it in writing.

US Chapter 11 is recognised in most jurisdictions given the United States’ adoption of the UNCITRAL Model Law. There is also the ability to launch parallel proceedings (Federal Mogul used a combined Chapter 11 and UK administration), or use Chapter 15 (see above) as a secondary US filing, recognising a main foreign proceeding.

The US Trustee has an important role in the Chapter 11 process. Its duties include:

First day orders — reviewing the debtors requests for emergency orders early on

Official committees — their determination, appointing members, overseeing committee actions

Reviewing Reorganisation Plans and Disclosure Statements

Ensuring Compliance — ensuring that all reports, schedules and fees are filed in a timely manner

Employment — reviewing applications by professionals to be joined into the case and their fees

Preventing Delays and Fraud investigative powers, can refer cases to US Justice department

A feature of DIP financing whereby pre-petition lenders offer post-petition financing that typically pays off (or rolls-up) some of their pre-petition secured debt. This elevates their position compared to non-participating creditors in the same class.

A roll-up effectively transforms the existing lenders’ pre-petition claims into a post-petition, administrative expense and can bolster the position of existing creditors within Chapter 11.

Courts are wary of roll-up financings as it puts creditors in a very powerful position in a restructuring as Fried Frank outlines in a client note on DIP Financings. But in recent years, they have become increasingly common, especially in times where third-party financing is constrained and/or expensive.

The Bankruptcy Code contains certain Safe Harbors from the automatic stay and the prohibition on ipso facto clauses (the ability to terminate a contract on a bankruptcy filing).

According to Allen & Overy “this allows for the netting or termination of certain financial instruments, including instruments, including some securities, commodity, forward, repurchase (or Repo) and swap agreements.”

This gives the ability to close out and terminate contracts subject to certain conditions.

Chapter and Verse — our read on Chapter 11

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