By Robert W. Lannan
My most significant project in 2024 was the reorganization of a financially distressed corporate client under Chapter 11 of the U.S. Bankruptcy Code. It had been years since I had represented a debtor in Chapter 11, and this was my first venture in Chapter 11’s still-new Subchapter V, for reorganization of small businesses. The case was rife with risks and challenges, including significant opposition from the government. However, I was able to overcome those and obtain an excellent result for both my client and its creditors.
I began working on the company’s reorganization during the summer of 2023, months before we filed a bankruptcy petition. My client had suffered an unexpected decline in business during the preceding year and had turned to subprime lenders to provide cashflow under crushing terms, in an attempt to avoid layoffs while rebuilding its customer base. This strategy proved unsuccessful. By the time the company engaged me, it had laid off most of its employees and was preparing for a final round of layoffs. This required coordination with a labor union that represented most of the company’s last employees and was understandably skeptical of everything the company did.
To make matters worse, by the time the company was ready to issue its final layoff notices, several of its customers were late on payments and it didn’t have enough cash to make its final payroll. Fortunately, the company’s principals were willing to come to the rescue. I drafted a secured credit facility between them and the company to fund the final payroll.
We filed the company’s Chapter 11 petition shortly afterward. At that time, the company was operating with a skeleton crew consisting of its few remaining shareholders, who worked from their homes for greatly reduced compensation. Their employees were gone, as were most of their one-time fellow shareholders, directors and officers. Dozens of former employees were still owed severance payments and were making demands on both the company and its remaining officers. The company owed withholding tax payments to multiple government agencies. Meanwhile, dozens of trade creditors were owed money, and the company’s subprime lenders were demanding repayment. Most of the company’s customers had abandoned it. On the date of my client’s bankruptcy petition it had no liquid assets (and few illiquid ones), and a negative balance in its operating account. Shortly after the petition date, the first question I received from the Office of the United States Trustee (the Justice Department agency that oversees bankruptcy cases) was, “Why didn’t you file this case under Chapter 7?” (Under Chapter 7 of the Bankruptcy Code, a corporate debtor shuts down and is liquidated by an independent trustee, as opposed to reorganizing under its own management.)
My answer to that question was threefold: First, my client still had a small base of loyal customers as a source of revenue. Second, the company was willing and able to serve those customers on a shoestring budget. Third, the U.S. Bankruptcy Code afforded my client protections that could enable most of its revenue to be available for its reorganization, to the benefit of both the company and its creditors.
As always, the first of those protections came from the automatic stay in bankruptcy, which prevented what would have been a fatal rash of lawsuits against the company all over the country.
Another protection was the power under the Bankruptcy Code to avoid security interests held by the company’s subprime lenders. Each of those lenders held a blanket lien encumbering all of the company’s property, including all of its incoming cash. At the beginning of the case, we had no choice but to accept a strict cash collateral order from the bankruptcy court, which prohibited my client from using incoming payments from customers for virtually anything until we had dealt with those liens. Fortunately for my client, few of its subprime lenders had taken steps to perfect their liens, and those that did had waited too long (filing financing statements within the 90-day “preference period” before the petition date). This made all of these liens subject to avoidance. Through a series of adversary proceedings (lawsuits within the bankruptcy case), I obtained judgments avoiding all of these liens, which converted my client’s subprime secured lenders into general unsecured creditors. That freed my client’s revenue for use in its reorganization.
However, reorganization could still not occur until we overcame additional challenges. The first of these was deep scrutiny of the Office of the U.S. Trustee centered on the pre-petition credit facility I had drafted to fund the company’s final payroll. The government’s scrutiny included objection to my appointment as the company’s attorney in the bankruptcy case, and insistence that special counsel be appointed to review the credit facility and report to the court on whether it resulted in any viable claim of the bankruptcy estate against my client’s principals. We overcame all of this scrutiny. The court overruled the U.S. Trustee’s objection to my appointment. Upon review of the pre-petition credit facility, special counsel reported that it did not give rise to any viable claim of the bankruptcy estate. Because of the way I had structured the credit facility, a blanket lien in favor of my client’s principals was not subject to avoidance as a preferential transfer. Neither could it be avoided as a fraudulent conveyance. Finally, special counsel concluded that it would not be appropriate for the principals’ loans to the company to be recharacterized as equity investments.
This would still not end the government’s scrutiny. Before the company had begun experiencing financial distress, it had paid dividends to its shareholders, which we disclosed in the bankruptcy case as required by law. At a hearing in the case, the Office of the U.S. Trustee announced that it expected the bankruptcy estate to pursue claims against the shareholders to recover these payments as fraudulent transfers. In response, I filed an amended plan of reorganization that explained at length why this would be a fruitless venture because the shareholders had complete defenses to any such claims. The government backed off its demand and did not object to our circulating the amended plan to my client’s creditors.
A balloting process followed, in which the creditors were given an opportunity to vote for or against confirmation of my client’s plan of reorganization. In the end, the plan won support of all the company’s former employees who returned ballots, and all but one of its general unsecured creditors who did so. The plan was also supported by the employees’ labor union, who continued to represent their interest in the case. The bankruptcy court confirmed the plan this summer.
Under the plan, over the next four years, all of the roughly 30 former employees of my client who are owed severance payments will receive 100% of the amounts owed, with interest. Nearly 20 state and federal taxing authorities will also be paid in full on their claims, with interest. The company’s principals will be repaid in full on their loans that funded the company’s last payroll. Finally, the company’s general unsecured creditors will receive more than a 15% distribution on their claims. All the while, we have been able to avoid litigation against the company’s current and former shareholders, officers and directors. At the end of the four-year period, the company will emerge debt-free, as a profitable enterprise for its shareholders.
“Why didn’t [I] file this case under Chapter 7?” If my client had not undergone the above reorganization process before and within Chapter 11, it would have been forced to shut down. Its last employees would not have received their final paychecks. What few assets the company had (if they could be recovered at all) would have been largely absorbed by the administrative costs of a liquidation process, whether in Chapter 7 or outside of bankruptcy. If any money remained at the end of that process, outside of bankruptcy it would have all gone to one of the company’s subprime lenders. In Chapter 7, a trustee may have avoided the same liens of the subprime lenders to make that money available to the company’s former employees; however, it would have been a few pennies on each dollar of their claims. Under no scenario would the taxing authorities or general unsecured creditors have been paid a cent. Under any scenario outside of Chapter 11, lawsuits would almost certainly have been filed by former employees and taxing authorities against the company’s officers and directors.
Chapter 11 enabled us to avoid all of that and obtain positive results summarized above. This case is a clearcut example of why Chapter 11 exists. Under the right circumstances, if a business is allowed to reorganize under the Bankruptcy Code as a going concern, it can generate much more wealth to pay its creditors than could be yielded from liquidating the business’ assets under Chapter 7 or outside of bankruptcy. I’m thrilled that my client has been able to do so in this case.
If you own or operate a business in financial distress or a creditor of such a business, please let me know if I can be of assistance.