Are ABI’s Bankruptcy recommendations too debtor friendly? – Part II

This post continues comment on the American Bankruptcy Commission's recent report to reform Chapter 11.

In essence, bankruptcy is a value reorganization event – it fixes value to an estate on the effective date of an agreed plan and finds a way to distribute that value to creditors if the firm cannot continue as a going concern. The valued received is a waterfall, that is, senior creditors get what’s owed to them first, than junior creditors, etc. till cash runs out.

For example, if a senior secured creditor with a blanket lien on the debtor’s assets is owed $10, a junior creditor is owed $2, and the enterprise value of the debtor at confirmation or sale is $9, the senior creditor will receive $9 and the junior creditor $0.

That all sounds simple enough, but few things are that clear in the world of bankruptcy. Consider:

  • What happens if during the next few years the enterprise value of the debtor proves to be much higher than today, such that the junior creditor could have been in the money?
  • What happens if the debtor’s assets depreciate rapidly such that creditors will see a rapid loss if a sales does not happen soon?
  • Or if some debtor in possession financing can be arranged so the company has cash to pay suppliers, but secured lenders must wait longer for payout?

This is why the bankruptcy plan needs to be approved by the creditors and also to comply with the Bankruptcy Code requirements for the Court’s approval, or " confirmation”, as it’s called under the Code.

Many economists and others believe the Chapter 11 process is costly, time consuming, and enriches lawyers and others who advise, manage, and finance distressed companies. Obviously the ABI thought bankruptcy was skewed in someone’s favor, likely secured creditors that have too much control over Chapter 11 and as a result the value of estate is not maximized and distribution is unfair for all creditors. This is by large a perception, as there is no clear data to support this according to LTSA. Nonetheless perception rules the day.

Valuation – Plan and Sales proposal
If a debtor files for bankruptcy his assets are subject to lien. If the assets are worth $100M and depreciate over course of the case at rate of $10M year, in a piecemeal liquidation the secured creditor would get little. Under existing law, if a debtor wants to make the secured lenders wait while they come up with organization plan they need to pay the secured lender extent of depreciation of $10m while the debtor reorganizes. Under a Chapter 11 plan, secured creditors are entitled to the reorganization value of their collateral.

How do you ensure adequate protection to a secured creditor when there is dimunation of collateral in bankruptcy? Here is where you get into concepts such as the Foreclosure Value of collateral versus Reorganize Value.

The ultimate objective is to not have to force a sale (that’s the worst option) but to keep the firm as a going concern. So how do you free up $10m cash for the debtor, so they can go get a 'Debtor-In-Possession Financing or DIP loan to pay suppliers and administrators for bankruptcy? (DIP is financing arranged by a company while under the Chapter 11 bankruptcy process and is unique from other financing methods in that it usually has priority over existing debt, equity and other claims)

As an aside, the LTSA did a study of 100 DIP loan cases and found no evidence of a negative impact of DIP loans on bankruptcy.

As you see, these recommendations are not easy to understand but are important in balancing the equation between debtors and survival and secured creditors and maximizing their value for the risk taken.

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