dealing with financially troubled businesses ......dealing with financially troubled businesses...

DEALING WITH FINANCIALLY TROUBLED BUSINESSES

Business Law & Corporate Counsel Section Program

David Bennett Thompson & Knight LLP

One Arts Plaza 1722 Routh Street, Suite 1500

Dallas, Texas 75201 (214) 969-1486

(214) 880-3293 Fax

Thursday, June 10, 2010 9:00 a.m. – 9:45 a.m.

D A V I D M . B E N N E T T

Partner, Thompson & Knight LLP

One Arts Plaza, 1722 Routh Street, Suite 1500, Dallas,

TX 75201

214.969.1486, Fax 214.880.3293

[email protected]

David M. Bennett is a Partner in the Corporate Reorganization and Creditors’ Rights Practice Group in Thompson & Knight’s Dallas office. He assists clients in the formulation, implementation, and confirmation of plans of reorganization, including loan restructurings and out-of-court plans. His practice includes the representation of debtors, creditors, capital providers, and other counter-parties in reorganization and liquidation bankruptcy proceedings. He has extensive experience in transactions and litigation involving troubled and insolvent businesses. Mr. Bennett assists clients in maximizing unsecured claims and counsels clients regarding post-bankruptcy recovery of security. He is also adept at the representation of unsecured creditors committees and other creditor or equity groups in bankruptcy cases. Mr. Bennett is a frequent speaker and writer on bankruptcy topics and is actively involved in the Dallas Bar Association, Dallas Bar Foundation, American Bankruptcy Institute, and the Dallas Chapter of the Turnaround Management Association, where he serves on the Board of Directors. He has received numerous distinctions and honors, including being named to The Best Lawyers in America® by Woodward/White Inc., Texas Super Lawyers® by Thomson Reuters, and Chambers USA “Leaders in their Field” by Chambers & Partners. He has also previously been named one of the five best bankruptcy lawyers in Texas by Texas Lawyer in their “Go-To Guide.” Mr. Bennett received his J.D., with high honors, from The University of Texas School of Law in 1986 and a B.A., with high honors, from The University of Texas at Austin in 1983.

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Managing and Mitigating Bankruptcy Risks in the

Commercial WorldCommercial World

June 11, 2010

David M. Bennett

Annual MeetingBusiness Law and Corporate Counsel

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Introduction

C id th! Consider the bankruptcy risks which exists in most commercial, business and contractual relationships

Contract Risk of Bankruptcy

Joint Operating Agreement

Any joint interest owner

Sale Contracts(goods or services)

Buyer or seller

relationships Service Contract Contract counterparty

Purchase and Sale Agreement

Buyer or seller, even after closing has occurred

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Bankruptcy Risks

! Categories of risk faced by a contract counterparty:! Categories of risk faced by a contract counterparty:

" credit risk – risk of nonpayment " avoidance risk – risk of repayment/transaction

unwound " business risks – loss of future value to assets &

business

! Risk Timeline:

" Yesterday – Avoidance Risks" Today – Credit Risk

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" Today Credit Risk" Tomorrow – Business Risk

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! BK may have a domino effect impact on the long-

Bankruptcy Risks (cont’d)

! BK may have a domino effect impact on the long-term value of both the debtor’s business as well as its business partners and contract counterparties

! Often defying short term quantifications, prospective business risks of BK ultimately mayprospective business risks of BK ultimately may have greatest negative impact on all constituencies

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! Risk of Nonpayment! Risk of Nonpayment

" No “Insolvency Requirement” to file BK

" However, filing typically is admission that the Debtor cannot pay its debts as they become due

# Once BK filed, Debtor cannot pay prepetition debts absent court approval

" BK comes with high costs

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! BK Reality! BK Reality

" Prepetition unsecured creditors often receive distribution of only a small percentage of their claims

" BK dollars do not spend the same as their real world co nterpartscounterparts

" Risk management, therefore, often includes an attempt to elevate contract claims up the BK “food chain”

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! Managing the Risks: Moving contract claims up to! Managing the Risks: Moving contract claims up to BK Distribution Food Chain

" Obtain security interest or lien;

" Prepayment;

" Setoff;

" Recoupment;

" Corporate guaranty;

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" Strict application of payment terms.

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! Once BK Filed! Once BK Filed

" Contract counterparty must act proactively from the outset of the case, to protect its position

" At a minimum, file a proof of claim prior to the bar datedate

" Explore and invoke strategies to elevate the priority of the claim

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Risk Management Strategies: Liens and Security Interests

! Elevated BK Treatment! Elevated BK Treatment

" A classic strategy: obtain a lien or security interest

" Efficacy of lien or security interest is limited to underlying collateral value

" Claim of secured creditor is split:

# Secured claim (up to value of collateral)

$ Elevated BK treatment

D fi i Cl i

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# Deficiency Claim

$ Treated as an unsecured creditor

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Risk Management Strategies: Liens and Security Interests (cont’d)

! Enforceability in BK! Enforceability in BK

" Importance of Perfection

# Adage ! Unperfected lien or security interest is mitigated by its enforceability as against a debtor

# In BK, an unperfected contractual lien or security interest offers little protection

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" To maximize value in BK holder should" To maximize value in BK, holder should contemporaneously perfect its lien or security interest.

" Automatic stay

# Injunction which takes effect upon BK filingInjunction which takes effect upon BK filing

# Among other things, prevents contractual lienholder from perfecting its interest after BK is filed

" Once BK is filed, it is too late

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# The holder will usually be treated as a general unsecured creditor

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" General Rule: Each debtor-entity is treated as a" General Rule: Each debtor entity is treated as a separate distributive pool

" Substantive consolidation is the exception

# Contrast: Administrative consolidation

" Hence, for BK purposes, imperative that lien or security interest is obtained from correct contract counterparty (record owner)

# Otherwise, holder risks treatment as a general unsecured creditor

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unsecured creditor

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! BK Risk Management & Modern Finance! BK Risk Management & Modern Finance" We live in an age of highly-leveraged companies and

mezzanine lending # How are BK risk management tools impacted?

$ Lending restrictions may prohibit granting liens or$ Lending restrictions may prohibit granting liens or security interst without lender consent

$ Lender consent is often difficult to obtain

" Highly-leveraged balance sheet often diminishes the value of junior lien or security interest in BK

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j y# If value of Debtor’s assets is consumed by more senior

liens, junior lien is treated as unsecured in BK

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! Statutory Lien Rights! Statutory Lien Rights

" Statutory liens intended to ensure that property owner does not receive added value from the contractor’s work without paying for it

" Important" Important:

# Understand whether you are a beneficiary of a statutory lien

# Comply with statute’s technical requirement

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" Beneficiary of statutory lien may receive elevated BK treatment

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" Unlike contractual liens perfection of statutory lien" Unlike contractual liens, perfection of statutory lien not restricted by automatic stay

# But, perfection may not be enough

" Proactive role in BK may be necessary to maximize BK resultBK result

# From earliest stages of case

# Example cash collateral dispute

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Risk Management Strategies: Offset v. Recoupment

! Setoff! Setoff

" Netting payables and receivables between the same (identical) counterparties

" BK recognizes offset rights for “mutual” debts and obligationsobligations

" In the absence of mutuality, offset is not available

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Risk Management Strategies: Offset v. Recoupment (cont’d)

" Contractual expansion of offset rights: Master Netting" Contractual expansion of offset rights: Master Netting Agreement # Contractual expansion of mutuality

# Triangular offset proposes setoff of payables & receivables among affiliates

" Is contractual expansion of “mutuality” enforceable in BK?

" Recent case: In re SemCrude, 399 B.R. 388 (Bankr. D. Del. 2009)

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# Contractual expansion of mutuality to include triangular setoff is not enforceable

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" Takeaway:" Takeaway:

# Master Netting Agreements may not be enforceable

# Influence of Delaware and New York BK courts over commercial disputes

D bt h i BK h i# Debtors have expansive BK venue choices

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! Automatic stay prohibits setoff after BK! Automatic stay prohibits setoff after BK

" Holder of setoff right may withhold amounts which otherwise would be due and payable to the debtor

" Holder of setoff right may seek modification of a tomatic staautomatic stay

# To permit offset of payable against receivable

# If creditor’s receivable exceeds payable

$ Deficiency claim is treated as general unsecured in

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BK

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! Recoupment! Recoupment

" Netting of obligations within or among the same agreement

" Narrow principle, but advantage is that recoupment not s bject to the a tomatic stanot subject to the automatic stay

" Inquiry ! Are amounts owed to/by a debtor so closely tied together contractually that recoupment, not setoff, may be applicable?

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" Blurry line often separates recoupment rights from" Blurry line often separates recoupment rights from setoff rights

" Exercise of a right of “recoupment” that is later determined to be a right of “setoff”

# Would subject the contract creditor to a claim forWould subject the contract creditor to a claim for damages for having violated the automatic stay

# Risk includes liability for actual and punitive damages

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Risk Management Strategies: Corporate Guaranty

! Guaranty ! from corporate parent or affiliate! Guaranty ! from corporate parent or affiliate

" Another strategy for mitigating BK risk

! Best obtained at time of original agreement

! At a minimum corporate guaranty results in! At a minimum, corporate guaranty results in additional leverage

" Automatic stay does not prevent creditor from advancing claim against non-bankruptcy guarantor

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Risk Management Strategies: Corporate Guaranty (cont’d)

! Corporate guaranty often has value even if the! Corporate guaranty often has value, even if the guarantor files a BK case

! Mega BK cases have vindicated request for corporate guaranty

" Most often, cases are not entirely substantively consolidated

" Enron/Lehman Brothers

# After initial market confusion, claims with a corporate

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guaranty trade at a premium

# In Enron, for example, distributions on account of guaranteed claims were substantially higher

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Risk Management Strategies: Corporate Guaranty (cont’d)

! QualifierQualifier" Parent guaranty is preferable to a subsidiary or an affiliate

guaranty

! Explanation" Downstream (Parent) Guaranty is less vulnerable to attack" Downstream (Parent) Guaranty is less vulnerable to attack

on lack of consideration or fraudulent conveyance grounds

" “Upstream” or “Sidestream” guaranty by a subsidiary or affiliate that is not a direct or indirect owner of a contract debtor

" Upstream/Sidestream is vulnerable to attack as fraudulent

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" Upstream/Sidestream is vulnerable to attack as fraudulent conveyance

# No reasonably equivalent value

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Risk Management Strategies: Elevation of Claims

! Executory contracts (Section 365)! Executory contracts (Section 365)

" Contract creditor with a prepetition general unsecured claim

" May have leverage to elevate its claim in the BK priorit chain ifpriority chain if:

# Contract is a prepetition executory contract and

# Contract is assumed by the Debtor

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Risk Management Strategies: Elevation of Claims (cont’d)

" Non-beneficial executory contracts" Non beneficial executory contracts# May be rejected in BK

# Creditor is left with a claim for contract damages

$ May be secured – in general, rejection does not disturb securitydisturb security

" Beneficial Contracts# Necessary to Debtor’s business operations and may be

assumed

# Requires:

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Requires:

$ Cure of default

$ Adequate assurance of future performance

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" Cure claim may be a trump card for a contract" Cure claim may be a trump card for a contract creditor

# Lacking a prepetition lien or other prepetition priority, contract creditors’ right of cure for assumed executory contract will elevate payment ahead of general unsecured creditorsunsecured creditors

" In fact, in appropriate circumstances, a contract creditor may seek to shorten the time period for a debtor to assume or reject an agreement

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! Chapter 11 Trend! Chapter 11 Trend

" Sale of assets pursuant to section 363 has become Ch. 11 debtor’s exit strategy of choice

" Frequently, 363 asset sales are linked to section 365 req ests to ass me and assign contracts to the b errequests to assume and assign contracts to the buyer

" Assumption/assignment of contracts requires:

# Notice to the contract counterparty

# Opportunity to demonstrate, among other things, the

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pp y , g g ,amount of the cure claim which must be paid

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# Contract creditors should (at a minimum) closely monitor BK case for:

$ Sale of assets

O ib ti t / i t t$ Omnibus motion to assume/assign contracts

# Debtor may purport to quantify a contract counterparty’s cure claim as part of a Section 363 sale process

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! Reclamation Rights! Reclamation Rights

" Strategy for elevating claims of seller of goods

" State-law right to “reclaim” goods from an insolvent buyer

" Bankruptcy Recognition

# Notice period = 20 days after BK

# Reach-back period = up to 45 days prior to BK petition

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! Reclamation Rights (cont’d)! Reclamation Rights (cont d)

" Notice to Debtor

# Usually all that is requested to secure reclamation rights

" Automatic Stayy

# Not applicable to reclamation notice

" Elevated Priority

# Even if goods in question are not actually recovered, reclaiming creditor ma recei e an ele ated priorit

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reclaiming creditor may receive an elevated priority

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! 20-Day Administrative Claims! 20-Day Administrative Claims

" Similar to the right of reclamation but arises exclusively out of the BK Code

" Elevated priority for claims of seller of goods

" A contract creditor is entitled to a 20-day claim for goods delivered to the debtor within 20 days prior to BK

" No notice is necessary

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! 20-Day Administrative Claims (cont’d)! 20-Day Administrative Claims (cont d)

" 20-day claimants are administrative creditors that must be paid in full in order to confirm a plan

" Consequence is greater liquidity required to exit BK

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Risk Management Strategies: Special Considerations

! Purchase and Sale Agreements (PSAs)! Purchase and Sale Agreements (PSAs)

" Pre-closing

# PSAs almost certainly are executory contracts subject to rejection by the BK debtor

# If rejected ! counterparty will have a claim for rejection damages in the BK case

" Post-closing

# PSA no longer executory, but counterparty may have

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residual claims

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Risk Management Strategies: Special Considerations (cont’d)

! Bar Date – contract creditor should at a minimum! Bar Date – contract creditor should, at a minimum, monitor BK filings for setting of a “bar date” for filing claims

" Claims filed after bar date are lost

" Ex of types of claims: PSA counterparty

# Should consider what, if any, ongoing claims exist

# P&A; indemnification; warranty

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Risk Management Strategies: Affirmative Liability

! Avoidance Liability = Risk of affirmative liability! Avoidance Liability = Risk of affirmative liability arising from pre-BK transactions

! Avoidance powers

" Creature of applicable Bankruptcy or State Law

" Includes preference/fraudulent conveyances

" Debtor or trustee seeks to impose affirmative liability on parties to pre-BK transactions

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Risk Management Strategies: Affirmative Liability (cont’d)

" Preference Liability (Section 547):" Preference Liability (Section 547):

# In general, a debtor may avoid any transfer of an interest in property made to it:

$ to a creditor;$ for or on account of an antecedent debt;$ for or on account of an antecedent debt;$ made while the debtor was insolvent;$ if to a non-insider, made on or within 90 days before

the date of the filing of the petition; or$ if to an insider, made between 90 days and one year

before the date of the filing of the petition; and

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g p$ that enables such creditor to receive more than such

creditor would receive if the case were a case under Chapter 7 and the transfer had not been made.

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" Preference Liability (cont’d)" Preference Liability (cont d)# Debtor must show that prepetition payment enabled a recipient

to “receive more than in a Chapter 7 liquidation”

# Result

$ Unsecured Creditor: At risk for preference liability

! If there is any distribution in BK to unsecureds, typically substantially less than payment in full

$ Secured Creditors: Perfected lien or security interest

! Not only elevates return in BK

! Also may provide insulation from preference liability

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! Also may provide insulation from preference liability

! Existence of security may enable SC to argue payment did not provide a greater return than SC would have received in Ch. 7

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" Qualifier – transfer of security may itself be" Qualifier transfer of security may, itself, be preferential if it occurs within the applicable preference period

# However, DON’T TURN DOWN SECURITY

" Receipt of security despite the preference risk" Receipt of security, despite the preference risk, almost certainly is better offer than a wholly unsecured creditor

# Or at least no worse off

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! Certain strategies will deactivate this preference! Certain strategies will deactivate this preference requirement

" True prepayment

" Cash on delivery (COD)

! Disciplined compliance

" Required with any prepayment or COD credit terms for the counterparty to receive the benefit

F il t f th dit t l

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" Failure to enforce these credit terms may leave creditor worse off than under the original contract term

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! Ordinary Course Defense:! Ordinary Course Defense:

" Debt incurred by Debtor in ordinary course of business or financial affairs of Debtor and Transferee; and

" transfer made in the ordinar co rse of b siness or" transfer made in the ordinary course of business or financial affairs of the debtor and the transferee; or

" transfer made according to ordinary business terms

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! Ordinary Course Defense (cont’d)! Ordinary Course Defense (cont d)

" Timing and manner of payment is key to establishing ordinary course payment terms

" Availability of this defense highlights the need to closel monitor an change in credit terms toclosely monitor any change in credit terms to prepayment or COD credit terms

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# If credit terms requiring prepayment or cash-on-delivery are imposed on a counterparty, enforcement of those terms should be closely monitored or the risk to the contract creditor may be increased, not decreased

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! Fraudulent Conveyance (Section 548)! Fraudulent Conveyance (Section 548)

" Risk of exposure to fraudulent conveyance liability comes in two forms

# Actual Fraud

$ Active intent to defraud the BK estate or its creditors

# Constructive Fraud

$ Lack of “reasonably equivalent value”

$ At or near time of insolvency

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$ At or near time of insolvency

$ Within 2 years prior to BK petition date

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! Fraudulent Conveyance (cont’d)


! Fraudulent Conveyance (cont d)

" Fraudulent conveyance risk exists for virtually any transaction with a bankrupt or near-bankrupt buyer or seller

" Third-party appraisal obtained at the time of the p y pptransaction may be helpful, but not definitive protection against FC risk

" Undervalued Assets # Buyer may become a victim of its own success

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# Acquire high-risk assets and, if successful, BK trustee is incentivized contend acquisition was a fraudulent conveyance

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! Fraudulent Conveyance (cont’d)y ( )" Strategy for Buyer

# Consider conditioning completion of transaction with troubled buyer on:

$ Seller filing a BK petition and

BK t d i th l t t S ti 363$ BK court order approving the sale pursuant to Section 363

! 363 Order provides insulation to buyer from avoidance risk, among other things

" Downside# Once Debtor has filed BK, no assurance transaction will occur

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# In BK, Debtor typically required to expose assets in question to the market

$ usually no exclusives in BK

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# In considering a transaction with a troubled counterparty, must weigh

$ Risk that transaction closes outside of BK and later is sought to be avoided in action by Debtor or trusteeg y

$ Risk that, if the transaction is conditioned upon a BK filing & BK court “free and clear” order, transaction may be lost to a competing buyer that materializes in the BK case

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dealing with financially troubled businesses ......dealing with financially troubled businesses...

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