May 25, 2016

Bankruptcy 101 for Investors: Salvaging Your Investments from the Ruins of a Portfolio Company Bankruptcy

Arnold & Porter's Private Client Services Newsletter

That intriguing little tech company in which you invested has just filed bankruptcy. Will you ever be able to recover any of that investment? Maybe. It depends upon the form of your investment. And because recoveries depend upon the form of the investment, you may want to consider how you document your investments in the future.

The harsh reality is that almost all businesses that file bankruptcy are "insolvent" in the most basic sense of that term: they have more debts than assets. This means that the asset pie is too small, and not everyone will be paid the amounts to which they are entitled.

Bankruptcy is a process designed to divide up that too-small pie among creditors and equity holders in the "fairest" way possible under the circumstances. All creditors and interest holders must file proofs of their claims or interests that document the basis for their right to distribution from the company, so that their claims may be "allowed" as valid both as to nature and amount of the claim.

For allowed claims, the Bankruptcy Code establishes a hierarchy for payments that takes account of contract rights, state law, and bankruptcy principles. Those at the front of the line – secured and priority creditors – have a decent chance of at least partial recovery. Those at the very end -- equity holders -- rarely receive anything.

But these allocations are not set in stone. In a chapter 11 case, the debtor and creditors are permitted to modify the treatment of claims, if the affected parties consent to the terms of a proposed plan of reorganization. So, if you think that the company has value worth fighting for (as opposed to simply writing off losses), then you may want to enter into negotiations with other constituencies in the case to try to improve your outcome.

The Front of the Line: Secured Claims

If you lent money to the company on a secured basis, good news: you probably will recover some amount. Secured creditors stand the best chance of achieving substantial recovery in bankruptcy, to the extent that their pledged collateral has value. If you are fully secured, you should be paid in full – eventually. If you are undersecured, at least your secured portion should be paid, and you may recover something on account of the unsecured portion of your claim.

Typically, secured creditors have lent money to the company subject to a security interest in either real estate or other assets, such as receivables, equipment, or intellectual property. Under state law, a secured creditor has the right to foreclose on the asset and sell it to repay the debt. Bankruptcy's automatic stay prevents foreclosures from proceeding, but in exchange, secured creditors are entitled to be repaid the equivalent value of their collateral and to retain their liens until that payment is made.

Bank lenders fit the classic stereotype of secured lenders, but private equity or individual lenders are increasingly commonplace. In addition to secured claims arising from loans, vendors may hold purchase money security interests in the goods or equipment they sold to the company.

Major Issues for Secured Creditors:

  • Value of the collateral: A loan may be secured by the company's headquarters building, but it is a "secured claim" for purposes of bankruptcy only to the extent of the current value of that real estate. In other words, a US$500,000 loan secured by a lien on a property now worth only US$400,000 will be treated as a US$400,000 secured claim and a US$100,000 unsecured claim for the amount of the debt that exceeds the collateral value.
  • Treatment: A plan of reorganization usually provides for repayment of secured claims over a period of years, during which the creditor will be paid interest at a specified rate. If you as a secured creditor expected payment at maturity on a three-year loan, you would probably be unhappy to find that the plan proposes to repay you over a ten-year period, especially if the plan proposes an interest rate substantially below that specified in your loan agreement.

Possible Responses:

  • Contesting valuation: A dispute about the fair market value of real estate or receivables will usually be resolved by the bankruptcy court based upon competing appraisals. More challenging, however, is the valuation of intellectual property, such as patents, copyrights or trademarks, which are often the only assets available to a tech start-up for securing a loan. If the IP hasn't yet generated any revenues, then valuation will essentially be speculative, although, whatever its value, the IP is probably the only asset of any material value. Such disputes are typically resolved by settlement, with the secured creditor allowing the other creditors a portion of the value, whether that value is realized by sale or from revenues of the business after reorganization.
  • Contesting treatment: Debtors often provide for a protracted payment period for secured claims and a low interest rate because that combination means lower payments that leave some amount of net cash flow available to pay (or at least promise) to unsecured creditors. The Bankruptcy Code requires that secured creditors receive discounted stream of payments that at least equal the current fair market value of the collateral. If you want to contest treatment, you will need to file an objection to confirmation of the plan as well as vote against the plan. Contested confirmation hearings usually require evidentiary hearings, and are thus expensive. However, most such objections are settled by re-trading the deal embodied in the proposed plan.
  • Leverage: If you are willing to advance more money to the company as a DIP (debtor in possession) lender, so that it has the cash necessary to stay alive during the case, you may be able to increase your leverage over the plan process. DIP lenders are entitled to be paid in full, with interest and fees, ahead of even prepetition secured creditors. Some courts allow a "roll-up" of prepetition secured debt into the DIP loan for inventory and receivables collateral as it is used by the debtor, in effect elevating the status of the prepetition loan into the even higher priority of the DIP loan and insuring against any attack on the original loan's validity or security.

    Moreover, if the company continues to lose money during the case, a DIP lender may effectively have a stranglehold on the case. Of course, it will also have sunk more good money into what may still be a black hole of need, but at least the company will be the DIP lender's very own money pit. This may make sense as a bet on the long-range value of the IP, but can be a highly risky proposition.

Lessons/Considerations for the Future:

  • Because of the likelihood of disagreements over the value of collateral, you should consider whenever possible seeking a blanket security interest covering all assets, rather than just one category. If you have a lien on everything, then other creditors cannot contend that the real value of the company lies in the assets to which your lien doesn't apply.
  • If your collateral is IP, be especially careful to take all necessary steps to perfect your interest by filing with the US Patent and Trademark Office, Copyright Office, and the state of incorporation. Otherwise, the creditors committee, acting on behalf of the unsecured creditors, may seek to invalidate your security interest. It is up to the creditor to assure proper recording.
  • A security interest granted within 90 days before the bankruptcy filing to provide additional assurances (usually after a payment default) to a previously unsecured creditor can be "avoided" and set aside on the grounds that the granting of the security interest gave an unfair extra edge compared with other unsecured creditors. However, the possibility of a challenge should not deter you; you should almost always seek such improvement in your position to provide better leverage in the event of bankruptcy. It is important to seek advice to structure such enhancements in a manner that offers the best possible defenses to any later attack.

The Middle of the Pack: Unsecured Claims

Unsecured creditors include bond or commercial paper lenders without collateral (or with insufficient collateral), trade creditors, employees, personal injury claimants, and other general creditors. By law, certain unsecured creditors have priority over others. Wage and benefit claims, tax claims, obligations for goods delivered on the eve of bankruptcy, and certain other types of claims are entitled to be paid before other unsecured claims, subject to statutory caps on the priority amounts. With the exception of pension claims in some cases, priority claims usually constitute a small percentage of the overall debt.

As an investor, you probably won't hold any priority claims. More likely, you may have made unsecured loans to the company or entered into other contractual arrangements that give rise to general, nonpriority unsecured claims.

A creditors' committee will usually be appointed to represent the interests of unsecured creditors collectively. Typically, the largest non-insider unsecured creditors are selected, but the US Trustee seeks to have representation of the various types of claims, so appointments are not strictly by size. If you want to be active in the case and you are representative of a grouping of similarly situated claims, you can apply to be appointed to the committee. Partially secured creditors will usually not be considered. Bear in mind that members take on fiduciary responsibility to maximize recovery for all unsecured creditors as a group. These obligations might limit the strategies you would otherwise want to pursue in the case.

Major Issues for Unsecured Creditors:

  • Fraud claims against insiders: The committee or trustee often pursues claims for fraud, mismanagement, breach of fiduciary duty, or negligence against management or the directors, particularly where recovery on director and officer liability insurance is a possibility. Be aware that, if you have played a major role in the company, you may be among the targets for such litigation. On the other hand, if you are not a target, then you may benefit from any such recoveries as a member of the class.
  • Defending against claims objections and preference claims: In most larger chapter 11 cases and many chapter 7 liquidation cases, the committee or trustee will review the filed proofs of claim to determine whether the claim is well founded and the amount is accurate. If not, the committee or trustee will file an objection to claim and the creditor will have the ultimate burden of proving its claim against the debtor. The committee and trustee are also likely to sue unsecured creditors who have received payment on their accounts within the 90 days before the bankruptcy filing, just as creditors who received a late security interest might be sued. Many defenses exist. Most preference actions are settled.
  • Plan treatment: Plans of reorganization often separate various types of unsecured claims into different classes that will then receive different distributions under the plan. The Bankruptcy Code confers on debtors considerable discretion to create multiple classes of unsecured claims. Some classification limitations do apply. Most importantly, first, all claims in a particular class (or subclass) must be legally similar in character. Second, all claims in a class must be treated the same way. Third, between classes, any differences in treatment must not "unfairly discriminate" against one or more classes. As you might expect, the third requirement generates the most litigation.

Possible Responses:

  • If you are sued, whether on fraud allegations, objections to your claims, or preference actions, you will have to deal with the defense just as with any lawsuit. However, more options may exist for fashioning a settlement, as such disputes are often settled as part of the general horse-trading process to achieve a global resolution of the case under a plan that satisfies most creditors as essentially fair.
  • The flexibility of the "similar claims" and not "unfairly discriminate" standards offer considerable leeway for fashioning creative global settlements. Ultimately, however, particular creditors or classes of creditors upset with their treatment may be able to extract additional value by filing objections to the plan, which may prevent the debtor from achieving a consensual plan. Occasionally, such disputes lead to confirmation battles when the amount at stake justifies the extremely high cost of such litigation.

Lessons/Considerations for the Future: Unsecured lenders usually wish they held secured claims, but that is not always possible, especially if secured credit has already been maxed out. And trade creditors usually wish they had monitored their accounts receivable more conservatively to avoid undue exposure. In short, unless they supply an absolutely critical component for the debtor’s products, trade creditors individually don't have much leverage.

The Back of the Line: Equity Interests

In most cases, it is obvious from the outset that equity interests are entirely out of the money. Most plans simply wipe out old equity. Equity holders rarely find it worth participating in the case, with only a few exceptions as discussed below.

Major Issues for Equity:

  • Asserting equity value: Occasionally, initial estimates of asset value and outstanding claims indicate the possibility of a recovery for equity. In most cases, it will turn out to be an illusion, when later, more reliable data shows that the initial asset values have been overstated and claims understated. But if a material possibility of equity recovery exists, then the court may be willing to appoint an equity committee, in addition to the creditors committee. And in such cases, the debtor or trustee bears the additional fiduciary duty to maximize the value of the estate for the equity holders, not just the creditors.
  • Subordination of securities fraud claims: In the cases of publicly held companies, bankruptcy filings are often entangled with allegations of securities fraud, often with pending class actions as a major cause of the bankruptcy filing itself. In bankruptcy, unlike under state or federal securities laws, securities fraud claims are not treated like typical claims. Instead, Bankruptcy Code §510(b) specifically requires fraud claims seeking damages arising from the purchase or sale of securities to be treated as subordinate to the class of that security. So such damages claims are last in line – behind the stock or other equity interest – and therefore never have value in the bankruptcy case.
  • Tax and control issues: For tax pass-through entities, the recapture of depreciation as the result of a bankruptcy filing can be expensive, even if no equity value remains as of the time of filing. In some cases, equity owners are simply far more optimistic than creditors about the long term prospects for the company or its IP, and correspondingly loath to cede control.

Possible Responses:

  • Even a relatively attenuated argument of equity value will likely lead to some value left on the table for equity in the plan bargaining process. It is almost always cheaper to give equity the hope of some recovery in the future if the reorganized company performs better than expected.
  • The conflicting goals of securities law enforcement actions seeking forfeiture of corporate assets and the bankruptcy process sometimes offer leveraging options if the securities regulators are willing and able to go to bat for the victims of securities fraud.
  • It is possible for old equity to become the new equity even though creditors are not being paid in full. To do so, old equity must contribute substantial "new value" to the plan so that they can come out of the case still owning the equity. If enough new cash comes into the distributional pot, of course, creditors may be quite happy to allow old equity to emerge as the new owners. Alternatively, a third-party buyer with the participation of some old equity may take ownership through a reorganization plan, subject to full disclosure. Complicated rules govern the circumstances where old equity can emerge as the new owners.

Lessons/Consideration for the Future: If your investments are primarily in equity, you must be prepared for a complete loss in the event of a bankruptcy filing, unless you are willing to buy back the company from its creditors. If you also have a senior secured position, however, you may not care about your equity, as you may end up owning all or most of the assets or new equity on account of your secured claim.

Final Comments

The opportunity to cut deals about priority and treatment of claims and interests really only exists in chapter 11. Chapter 7 liquidations are governed by a relatively strict interpretation of priorities and proper treatment. If a feasible plan can be proposed, a case may be converted from chapter 7 to chapter 11 to make the deal possible through a plan.

Next in the series: Doing business through special purpose entities to limit bankruptcy risk.

[1] This article is intended only as a general guide. It is not a complete description of every scenario you may encounter. Every situation is fact-specific. The law constantly evolves. You should consult with legal counsel before taking action in a particular case.

[2] Other articles in this series have discussed the immediate impact of a bankruptcy filing on investors and creditors, including the scope of the automatic stay and early case events, and how and when the assets or business may be sold and how to buy them.

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