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Legal Review: When the Party’s Over, It Pays to Understand Bankruptcy

1 May, 2014 By: Jeffrey D. Knowles, Venable LLP’s Advertising, Andrew J. Currie, Bankruptcy Practice Group Response

No one wants to talk about bankruptcy, but in a volatile industry like direct response, it’s likely something you’ll have to discuss eventually.

The Basics
There are many causes of corporate bankruptcy, ranging from bad business plans and poor recordkeeping to market conditions and lack of execution. Accepting insolvency can be personally and professionally difficult for corporate leaders, and it requires a shift of mindset from maximizing value for shareholders to maximizing value to the company’s creditors. Early recognition and engagement can make the difference between a well-planned, effective bankruptcy and a “free-fall bankruptcy,” which can have disastrous consequences for both the company and its creditors.

Insolvent companies have numerous options, each with its own situational advantages and disadvantages. The most well-known bankruptcy avenues are Chapter 11, which allows companies to continue operating while restructuring, and Chapter 7, under which companies are wound down and liquidated. One of the most powerful tools available to debtors in an in-court bankruptcy is the “automatic stay,” which suspends virtually all litigation or creditor action against the company’s assets. While this gives the debtor important breathing room to continue operations, it can also add complexity for the debtor and creditors.

In addition to Chapter 7 and 11 bankruptcies, out-of-court “work-outs” are another option. Although they lack all the legal protections of in-court bankruptcy, work-outs can provide more flexibility for both the debtor and the creditors.

Priority is the single most important factor for creditors because it dictates when and how much they will be paid. Section 507 of the Bankruptcy Code outlines types of claims that deserve special treatment, which typically enables the debtor to continue operations. Outside of those exceptions, payouts in bankruptcy work like a cascading fountain: higher priority claims must be paid in full before a more junior claim receives anything.

A creditor providing post-bankruptcy funding (or DIP funding) is typically paid first. Secured creditors with valid liens are paid next, assuming there is enough value in the underlying collateral of the bankrupt business. If anything is left, unsecured creditors are paid. Once the debtor’s assets are insufficient to pay a class of creditors in full, those creditors divide up what is left according to the size of their claim.

The Creditors’ Committee
At the outset of a Chapter 11 case, the U.S. trustee will hold a meeting to form a committee of unsecured creditors. These committees consist of the largest unsecured creditors, but they represent, and owe fiduciary duties to, all unsecured creditors. The committee’s primary goal is maximizing payment to all unsecured creditors.

Its duties include consulting with the trustee or debtor in possession concerning case administration, investigating the conduct, operations and financial condition of the debtor and participating in the formulation of a plan. Because it has standing on any issue in the bankruptcy case and the court takes its views seriously, the committee can exert pressure on the debtor, and on secured creditors, to expedite the process and achieve an acceptable payout to unsecured creditors.

The Bankruptcy Plan
The bankruptcy plan is essentially a binding contract between the debtor and all of its creditors. Creditors should monitor the plan to ensure their claim is assigned the right priority under the plan. The creditor can object to the confirmation of the plan. However, a plan can be confirmed and approved over the objection of certain creditors, depending on the circumstances.

Bankruptcy can be an arduous process for both debtors and creditors. However, it does not have to be the end of the world for either. When doing business in a volatile industry, it’s important to develop plans to respond to the bankruptcy of a partner or supplier. It’s equally important to develop plans should restructuring become necessary for your own organization. ■

About the Author: Jeffrey D. Knowles

Jeffrey D. Knowles

About the Author: Andrew J. Currie

Andrew J. Currie

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