WHEN INSOLVENCY CHANGES THE DEAL

“WHO’S ON FIRST”?

When Bud Abbott put that question to Lou Costello, it was the beginning of a famous dialogue. At last count, it has been viewed over a million times on YouTube. The answer, of course, is “Yes”. “I Don’t Know” is on Third where he cannot provide much help.

Throughout the history of American law, when creditors and other stakeholders in a troubled company learned of its insolvency and tried to figure out where the line formed to recover on their claims, they asked the same question and often found themselves going through the same confusing inquiry as the answers seemed to ignore the question. The playing field gets crowded very quickly when there is not enough to go around, and a simple two party deal becomes a community event.

While there have always been recognizable groups of professionals and businesses operating in the insolvency world who seem comfortable with the incoherence and ambiguity in the legal environment, new players show up, albeit under protest, with some regularity and often find it unacceptable and inscrutable.

In some cases, they have sufficient political power to rewrite the rules and legislation as labor unions did when they discovered that their collective bargaining agreements were being treated like normal commercial contracts. Groups with legislative constituencies such as retirees secured legislative assistance as well. Consumer lenders had extraordinary success in the 2005 amendments to the Bankruptcy Code that are now under close scrutiny in this election season.

If you have access to legislative solutions to the vagaries of insolvency law, you may have already carved out a place of safety in the insolvency world. Nevertheless, as the aircraft leasing industry discovered as they have continued to amend and amend again their own special provision in the Bankruptcy Code, it is a good idea to keep an eye on what is going on.

For those who have not yet seen the need to call in the lobbyists or whose businesses do not lend themselves to the special treatment that credit card companies, swap participants, and home mortgage lenders have already found, this issue of Insolvency Insights offers an introduction to the insolvency ideas that may leave them at risk if they do not consider them as they go about their business. 

It’s That Time Again

With the country facing the worst financial crisis since the Great Depression, a familiar process will repeat itself in the courts, legislatures, government agencies and among businesses. The unacceptable or unanticipated impact of insolvency on borrowers, powerful economic interests, and transactions that followed their own logic and idiosyncratic interpretation of the law will create surprising liability risks and loss. 

As you consider the discussion of the new obstacles to payment or performance by key business partners, you should also keep in mind the impact of Insolvency Principles on continuing business relations with business partners who remain operating their enterprises but make use of special rights and powers. The most visible group whose operations continue but change the terms of their obligations is financial institutions under FDIC receivership or conservatorship. Those institutions may continue to operate and go through government assisted sales or restructurings. Parties who continue to supply goods, services, or lease rights will find changes to their terms imposed under special federal law. 

“WHO CARES?”

Remember: There’s Always Something for Someone

It is the rare case in which a financially distressed or failed business has no property in its control or value to someone when the creditors and other stakeholders start looking for recoveries. In some cases, the value to its owners and lenders may lie in seeing the company disappear without further scrutiny of its troubled past. More often, there are assets with some value remaining in the company. The trick is to get to the table while there is still meat on the bones.

What matters to most claimants is whether they can recover what is theirs and avoid further losses. What they may want can be as varied as their continued relationship with the target company even if it is in new hands or a quick liquidation to end future losses and preserve asset values. 

They may want money in payment. They may want their goods back. They may want their intellectual property or trade secrets back. They may want their investment back. They may be tort claimants. They may be employees or owners who want to remain employed. 

With increasing frequency, the ostensible creditors may be investment groups who have acquired controlling positions in certain debt issues at very steep discounts that they will use to take control of the company. And, of course, one should never overlook the government. Each claimant has its own goals, and they are often in conflict.

Whether others will be equally successful is usually a matter of indifference to claimants so long as they are not in competition for the target company’s assets. In the insolvency world, however, everyone is in competition since there is not enough value to go around.

Even those business partners who have successfully concluded their business with or investment in a distressed company may find themselves called to account for their dealings in litigation filed years later. The owners, managers, and other business partners of the company should understand the risks that their dealings with the company will be reviewed and lead to efforts to recover benefits, property or payments received in the past or to impose restitutionary liability to account for profits or other value they appropriated at the expense of the company.

Having care for the risk that insolvency creates requires more than rote knowledge of business law or business practices. Insolvency is a dynamic environment in which new ideas appear with some frequency and even old ideas find new life. 

JUST READ THE CONTRACT

Everything Has to Start Somewhere

Commercial law exists to provide predictability and fulfill the reasonable expectations of the parties that their agreements will be performed. That fundamental idea, however, falls away in the face of insolvency when political, social, and economic views change the rules. 

This issue of the SFS Law Group Insolvency Insights offers our thoughts on key insolvency ideas that have given some stakeholders access to a better deal than others even though the documents and the deal seemed to provide otherwise. Our clients have found it helpful to follow the fortunes of their suppliers, customers, investors, and other important stakeholders and make course adjustments that respond to potential risks that insolvency may create. 

The SFS Law Group Insolvency Response Plan is a way for clients to study at key relationships and adopt the best strategy to avoid losing their rightful place in line when there are fewer assets than claims. Priority is the name of the game and the rules keep changing. It also examines exit options when the relationship is no longer beneficial.

Some rules, however, have a general consistency and clients who do their homework and understand the environment usually restructure their deals, negotiate new terms, and deal with possible competitors in ways that often enable their important business partners to work through the insolvency process and continue on. When you understand the lay of the course and where the hole has moved, you can plan your next shot.

WHO ARE THOSE PEOPLE?

A seller may have a clear contractual right to payment from his buyer but may discover that the buyer’s assets are already spoken for under secured financing or other arrangements. A company may have a successful business and bright future but discover that its parent corporation is out of cash, out of credit, and diverting the resources of its affiliates to survive. Despite strong cash flow, great profit margins, clear growth opportunities, a struggling parent may pledge the assets of its affiliates to its own creditors and turn a great company into a failing company.

While a customer’s credit seems solid and the path to the assets may seem clear, the government taxing authorities and other regulators may have a priority right to take the buyer’s property. Even when a seller does get his hands on the debtor’s money or property, he may discover that he must give it back under preference, fraudulent conveyance, or other grounds that were unforeseen and unknown.

Some stakeholders in a business have the ability to negotiate terms and create rights that will protect them from competition for a customer’s assets. Secured lending by major financial institutions usually involves such an important source of capital for an enterprise, that a borrower will agree to many, many special provisions designed to frustrate and avoid competition from others. 

Life on the “A” List

The “A” list or protected class of creditor interests in American commercial law is generally recognizable, though new members do appear as politically powerful groups discover that they do not have the priority or place in line that they expect. If you know your key stakeholders and business partners, understand their businesses, and know your industry, there are often measures and procedures you can adopt that will provide some protection from the A List stakeholders or even get you on the list yourself.

Mechanic’s liens, chattel liens, warehouseman’s liens, materialman’s liens, and a complex variety of other special rights in property have been created under both state and federal law to protect certain classes of creditors whose contribution to the value of their customer’s property may be recovered ahead of an existing secured creditor. Those interests, however, are usually addressed in the lending documents and through a well-developed lien waiver process in many transactions. 

But before thinking about the competition, who really is on first when cash grows short, bills pile up and the accounts payable start to decompose? 

The usual suspects in the struggle should not be a surprise but how they go about their business may cause some indigestion to the rest of us:

Secured Creditors and Those Who Get Similar Deals

If you have a valid, enforceable first lien available to satisfy your claims the answer to the question seems clear. “Who’s On First”? You are. (Unless, of course, some special legal ideas, judicial rulings, favored classes, or government enactments change the deal by challenging the grant of security.)

Security given by an insolvent debtor for less than fair value, given with the intent to hinder delay or defraud creditors, given to an insider for an outstanding debt, or given to secure someone else’s debt may end up avoided in litigation and the first position given to a private litigant, receiver, bankruptcy trustee, or government claimant. 

Advances under valid commercial financing agreements may lose their priority to a tax lien. In bankruptcy, a debtor may secure a priming lien for funds spent protecting the collateral. State lien laws may also create priming liens for suppliers and others even if there is no insolvency. 

It is always possible that the property securing a claim is insufficient to satisfy the full debt. Efforts to limit the value of a secured claim to the value of the collateral itself can leave a secured creditor with a dramatically reduced secured claim and an unsecured claim of questionable value. 

For most secured lenders dealing with businesses, however, their liens on accounts receivable give them a strangle hold on borrowers in their business operations that continues in bankruptcy cases. Bankruptcy law has an immediate and self-executing bar to the borrower’s use of this cash collateral without the lender’s consent or a court order. The effect of the special protections of accounts receivable liens is to give the secured lender such a degree of control over the lifeblood of the company that it can dictate terms of continued use of cash. 

Even outside a bankruptcy case, the right to notify account debtors to pay the secured creditor enables the secured lenders to cut off cash flow to an uncooperative debtor. Courts are also quite willing to enter injunctions requiring payment to the secured creditors from debtors and their customers.

In many business bankruptcies cases, the resort to bankruptcy protection does not provide any escape from the power of the secured lender and servicing the secured creditor’s claim is the most important business issue the debtor addresses. Without making peace and securing the cooperation of the secured lenders, survival is unlikely and efforts to reorganize remote. 

Though the need to avoid liability for control over the debtor leads the senior secured lenders to deny that they are in control, if a company has viability and value as an enterprise or there is some value in preserving it for sale, there is usually an arrangement under which a turnaround professional or acceptable manager is engaged by the company to pursue the reorganization, sale, or liquidation goals of the senior lender. 

The preferred position granted to secured lenders also influences the attitude of the courts when borrowers feel that lenders are adequately secured and depriving other stakeholders of residual or future values by using the power to cut off cash and prevent new secured borrowing to support operations.

It is quite rare for companies with substantial secured debt to make independent business decisions in workouts, bankruptcy, or other business activity where they must deal with insolvency concerns. As targets for acquisition, companies under the domination of their senior lenders can be true bargains for sophisticated and knowledgeable bidders who understand how to use bankruptcy to remove competing claims to assets and redefine other business relationships. Indeed, bankruptcy is a useful vehicle for disposing of an illiquid secured debt for lenders. 

If there is a risk of a deficiency in the collateral value of a company that may be resolved by preserving its going concern value or finding a buyer willing to protect the senior debt, secured creditors often facilitate sales and reorganizations that leave other creditors receiving little or nothing. 

From the perspective of the secured creditors and cooperative management of the distressed company who may have personal guarantees and other financial interests, cutting out junior interests is not a concern. 

Holding Off the Unworthy Hordes

It goes without saying that the creditors and stakeholders left out of the deal may be unhappy with an ending that leaves only the secured creditors satisfied with the terms. In many cases, there is little leverage for junior interests. However, the world of the secured creditor is also fraught with risk. Once insolvency arises as an issue in their relationship with their borrower, the validity, enforceability, and perfection of their interest may be challenged. 

From time to time, courts have surprised secured lenders by denying them their secured status or creating unexpected liability risks. Over the years, the ingenuity and lobbying efforts of the financial community have led to statutory remedies that restore the priority of secured lenders when they discover new competitors. Legislation requiring loan agreements and modifications to be in writing provided substantial relief to banks who faced the lender liability movement which generated some notable recoveries for borrowers who claimed they had oral lending agreements that were dishonored.

When secured creditors learned they would face environmental cleanup obligations if they foreclosed on toxic assets, legislation corrected the problem and changed the law so that they would not be operators of the property while they held it for liquidation of their claims. 

When aircraft lessors discovered that their leases could be treated like real leases in bankruptcy and rejected, they created a special legislative cure that they continue to refine with new amendments as needed. 

The de facto extension of loan and payment obligations that resulted from court delays in bankruptcy cases has also been addressed through detailed time periods during which the court must act. Indeed, the aircraft lease finance industry decided that shortening times was not enough and secured legislation that simply divested the court of jurisdiction to limit their rights to possession after a fixed period. 

Labor interests secured special legislation requiring bargaining in bankruptcy before a labor agreement could be rejected. Retirees now have special committees to deal with their interests.

The creation of special rights in the property of a distressed company by state or federal laws, and other regulations is often industry specific and require close analysis of the priority and rights in property for a specific industry, customer, supplier, or business partner. 

In the health care industry, the limitation on the right to alienate Medicare receivables left many secured creditors at risk if their borrower defaulted due to the treatment of their interest as unperfected. Government licenses such as FCC licenses, alcoholic beverage licenses and other regulated rights did not lend themselves to effective secured protection since government regulations often identified the license as a grant that could not be transferred by the licensee. As lenders sought to secure their loans with new forms of collateral and to ensure that they had valid liens in more familiar collateral, the Uniform Commercial Code was amended to support those efforts and provide more certainty to the secured lending community.

It is a continuing saga as new rights are created to protect that first position that financial creditors consider an essential entitlement. In recent years, the creations of “Bankruptcy Remote” borrowers who could not file voluntary bankruptcy cases became a common device used by lenders to place assets in companies that could not become debtors in bankruptcy cases and whose general creditors would be so few that the likelihood of an involuntary filing was remote. The goal was to escape the reach of the Bankruptcy Code entirely. Even under those provisions, however, supposedly bankruptcy-proof remote entities have been placed in involuntary bankruptcy and commenced bankruptcy cases despite the structural impediments.

Life on the “B” List

For those clients who rely on the viability and underlying asset value of their trading and business partners, it is important to know whether that value is really available in times of financial distress. Wholly apart from rights in liquidation or litigation, the lack of value in insolvency itself becomes a powerful and persuasive point in allowing a favorable contract to get renegotiated, forgiven, released, or restructured. 

Being dependent on a business partner whose assets and operations may be under the control of parties with no interest in preserving a beneficial business relationship often leads to genuine financial risk. While it is understandable that operating line managers may feel the need to provide inventory to critical suppliers, guarantee payment of essential suppliers to their own essential suppliers, and provide credit terms that resemble an unsecured loan, an undisciplined approach in providing support to the supply chain can turn the troubled supplier into a permanent dependent and create new problems if other creditors seize assets supposedly set aside for the generous customer.

The saga of US Airlines illustrates how the continuing separation of ownership in commercial airlines from the real control over business decision-making has made bankruptcy courts look rather foolish in their accommodation to those companies as bankruptcy debtors.

A painful illustration of the hard life of those creditors who do not make the “A” List appears in the continuing recidivism of airlines as debtors in bankruptcy cases. 

The same classes of creditors and equity investors discover in the new bankruptcy case that they are last in line at a closed window when a company that has confirmed a reorganization plan decides that is will not make the promised payments under the plan and pursues a second reorganization case. 

When US Airlines filed its second bankruptcy case, many creditors in the earlier case were still trying to get their claims allowed and paid in that case.

The companies themselves seem to be under the control of their equipment providers, rather than their equity holders. For a stakeholder who leases aircraft, engines, or spare parts, the rules of the game provide substantial protection from continuing operation without payment and cure of deficiencies. Airports have now found ways to protect the passenger facility charges collected by the airlines that were once a source of loose cash. 

Nevertheless, even under the heavily lobbied and negotiated priority regime in the airline industry, the economic realities have often created uncovered risk and provided opportunities for junior or out of the money claimants to advance their interests over what appear to be clearly senior claimants. The most notable example is the funding of employee benefit plans and unpaid wage and benefit claims as part of the operating expenses during a bankruptcy case while other creditors go unpaid.

The senior and secured interests, however, usually require protection in the form of special cash collateral and post petition financing orders that provide them with super priority and replacement lien rights that reach new assets and keep outside parties from putting in money at high costs and higher priority rights. 

The primacy of secured creditors is long and well established in American Law. They are the barons of bankruptcy cases. They, too, however, sometimes have trouble knowing, “Who is on First” as subordination, pari passu relationships, intercreditor agreements, and investments in slices or “tranches” of cash flows from secured interests move commercial financial agreements into metaphysical dimensions. But that is a family feud that still keeps the values inside the secured creditor community.

Understanding who it is that has the first seat at the table and controlling position in a workout is an essential first step in the restructuring and insolvency planning process. The December issue of Insolvency Insights will discuss the future of this exalted class in light of the new cycle of insolvency challenges that the faltering economy has created. The December Issue will consider the best response by the “B” list players who must operate in the shadow of the senior creditors. It is possible to coexist with senior interests if there is something special that you provide to the target company and you avoid being held hostage by an essential supplier or outlet.