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Who ‘slips out the back’ when bankruptcy arrives at the door

Denver Business JournalOn the Money
From the October 1, 2004 print edition

In the 1975 song “50 Ways To Leave Your Lover,” Paul Simon sang, “Just slip out the back, Jack, Make a new plan, Stan; You don’t need to be coy, Roy; Just get yourself free; Hop on the bus, Gus; You don’t need to discuss much; Just drop off the key, Lee; And get yourself free.”

The financial equivalent of those lyrics is the US Bankruptcy Code, specifically Title 11 of the U.S. Code.. For example, “Slip out the back, Jack” could mean Chapter 7 liquidation, “Make a new plan, Stan” might be Chapter 11 reorganization.

Here’s a closer look at the corporate bankruptcy process.

Federal bankruptcy laws govern how companies shut down or recover from crippling debt. The company that’s in trouble-the “Debtor,”–might use Chapter 11 of the Bankruptcy Code to “reorganize” its business and try to become profitable again.

Management continues business operations but all major business decisions must be approved by a bankruptcy court.

Under Chapter 7, the company terminates all operations. A Trustee is appointed to liquidate the company’s assets and the money is used to pay off the debt, which may include debts to creditors and shareholders.

In a bankruptcy, assets are divided in this order.

1. Secured Creditors – often a bank, is paid first.

2. Unsecured Creditors – such as banks, suppliers, and other lenders, have the next claim.

3. Shareholders – owners of the company, have the last claim on assets. Existing shareholders may not receive anything if the Creditors’ claims are not fully repaid.

Many companies will file under Chapter 11 rather than Chapter 7 because they can still operate and have some control over the bankruptcy process.

Bankruptcy papers consist of a two-page “Petition”, a 15 to 21 question Statement of Financial Affairs, and schedules showing: Real Property, Personal Property, Property Claimed as Exempt, Creditors Holding Secured Claims, Creditors Holding Unsecured Priority Claims (Taxes, etc.), Creditors Holding Unsecured Non Priority Claims, Executory Contracts and Unexpired Leases, and Co-debtors.

In addition, a Chapter 11 Debtor needs to file a list of the 20 largest unsecured creditors, including the creditor’s name, address and telephone number.

The filing of the Petition creates an automatic prohibition, “stay,” against virtually any action to pursue any claim against the Debtor or any assets without first obtaining court approval.

Occasionally companies prepare a reorganization plan that is negotiated and voted on by creditors and stockholders before they actually file for bankruptcy. This abbreviates and simplifies the process.

If the pre-approved plan entails an offer to sell securities, the securities may have to be registered with the SEC. Shareholders will get a prospectus and a ballot.

It’s important to vote. Under the Bankruptcy Code, two-thirds of the shareholders who vote must accept the plan. Dissenters will have to go along with the majority.

Without a pre-approved plan, the Trustee, often appoints one or more committees to represent the interests of creditors and shareholders to collaborate with the company to develop a plan of reorganization to get out of debt. The plan must be accepted by the creditors and stockholders. The bankruptcy court must confirm the plan.

Committees of creditors and stockholders negotiate a plan with the company to relieve the company from repaying part of its debt so that the company can try to recover. However, even if creditors or shareholders vote to discard the plan, the court can disregard the vote and still confirm the plan. The plan must treat creditors and shareholders fairly.

One committee that must be formed is called the “official committee of unsecured creditors.” They represent all unsecured creditors.

An additional official committee may sometimes be appointed to represent shareholders. The Trustee may appoint an additional committee to represent a distinct class of creditors, such as secured creditors, employees or subordinated bondholders.

After the committees work with the company to develop a plan, the bankruptcy court must evaluate the plan to guarantee that it contains no fraud and complies with Bankruptcy Code. This is the “plan confirmation,” process; usually taking a few months to complete.

Although a company may emerge from bankruptcy as a viable entity, generally, it is the creditors and the bondholders, not the existing shareholders, that become the new owners of the shares.

In most cases, the company’s reorganization plan will cancel the existing equity shares because secured and unsecured creditors are paid from the company’s assets before common shareholders.

In situations where shareholders do participate in the plan, their shares are usually subject to substantial dilution.

The Legal Information Institute or the Cornell Law School has an excellent website containing the complete U.S. Code, at http://lii.law.cornell.edu.

Of course the relative appeal of bankruptcy is largely dependent upon which side of the “bus” you’re on; creditor or debtor. For every “Jack that slips out the back,” there’s a Jill left holding the bag.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.