Unwinding The Deal When Bankruptcy Looms

Tuesday, May 1, 2007 - 01:00

Coping With Insolvent Business Partners

Joint ventures and other strategic partnerships have been criticized as a challenge to manage and difficult to unwind. Synergies can become the "ties that bind," with the financial failure of the venture adding insult to injury and posing challenging legal issues and potential liability to the non-bankrupt partner. Understanding the impact of a chapter 11 filing allows innocent parties to effectively negotiate with the debtor before a filing and enables them to best cope if and when the bankruptcy is filed.

Nature Of The Problem

An insolvent business partner may default on its obligations and leave the solvent business partner (SVP) with unexpected losses. Even the perception or threat of a chapter 11 filing can cause lasting damage to a business venture and all those associated with it.

In order to effectively evaluate the impact of a possible chapter 11 filing by a co-venturor of a joint venture, it is critical to first obtain as much information as possible. Depending upon the exact type of relationship, i.e. a joint venture, subcontract or partnership, the SVP may be able to take steps, before and after bankruptcy filing, to protect its economic interests to maximize the value of the investment and preserve business relationships. Factors such as the level of financial distress, the relative size of the business and the extent of other contracts or investments with the troubled company can affect the appropriate course of action.

Any due diligence performed at the inception of a business venture will become unreliable over time. It is imperative to gather relevant information as soon as possible upon learning of a business partner's distress. Additional business relationships may provide leverage before and after a bankruptcy filing and enhance the prospects for an optimal result from the otherwise bleak situation. Distressed businesses are often deluged with demands from various parties and usually only pay attention to their most demanding business partners. Also, other business partners of the potential debtor may be willing to share information regarding the distressed company. Even identifying these business partners and the extent of their relationships with the debtor can assist in formulating an effective strategy.

The next step is to formulate a plan of action. If the failing enterprise is cooperative, a beneficial step may be to restructure the transaction to avoid a bankruptcy filing or minimize its damage. Workout agreements, also called voluntary restructures, are useful tools in preserving business relationships and can often reduce or eliminate the need for bankruptcy. However, there are limits to what can be accomplished in a workout agreement, and certain transactions can be set aside by the bankruptcy court. Prior to acting, it is important to identify maximum exposure and any previously paid costs so that resources are not expended unnecessarily. Fully appreciating the maximum exposure and how the claim may be impacted by a bankruptcy filing provides the SVP with the overall framework of any workout agreement and should establish the boundaries for any course of action.

Armed with relevant information and an understanding of the nationwide injunction that issues automatically upon a bankruptcy filing, SVPs can navigate a business reorganization under the Bankruptcy Code to limit exposure and enhance the prospects of preserving value. Dealing with bankrupt business partners and knowing when contracts have to be honored irrespective of the filing can prevent the SVP of being accused of breach of contract and may be used to elevate certain contracts to critical and administrative status. Knowing your exposure for the liquidated losses and for any potential new liability provides essential insight on how to manage a financial disaster. Keeping abreast of the debtor's reorganization efforts and possible distressed assets sales also enables the SVP to gauge its conduct and may allow it to capitalize on the bankruptcy.

The filing of a bankruptcy petition triggers an "automatic stay," a nationwide injunction that prohibits certain actions, including any actions by a creditor to collect on pre-petition amounts owed by the debtor. SVPs should be aware of restrictions imposed by the automatic stay and the consequences - sanctions and possibly punitive damages - that can result from violation of the same. Accordingly, routine attempts by a creditor to collect on a pre-petition debt must cease once the bankruptcy petition has been filed. In certain circumstances, a creditor may petition the court to have the stay lifted to permit such creditor to exercise its rights. The Bankruptcy Code provides for the lifting of the automatic stay for "cause" or in cases where the debtor has no interest in the property at issue and such property is not necessary for an effective reorganization.

As they assess their rights and obligations surrounding the automatic stay, creditors should also consider their rights of setoff immediately upon learning of the bankruptcy filing. Setoff involves a creditor's right, arising under nonbankruptcy law, to "setoff" mutual debts owed between the debtor and creditor. While the automatic stay initially prohibits a creditor from enforcing its right of setoff, creditors can petition the court for relief from the automatic stay in order to enforce their setoff rights. In the interim, the SVP may place an administrative freeze on the payment of any amounts due to the debtor that the creditor reasonably believes are subject to setoff as long as court approval of the setoff is sought promptly. Recognition and enforcement of setoff rights enable creditors to recover a greater percentage of their claims, so such rights should be vigorously pursued.

Executory Contracts

One of the most common business relationships with a bankrupt party is by contract or subcontract. Upon a bankruptcy filing, certain rules come into play with respect to the debtor's contracts and leases. Parties to leases or executory contracts with the debtor may be able to force the non-debtor party to adhere to such contracts. As a general rule, the non-debtor party is required under the Bankruptcy Code to continue performance under the contract, notwithstanding the debtor's pre-petition failure to make payment on it. A debtor has 120-days from the petition date to decide whether to assume (retain post-petition) or reject (breach or disavow) its leases of real property. The bankruptcy court may extend this deadline only once for a period of 90 days, unless the commercial landlord agrees to further extensions. The debtor typically has until confirmation of a reorganization plan to assume or reject other contracts or residential leases; this is where the problem arises for the SVP with a pre-petition contract (other than a commercial lease) with the debtor. Because confirmation of a plan (and the debtor's deadline to decide on the executory contract that the SVP is obligated to continue to perform under) may take months, creditors should request that the bankruptcy court order the debtor to render its decision on a particular executory contract ahead of this deadline.

In order to assume a contract, the debtor must cure all pre-bankruptcy defaults under the contract, meaning assumption of an executory contract by a debtor enables a creditor to fully recover the amounts owed by the debtor prior to the bankruptcy filing. Once a contract is assumed, the debtor is required to perform under such contract as if the bankruptcy never happened. Any subsequent breach following assumption would allow the non-debtor, non-breaching party to sue for breach and recover all resulting amounts due.

Critical Vendors

Creditors who believe that they are integral to the successful reorganization of a debtor may consider seeking court-determined "critical vendor" status. Typically, these creditors provide goods and services that cannot be obtained elsewhere without substantial additional costs. Thus, if another party provides a similar good or service at a reasonable price, the vendor is not "critical" by definition and such status will be difficult to obtain. Upon the debtor's request, the bankruptcy court may authorize the debtor to pay all or a portion of a critical vendor's pre-petition claim in exchange for that creditor's agreement to continue to do business with the debtor. SVPs who believe they may be critical vendors need to proceed cautiously so as not to transform their appreciation that their goods or services are critical to the debtor into a refusal not to honor the pre-petition contract without payment of the amounts owed pre-bankruptcy. Critical vendor status requires an order by the bankruptcy court, and it would be improper for an SVP party to a pre-petition contract to condition its performance post petition on critical vendor status. Critical vendor status elevates a creditor's unsecured pre-petition claim, typically from very low priority, to that of an administrative claim that must be paid ahead of general unsecured claims.

Potential Exposure To Liability

An SVP must also know its own exposure to potential liability. While most properly drafted agreements will prohibit the distressed company's creditors from looking to the SVP for payment, certain guarantees or indemnity provisions may apply. In addition, once a bankruptcy is filed, the debtor or bankruptcy trustee is vested with additional "strong arm" powers that provide additional remedies that may result in liability against certain seemingly innocent third parties.

Among these potential liabilities is an action, known as a preference, brought by the debtor or bankruptcy trustee to recover payments made by the debtor to a creditor prior to the bankruptcy filing. Early assessment of any potential preference exposure can substantially impact the SVP's overall strategy. Notwithstanding the validity of any debts paid by the distressed company, a party may be required to return any payments received within the 90 days prior to the bankruptcy filing. In addition, the debtor may seek to set aside any lien granted on property made prior to the bankruptcy case for which "reasonably equivalent" value was not received by the debtor.

The Bankruptcy Code permits such actions as a means of remedying past preferential treatment of certain creditors for the benefit of all - even where the debtor did not expressly intend to prefer the creditor. Under the recently enacted bankruptcy reform legislation, however, defending preference cases should become easier.

Get Involved

The Bankruptcy Code affords creditors opportunities to become involved in the bankruptcy proceedings. In cases where a creditor has a significant stake in the proceedings, the creditor may wish to consider seeking appointment to the unsecured creditors' committee. In most commercial chapter 11 cases, the Office of the U.S. Trustee appoints a committee comprised of the largest unsecured creditors who represent the interests of their class of creditors and work toward achieving an optimal distribution for unsecured creditors. A committee of unsecured creditors typically participates in plan formation, evaluates proposed actions advanced by the debtor, employs its own attorneys and financial advisors (at the expense of the debtor) and often has standing to pursue litigation on behalf of the debtor. Through participation on the creditors' committee, parties often receive access to information not available to the general public regarding the debtor's future. While confidentiality requirements may prohibit certain use of this information, parties interested in serving on the committee might consider informing the U.S. Trustee's Office early in the case that they would be willing to serve in this capacity.

Asset Sales

The bankruptcy process often allows for the orderly sale of a debtor's assets as opposed to a reorganization. Where the debtor is unable to craft a successful turnaround and emerge as a viable venture, it may seek to sell its assets outside the ordinary course of business. If you are a party to a joint venture or have contracts with the debtor, assets sales in bankruptcy may provide an opportunity to salvage the enterprise and minimize the risk of being trapped with an unknown replacement partner. Any sale of assets outside of the ordinary course of the debtor's business must be approved by the bankruptcy court, and the Bankruptcy Code provides that a debtor must seek court approval to authorize the sale of its assets free and clear of all liens and encumbrances. These bankruptcy sales, often public auctions, can present a unique opportunity for a creditor to obtain valuable assets at a favorable price. Often, debtors present the court with "stalking horse" bids to encourage other purchasers; typically, the bankruptcy court approves bidding procedures, a break-up fee for the "stalking horse" bidder and an auction date.

Conclusion

SVPs should be aware of the ways they can preserve their claims and assert their rights in bankruptcy proceedings. Non-debtor business partners can become involved in the bankruptcy in several ways that may affect its outcome. From filing timely proofs of claim to seeking relief under the automatic stay, non-debtor business partners have options to proactively assert their rights and play a role in shaping the bankruptcy proceedings.

H. Jason Gold chairs Wiley Rein's Bankruptcy & Financial Restructuring Practice. Alexander M. Laughlin is a partner in the group.

Please email the authors at jgold@wileyrein.com or alaughlin@wileyrein.com with questions about this article.