Business Vantage Point Blog

This is the first part of a two-part series on bankruptcy options for subsidiary or affiliate winddowns. Part one provides an introduction and discusses the benefits and drawbacks of Chapter 7 of the U.S. Bankruptcy Code. Part two will discuss the benefits and drawbacks of Subchapter V.

Navigating the hazards of an affiliate or subsidiary winddown is no easy task, and extensive planning is needed to minimize any potential liabilities. When a parent company is contemplating the dissolution or winddown of an affiliate or subsidiary but also wants to transfer assets out of the entity prior to dissolution or winddown, bankruptcy can provide a feasible mechanism for transferring such assets free and clear of liabilities while protecting the parent, managers and transferee from potential fiduciary or fraudulent transfer claims.

Although such a process can be achieved through a traditional Chapter 11 bankruptcy, such proceedings can be expensive. Where the dissolving entity has limited assets and liabilities, a bankruptcy proceeding under either Chapter 7 or Chapter 11’s Subchapter V of the U.S. Bankruptcy Code can provide a less costly and more efficient means of effectuating a free and clear transfer of assets while limiting any potential resulting liabilities. Under either process, the assets can be sold in an open, court-supervised process that should reduce, if not eliminate, any potential exposure.

Making the Appropriate Decision for Your Business
Choosing between Chapter 7 or Subchapter V is ultimately one of control versus cost. The primary benefit of Chapter 7 is that it is relatively cost-effective, with the catch that management cedes control of the dissolving entity to a Chapter 7 trustee who is charged with, among other things, liquidating available assets through a potential sale. A Subchapter V bankruptcy will entail significantly more cost than Chapter 7, but provides a less expensive, more efficient alternative to a traditional Chapter 11 that allows existing management to retain control of the bankruptcy and sale process — provided the dissolving entity meets the qualifications for filing a Subchapter V.

Benefits and Drawbacks of Chapter 7
Chapter 7 of the Bankruptcy Code provides a liquidation process in which an independent trustee is appointed to administer the liquidation by marshaling all available assets, liquidating them and distributing the available funds to creditors pursuant to the absolute priority scheme of the Bankruptcy Code.

The primary benefit of a Chapter 7 filing is cost. The debtor files a bankruptcy petition, its schedules of assets and liabilities, a statement of financial affairs, and a schedule of executory contracts and unexpired leases. The debtor must also provide the Chapter 7 trustee with recent tax returns and turn over its books and records. In addition, a representative of the debtor will be required to appear at a meeting of creditors during which the Chapter 7 trustee and creditors may question such representative under oath regarding the assets and liabilities of the debtor. Otherwise, the Chapter 7 trustee is charged with administering the bankruptcy estate, and the costs will be paid out of the money realized through the liquidation. Generally speaking, commencing a Chapter 7 bankruptcy is relatively inexpensive.

The most significant downside of Chapter 7 is that the debtor immediately loses control of the process, and the company, upon filing. Instead, the Chapter 7 trustee is promptly appointed to administer the bankruptcy estate. Thus, if a parent or management puts an entity into Chapter 7, they will have no control over the sale process which is controlled by the Chapter 7 trustee and subject to bankruptcy court approval.

Individual debtors most often utilize Chapter 7, but it is also frequently utilized by corporate debtors where there is no possibility of a restructuring. In all bankruptcy proceedings, distributions are made to creditors in accordance with the absolute priority scheme outlined in Section 507 of the Bankruptcy Code, with the administrative costs of the bankruptcy satisfied first, followed by secured claims, priority unsecured claims, general unsecured claims and finally, equity holders to the extent there is anything left over. Under the absolute priority rule, each class of creditors must be paid in full, in order of priority, before distributions may be made to the next junior class.

As previously mentioned, the Chapter 7 trustee fees are paid from the funds realized by liquidating the debtor’s assets. The debtor is not required to pay the Chapter 7 trustee who is entitled to a commission based on the value of assets marshaled, liquidated and distributed to creditors. In fact, upon filing a Chapter 7, other than in exceptionally rare circumstances, a corporate debtor’s operations terminate, and the debtor is out of business as of the filing date. Unlike an individual debtor, a corporate Chapter 7 debtor does not receive a discharge of its debts following liquidation, as discharge is only available to individual Chapter 7 debtors. Nevertheless, through the Chapter 7 process, all, or most, of a corporate debtor’s assets are typically liquidated with the proceeds distributed to creditors, meaning that any post-bankruptcy actions taken against the debtor would be of little value to claimants and in most circumstances would be unnecessary to defend in litigation.

A Chapter 7 trustee may conduct a sale of assets pursuant to Section 363 of the Bankruptcy Code, which permits a trustee, with the court’s permission and oversight, to sell a debtor’s assets free and clear of all liens and encumbrances. Typically, such a sale is conducted pursuant to an auction and bidding process in which the Chapter 7 trustee initially negotiates a baseline bid with a stalking horse buyer. The sale must be conducted pursuant to procedures approved by the bankruptcy court to obtain the highest potential sale price. Once the bankruptcy court approves the process, the Chapter 7 trustee will conduct the auction, select the highest and best bid, and return to the bankruptcy court for approval of the sale. Creditors and interest holders have at least two opportunities to object. First, such parties may object to the sale process and bidding procedures proposed by the Chapter 7 trustee. Second, such parties may object to the sale once the winning bidder is determined.

Although less common, it is also possible for a Chapter 7 trustee to conduct a private sale of a debtor’s assets pursuant to Section 363 without subjecting them to a bidding process. Such private sales are typically entered into where there is limited interest in the assets, and no competing offers are forthcoming. A private sale remains subject to the scrutiny and approval of the bankruptcy court. As with an auction, creditors and other interested parties must have an opportunity to object to such a sale, which remains subject to notice and a hearing. Private sales, without a bidding process, are much more susceptible to objections based on arguments that the Chapter 7 trustee did not sufficiently market the assets or that the sale price does not represent fair market value. It is also sometimes the case that once the trustee files a motion for approval of a private sale, an interested party comes forward with a higher and better offer, at which point the trustee may pivot to a private sale to the higher bidder or an auction process.

Chapter 7 and Your Board
In a Section 363 sale, it is possible for an insider — such as a parent, affiliate, stockholder or board member — to bid on the assets. It may even be the case that such an insider may act as the stalking horse bidder. Such a process may be subject to greater scrutiny, and there remains the possibility that another interested party will submit a higher bid and walk away with the assets. It should be noted that for a Chapter 7 trustee to proceed with a Section 363 sale, there will need to be sufficient value in the assets to justify the trustee’s time and expense. This is because the trustee is compensated based on the value of assets liquidated and distributed to creditors.

Such a sale process must realize sufficient value to cover the trustee’s commission, the fees of the trustee’s professionals, and the cost of administering the sale process — yet leave enough on the table for a meaningful distribution to creditors. However, such distributions can be as little as pennies on the dollar. Ultimately, it is up to the Chapter 7 trustee to make a value determination and decide whether the cost of a sale process is justified. Alternatively, the trustee can elect to abandon assets of minimum value to the bankruptcy estate.

In a Chapter 7 bankruptcy, ownership should be more or less insulated from any claims for breaches of fiduciary duties or fraudulent transfer relating to the sale of the assets because the sale process is public and is subject to the oversight of the bankruptcy court. The organization’s board members would have no involvement with the sale or bidding procedures. Because creditors and other interested parties, such as the shareholders, have an opportunity to object to the sale process and the sale itself, and because the sale is subject to the oversight and approval of the bankruptcy court, following a Section 363 sale, creditors and shareholders generally do not have any viable claims for fiduciary breaches or fraudulent transfer. In addition, if the bankruptcy court finds that the sale was made for fair consideration, it will insulate the sale from any fraudulent transfer claims. Similarly, if the bankruptcy court finds that the sale was consummated in good faith, it further protects the sale from any potential unwinding on appeal by a disgruntled party.

Stay tuned for part two of our two-part series.