Matts Batryn

This is the second 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 discusses the benefits and drawbacks of Subchapter V. Benefits and Drawbacks of Subchapter V The intent of Chapter 11 of the U.S. Bankruptcy Code’s Subchapter V is to provide a streamlined, cost-efficient process by which small businesses can reorganize under Chapter 11 of the Bankruptcy Code. Subchapter V allows small businesses to utilize the benefits of a Chapter 11 filing without expending substantial funds. Although Subchapter V was enacted ostensibly to allow small businesses to inexpensively and quickly reorganize, it may also be used to sell the debtor’s assets and winddown operations. To qualify for Subchapter V, a debtor must be engaged in commercial or business activities (per the courts, a low bar), at least 50% of the debtor’s debt must be business-related, and the debtor must have less than $7.5 million in non-contingent secured and unsecured debts. The primary benefit of Subchapter V bankruptcy as compared to Chapter 7 bankruptcy is that the ownership or management remains in control of the debtor pursuant to Section 1107 of the Bankruptcy Code. Moreover, a Subchapter V is substantially more cost-effective than a traditional Chapter 11 case for all of the aforementioned reasons. The primary downside, as compared to Chapter 7, is that it will be more expensive since the debtor remains in control and must administer the estate, arrange and obtain approval of the sale process, incur the cost of preparing a proposed plan, negotiate with creditors, and pay the fees of a Subchapter V trustee. Subchapter V modifies or does away with many of the requirements and/or hurdles present in most Chapter 11 cases with the intent to effectuate a less costly and quicker process. Among other things, in a Subchapter V, there is typically no creditors’ committee to drive up costs. In a Subchapter V, as in most Chapter 11 bankruptcies, existing ownership or management continues to operate its business and a traditional bankruptcy trustee is not appointed to take control of and manage the debtor’s business. Instead, a Subchapter V trustee is appointed. However, the Subchapter V trustee does not have the same powers as the Chapter 7 or Chapter 11 trustee. Instead, they act as something akin to a mediator, facilitating negotiations between the debtor and its creditors to attempt to achieve a fully consensual Subchapter V plan. Although in some cases the Subchapter V trustee’s role may be expanded, the Subchapter V trustee does not have the same broad powers as the Chapter 7 or Chapter 11 trustee to investigate causes of action, operate the debtor’s business, receive estate property, review and object to claims, and propose a Chapter 11 plan. The Subchapter V trustee’s fees must be paid out of the bankruptcy estate. Subchapter V confers significant benefits upon debtors. For example, the Subchapter V debtor is not required to file a disclosure statement in connection with its plan, which can greatly reduce the expense of a Chapter 11 filing. Subchapter V also does away with the absolute priority rule, meaning that ownership may retain its equity interests in the debtor even where senior creditors are not paid in full. Rather than pay all unsecured creditors in full before equity is permitted to retain its interest, a Subchapter V debtor need only propose a plan that pays unsecured creditors all projected “disposable income” over three to five years. This is a substantial benefit for reorganizing small businesses although less so for liquidating debtors. Further, unlike traditional Chapter 11 bankruptcies, creditors cannot propose competing plans, so the debtor remains fully in control of the plan process. Finally, although one of the fundamental goals of a Subchapter V bankruptcy is to obtain a fully consensual plan, the Subchapter V debtor can confirm the Subchapter V plan without obtaining the consent of any creditors. In contrast, in a typical Chapter 11 bankruptcy, where the debtor proposes to impair creditors’ rights, the debtor must obtain the approval of at least one impaired class of creditors. However, in exchange for such benefits, Subchapter V debtors are expected to move quickly and, among other things, must propose a plan within 90 days of filing. Missing the plan deadline can result in dismissal or forced conversion to a Chapter 7 bankruptcy. Because of these tight deadlines, ownership should not put an entity into Subchapter V without a preformulated plan and strategy already in hand so that the bankruptcy court can establish and approve a sale process early in the case. Generally, the sale process would be similar to the sale process described in the first part of our series regarding Chapter 7, but the debtor remains in control rather than a bankruptcy trustee. The debtor will typically market its assets for sale, identify an initial bidder, obtain the bankruptcy court’s approval of the bidding procedures, and then obtain the bankruptcy court’s approval to sell the assets to the winning bidder. Along the way, interested parties have an opportunity to object to the process and the sale. In Subchapter V, the debtor’s efforts to sell its assets to an insider may face increased scrutiny from creditors, interest holders and the bankruptcy court since the debtor remains in control of the process. However, so long as the court approves the sale, the court finds that the process is fair, the debtor maximizes value for the bankruptcy estate, and the sale is made in good faith, ownership, management and any buyer of the assets should largely be insulated from exposure to any post-sale claims that they breached their fiduciary duties or that there was a fraudulent transfer. Ultimately, although the debtor remains in control of the process, it remains an open, court-supervised sale process that presents ample opportunity for interested parties to object. As such, any exposure arising from a sale of the debtor’s assets should be de minimis. It should be noted that just as in a Chapter 7 case, the debtor-in-possession in a Chapter 11 case has the power and, indeed, an obligation to investigate potential claims against third parties, including potential claims against directors and officers for prepetition breaches of fiduciary duties. However, in the absence of a creditors’ committee, a creditor is much less likely to challenge such a decision. Nevertheless, a particularly invested or active creditor could elect to challenge that decision and make the process more costly and drawn out. Consult with Bankruptcy Counsel Any parent or management considering how to most effectively dissolve or wind down an affiliate or subsidiary, particularly when considering whether or how to first transfer valuable assets out of the dissolving entity, should consult with bankruptcy counsel for a fuller evaluation of whether a Chapter 7 or Subchapter V bankruptcy makes sense. Although a non-bankruptcy dissolution or winddown may make sense for some entities, there are circumstances in which a Chapter 7 or Subchapter V bankruptcy will be more desirable, particularly where liabilities exceed assets but there nevertheless are valuable assets to be administered.

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.

Net operating losses (NOLs) represent a valuable asset for corporations realizing a net loss in a given year. The Internal Revenue Code permits taxpayers, including corporations, to carry forward NOLs to offset against taxable income and reduce tax liabilities for future years. However, as they are generally not transferable, the IRS Code limits corporations from utilizing NOLs following a change in ownership. Pursuant to Section 382 of the IRS Code, an ownership change occurs when the percentage of a corporation’s equity held or beneficially owned by persons holding 5 percent or more of the corporation’s stock increases by more than 50 percentage points over the lowest percentage of equity owned by such shareholders at any time during the preceding three-year period or since the last ownership change. An ownership change can also result from a worthless stock deduction claimed by any person or entity owning 50 percent or more of the corporation’s stock. Sections 382 and 383 of the IRS Code limit the amount of future taxable income if an ownership change occurs, that may be offset by a corporation’s pre-change losses and excess credits, which include the corporation’s NOLs. When a corporation files for protection under Chapter 11 of the U.S. Bankruptcy Code, it can set off a flurry of activity by shareholders, including both trading — as shareholders seek to dump their stock before losing any more value and distressed debt investors seek to acquire such stock at a discount — as well as claiming deductions for worthless stock. Once NOLs or other similar tax credits are limited under Sections 382 and 383 of the IRS Code, their use is limited forever. When a corporation files for Chapter 11 protection and the resulting transfers of stock result in an ownership change before the corporation’s exit from Chapter 11, such transfer may negatively impact the corporation’s ability to utilize its NOLs to offset tax liabilities following successful restructuring. A successful Chapter 11 restructuring almost always results in a change of ownership because equity cannot retain its ownership unless all unsecured creditors first get paid. However, under specified circumstances, the IRS Code permits a debtor to retain its NOL credits during a Chapter 11 restructuring, notwithstanding substantial change of equity holders under a confirmed Chapter 11 plan. Therefore, where valuable NOL credits are in play, a debtor may need to limit any potential for ownership change during a Chapter 11 case that could negatively affect its ability to utilize NOL carryovers after emerging from bankruptcy. Accordingly, debtors are interested in closely monitoring their shareholders’ identities during a Chapter 11 case and potentially limiting trading. It has become increasingly common for corporate Chapter 11 debtors to seek the intervention of the bankruptcy courts at the outset of the case to place limits on stock trading and prevent any change in ownership that could impact the availability of NOL credits and, in turn, the value of the corporation’s bankruptcy estate. Such relief is often sought via a first-day motion — i.e., a motion filed on the first day of the bankruptcy case — requesting entry of both preliminary and final orders enjoining shareholders from transferring stock, requiring shareholders to provide notice of any material transfer, voiding any transfers that are made without such notice and/or limiting the shareholders’ ability to take a worthless stock deduction. Although the Bankruptcy Code does not expressly authorize bankruptcy courts to impose such injunctive relief, courts reason that NOL credits represent a valuable asset of the bankruptcy estate that must be protected via trading injunctions, finding justification for such relief in Section 362(a)(3) of the Bankruptcy Code, which acts as a stay of “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.” (See In re Prudential Lines, 928 F.2d 565 (2d Cir. 1991).) Because trading injunctions typically are sought early in Chapter 11 cases, and the bankruptcy courts usually adjudicate first-day motions on an expedited basis, stock trading injunctions may be entered before many creditors or shareholders are even aware of the bankruptcy filing or have time to get their arms around such requests and appropriately respond. It is important for institutional investors, upon learning of a corporation’s bankruptcy filing, to promptly consult with bankruptcy counsel to determine whether the debtor is seeking a trading injunction and the impact that any such injunction will have on the investors’ ability to trade their shares or claim a deduction for stock that has become worthless. Among other things, a holder of a debtor’s equity must quickly address the following questions: Has the debtor requested a trading injunction? What is the scope of any such request? What equity threshold would trigger trading restrictions or notice requirements (typically around 5 percent)? What form of notice is required to be provided to the debtor before a transfer of stock? Are there any substantive objections that should be raised to the request for a trading injunction? Because the specifics of each request for a trading injunction will depend on the circumstances, the exact terms of a trading injunction will vary from case to case. Trading injunctions might include provisions that enjoin the transfer of equity interests outright. Such injunctions should be tailored and limited to investors holding 5 percent or more of the debtor’s stock. In addition, trading injunctions may provide for a prohibition on trading that is only triggered upon a certain dollar amount of claim trades. These injunctions may limit claims trading to protect a debtor’s ability to preserve NOLs through a confirmed plan. When an investor has owned 50 percent or more of a debtor’s stock during the prior three-year period, debtors may seek to limit investors’ ability to take a worthless stock deduction, which could also result in a loss of NOL tax deductions. Although corporate Chapter 11 debtors may have a strong interest in protecting their NOL carryovers and trading injunctions may well preserve value for a debtor’s bankruptcy estate, the imposition of trading injunctions is strong medicine, and the practice is not without its critics. Critics assert that Congress never intended the automatic stay imposed by Section 362 of the Bankruptcy Code to extend to NOLs. They claim the automatic stay is intended to limit actions to exercise possession or control over estate property and should not be extended to limit investors’ ability to exercise their rights for their property — i.e., their stock holdings — simply because such exercise may have an incidental effect on a debtor’s NOLs. Critics have also argued that the imposition of trading injunctions goes far beyond the bankruptcy court’s equitable powers and that trading injunctions violate the Fifth Amendment by interfering with shareholders’ property rights. In consultation with bankruptcy counsel, shareholders should consider whether any requested trading injunction is overly broad and has a greater limiting effect than is necessary to protect the debtor’s NOL carryovers. Where trading injunctions are sought on the first day of a Chapter 11 filing, shareholders may argue that such injunctions are premature, particularly where the value or utility of the debtor’s NOLs has yet to be determined, and no plan of reorganization has been formulated. At the outset of a case, a debtor likely cannot show that it will generate future taxable income before the NOLs expire or that its NOLs have not already been limited by pre-bankruptcy trading. To obtain a preliminary trading injunction in connection with a first-day motion, a debtor must show: The debtor is likely to succeed on the merits. The debtor will suffer irreparable harm without the injunction. Whether the injunction will harm others or serve the public interest. As some critics have noted, these standards are challenging to establish on the first day of a Chapter 11 case because a debtor will have difficulty showing that successful reorganization and future profits are likely or that NOL credits will be limited without such an injunction. (See “Winning Losses: Trading Injunctions and the Treatment of Net Operating Loss Carryovers in Chapter 11,” Yale Journal on Regulation, Vol. 32 (2015).) Trading injunctions frequently include provisions rendering stock trades void ab initio where an affected investor fails to provide the debtor with the requisite notice required by the court’s order. Accordingly, consultation with bankruptcy counsel is necessary regardless of whether a shareholder intends to challenge the imposition because noticing provisions might impose affirmative reporting obligations upon the shareholder.