C. W. Wied Professional Corporation, lawyers in San Diego, CA, California

It is the author's view that most troubled businesses can and should
be saved. Any business failure has a ripple effect. When a business
fails, employees who lose their jobs file bankruptcy, leaving their
creditors unpaid. Creditors in turn find themselves insolvent when
they lose customers to business failure. The United States Supreme
Court has stated: "The fundamental purpose of Chapter 11 is to
prevent [a business] from going into liquidation, with an attendant
loss of jobs and possible misuse of economic resources."

It is a tragedy that out of ignorance, embarrassment and denial,
business owners let their businesses fail. These articles will
demystify Chapter 11 and explain the tools of business rehabilitation.
The title of Chapter 1 is the recurrent theme of the articles.

There is no good reason for a business failure. Business lives can
and should be saved, no matter how great the crisis -- unless the
crisis is the result of procrastination, denial and delay. Economic
recession, military base closings, inflation, interest rate increases,
and of course mismanagement, can turn a business on its ear. It
need not be fatal, however, if the problem is recognized in time, and
if prompt curative action is taken.

Remember, your business, or that of your customer, can and should
be saved. Some powerful tools that you should know about exist to
do the job. All of the tools are contained in Chapter 11 of the
United States Bankruptcy Code, and you can use them either by
filing or sometimes by merely threatening to file a Chapter 11
petition.

Bankruptcy law is complicated, and bankruptcy procedures are full
of traps for the unwary. Moreover, financial illness is not the sort of
thing that responds well to self treatment; that is because the
unrepresented patient usually procrastinates and typically seeks
only temporary, symptomatic relief, neglecting to take curative
medicine. Creditor demands for immediate payment of delinquent
accounts is a typical, painful symptom. The pain can be temporarily
alleviated by sending partial payments to the noisiest of the
creditors. In medical jargon, this is contraindicated, because it
leaves a business without the one thing it needs most to continue
to operate -- cash.

This series of articles will equip you to recognize the signs of
impending insolvency, avoid common mistakes, retain competent
professional help and get reorganized at a reasonable cost.
Incidentally, all "insolvency" means is that the business generally
cannot pay its bills as they come due. There aren't many businesses
that haven't been, at one time or another, on the edge of
insolvency. Your goal, in or out of Chapter 11, is to reorganize and
save your company. This series of articles was written to help you
reach that goal.

The information in this series of articles is not for business debtors
alone. Everyone does business with companies that may be
insolvent. To determine whether to continue doing business with a
company, a creditor should ask whether the business is responding appropriately to its financial difficulties, or, alternatively, is making
all of the mistakes warned about in this series of articles. A wise
supplier who wants to retain a viable customer may be the first to
recommend Chapter 11. In addition, creditors have rights in
bankruptcy, but they aren't automatic. You have to ask for them.
Chapters 6, 7 and 8 explain those rights.

Over the years we have handled many Chapter 11 cases. Most of
our clients are referred to us by other lawyers. Incidentally, the
best way I know to select a legal specialist is to ask other lawyers.
A lawyer's reputation in the legal community is the first thing you
want to check out before retaining counsel. Be sure to consult a
competent, experienced business bankruptcy lawyer the minute you
suspect your business may be headed for financial trouble down the
road. The old adage "An ounce of prevention is worth a pound of
cure" is particularly applicable to business financial health.

There are two main things you need to do before embarking on your
business reorganization journey:

First, inform yourself about the reorganization process you are
about to encounter. The best way, indeed perhaps the only way, I
know to do that is to read this series of articles. Surprisingly, there
is little or no literature available for business people to guide them.
Yet every business at some time encounters problems that threaten
its solvency. Seminars are there to be attended that discuss
solutions to all manner of problems and opportunities that business
people encounter. You will not see seminars, however, that aim to
educate the business man or woman whose business has been
threatened economically. Why? No one will attend, because that
would amount to a public admission by the business person that his
or her business was in trouble. That is why I wrote this series of
articles - to explain in non-technical language how to recognize and
respond in a timely manner to economic misfortune before it
becomes a calamity.

Second, act now! No one ever filed Chapter 11 too soon. Most
people don't seek advice until too late. Instead, the typical business
person is in denial until some catastrophic event forces the issue.
When the IRS files a tax lien and threatens to shut down your
business on account of unpaid payroll taxes, when a big judgment is
entered against your company and the judgment creditor levies on
money in the payroll account, when your lender forecloses or the
bank calls your credit line, or when trade creditors start putting your
company on COD because your accounts payable are running sixty
days or more without payment, it will become clear to you that
something needed fixing a long time ago. Months earlier, all of the
warning signs were there, but they weren't heeded.

Please pay attention to the overriding message of this series of
articles - Act now! Seek legal help from a competent business
bankruptcy lawyer long before your business is in crisis. With help,
and the cooperation of your creditors, you may be able to avoid
having to file Chapter 11, and may be able to reorganize your
business informally at minimal cost. Any good business bankruptcy
lawyer will help you explore the ways of accomplishing this. Even if
Chapter 11 is necessary to accomplish the reorganization, early
recognition and planning will do two things: markedly increase the
odds of successful reorganization, and decrease the cost.

Don't avoid legal help because you may be afraid it will cost too
much. When you talk to your lawyer, ask about the legal costs and
do a cost-benefit analysis. Also, ask about the risks and costs of
doing nothing. Above all, don't continue to deny and delay in hopes
somehow things will improve. Businesses don't fail over night
Generally it is a long process. Along the way, without skilled legal
help, a business person will inevitably do seriously wrong things.
The earlier you seek legal help, the less it will cost. That is because
1) you will avoid serious, perhaps fatal errors, and 2) the solution
will be simpler and faster.

CHAPTER 2

Can a Chapter 11 Save My Business?

For a $5,000 retainer or less, there are any number of lawyers
who will file a Chapter 11 petition for your company. Bad choice!
Too many Chapter 11s are filed and too few (less than 10%)
result in a confirmed plan.

A competent counselor will analyze the reorganizability of your
business and explore alternatives before recommending
Chapter 11. The trick is to focus on the problem and its solutions
rather than the immediate crisis.

The Chapter 11 automatic stay will take care of most crises such
as lawsuits and foreclosures, and even temporary cash flow
shortages. It won't take care of the problem, which usually
boils down to unprofitability.

If your company is facing a financial crisis, thoughtfully consider
and answer the questions that follow. If your answer to the
first five questions is (or with a little effort could be) yes, the
crisis can be resolved. Answering the remaining questions will
enable you to determine whether a Chapter 11 petition is
necessary or appropriate.

1. Does my business produce a product or deliver a
service that is still needed by customers or clients?

Times change. There is not much demand anymore for mechanical
typewriters or three speed bicycles. Because most television sets
now come in plastic rather than plywood console, some furniture manufacturers were forced out of business. Manual pegboard accounting systems have been largely replaced by computers, and accountants who can't use them are now retired or retraining.

Make a realistic assessment of future demand for your company's product or service.

2. Have I been honest and straightforward with my company's creditors?

Your creditors need customers. They want you to succeed and they will support you if they trust you.

When money is short, the natural tendency is to ignore your creditors, if possible, and if it isn't, to be evasive or misleading. That's fatal! Build and maintain the support of your creditors, banker and customers, with candor, honesty and a realistic turnaround plan.

3. Are my company's financial records up to date (e.g. balance sheet and operating statement, tax returns, aged accounts receivable and accounts payable, and physical inventory)?

If your answer is "not really," run, don't walk, to a good business consultant, not your accountant. That's right! Bringing your books up to date will take too long and really won't help. Instead, identify some critical data, including payables, receivables and realistic operating projections (essential expenses and probable revenues). You need to figure out quickly how your business can begin meeting current operating expenses. Once the business is stabilized, have your accountant get those books current.

4. Can my business be made to operate profitably?

Sometimes the best alternative is to shut down a losing operation and stop continuing losses. To decide whether to continue, prepare a projection of operating income and expenses. Ignore for the moment all other debt. A business consultant can help you trim nonessential expenses and accelerate collections. Pay attention, and be prepared to make some unpleasant cost cutting decisions.

5. Will I honestly evaluate how to restructure my business to be profitable (using expert assistance if appropriate) and then act decisively to do so?

The euphemism is "downsizing." Without the sugar-coating, it means lay offs (especially at the management level). Your judgment will be clouded by personal loyalty. That is why you should seek and heed independent advice on how to restore your business to profitability.

6. Is the cash flow of my business being used to pay past due debt as opposed to current operating expenses (i.e., defaulted bank debt, payroll taxes, trade debt over 30 days, and delinquent rent)?

Sprinkling money like water on the hottest creditor fires is a big mistake. Chapter 11 eliminates the need to do this, and it lets you concentrate on stabilizing your business and returning it to profitability.

Remember, after filing your Chapter 11 petition, you cannot pay pre-petition debts. Instead, you are expected to concentrate all your efforts on making your business profitable. Most likely, your reorganization plan will be to pay off pre-petition creditors out of future operating profits.

7. Has my lender (as a condition to rolling over my business loan or advancing more money) required any of the following: substantial debt pay down, guarantees,security,a higher interest rate,waiver of lender liability claims, orwaiver of the right to file Chapter 11?

Don't do it! Chapter 11, or the threat of it, is your best leverage in negotiating loan restructurings. Above all, preserve cash sufficient to enable the business to operate.

8. Is my business threatened with a foreclosure, an eviction, atax lien orseizure, orenforcement of judgment(s)?

Such events indicate that you waited too long to recognize and address your business problems. Don't try to solve these problems with money. You need it to operate. Chapter 11 may be the best way to put these problems on hold.

9. Is my business losing money on long term contracts and leases?

Long term business arrangements often prove to be financially crippling. Examples of such arrangements include franchise agreements, collective bargaining agreements, hotel management contracts, equipment leases and real property leases. Chapter 11 lets you get out from under these unprofitable relationships.

10. Is my business facing catastrophic toxic waste claims or mass or massive uninsured tort claims?

Bankruptcy law and environmental law are being pitted against one another in a struggle for supremacy. For the moment, bankruptcy law has the upper hand -- not surprising since bankruptcy courts are deciding the issues. Payment of assessed toxic cleanup costs may bankrupt a company, leaving Chapter 11 as the only alternative for survival.

Examples of mass or massive tort claims include the asbestos cases, the 1990 toxic spill into the Sacramento River, and construction defects resulting from soil movement. The cost of litigating these claims is enough to put most uninsured or under insured companies out of business. Chapter 11 may be the best way to reduce litigation costs and to keep your company alive.

11. Would my shopping center/office building/apartment complex show a positive cash flow if the cost of interest on secured debt were reduced?

Chapter 11 permits a business to adjust interest rates on secured debt to current market rates. It also permits you to lower monthly debt service costs by extending the period of loan amortization.

12. Will my customers and suppliers continue to do business with me if I file Chapter 11?

The answer with respect to suppliers is probably yes, if you have built a relationship with them based on trust and confidence over the years. The problem is with customers where long term survival of the business is critical to sales. Products that must regularly be serviced or updated (such as computer software) can't easily be sold without assurance that the vendor will be around to supply the updates and service. Careful planning coupled with strong creditor and customer support may make possible an in-and-out Chapter 11.

CHAPTER 3

Alternatives to Chapter 11 and Their Limits

Chapter 11 is Available to Almost Anyone.Chapter 11 is part of the United States Bankruptcy Code. Its provisions (in combination with Chapters 1, 3 and 5) regulate the operation of a business while it is in Chapter 11, and the reorganization process which brings the business out of bankruptcy. Any individual, corporation or partnership can file Chapter 11 except a railroad, insurance company or bank. Insolvency is not a requirement, either in the bankruptcy sense (liabilities exceed assets) or the commercial sense (unable "generally" to pay debts as they come due). Commercial insolvency, however, is usually what triggers a Chapter 11 petition. Being engaged in business is not a prerequisite. Liquidation in Chapter 11 is permitted.

Informal Workout. If financial problems are truly temporary, it is often possible to work out informal arrangements with creditors. Be candid and open with your creditors with respect to the business problems and solutions. Do not favor one creditor over others. If creditors trust you they usually accommodate short delays in payment.

In and Out Before Customers Find Out. There is generally no such thing as an in-and-out Chapter 11. Don't assume that you can file a Chapter 11 petition and then be out of bankruptcy in a month.

There are exceptions. One is the so-called "pre-packaged Chapter 11." This term was coined to describe a plan to de-leverage a company after it had gone through a leveraged buyout. A leveraged buyout is simply the purchase of all of the stock of a company with borrowed money. Typically the borrowing is secured by the company's assets, and it is paid back with the company's money. In other words, equity is converted to debt. When it becomes apparent that the company cannot afford the high cost of repaying the buyout debt, it proposes a "pre-packaged plan" to convert the buyout debt back into stock. Generally in these cases, the business operates profitably, except it cannot afford to pay back the buyout debt. Usually, most but not all of the holders of the buyout debt are willing to go along with the restructuring. A Chapter 11 is filed with a plan that has been pre-approved by the necessary majority, and the plan can be confirmed immediately over the dissent of the minority.

Something like a pre-packaged Chapter 11 can be tried for businesses that sell products that require future services or updates (such as a computer software company). They sell products based on a promise to provide the future service. It's hard to do that convincingly when you are in a Chapter 11. For these companies, an in-and-out Chapter 11 is a possibility. Actually, all the work, including the reorganization plan preparation and solicitation of acceptances is done before filing, and plan confirmation can take place as little as three weeks later. Success at this requires careful planning and preparation, and both creditor and customer support.

Where extensive financial reorganization is necessary, or where a period of business rehabilitation is required before a plan can be devised, the in-and-out plan approach is usually not feasible. Most often, a crisis, such as foreclosure or judgment levy, compels the immediate filing of a Chapter 11 petition.

Where time permits, always try an informal work out before resorting to Chapter 11. Then, if necessary, use the Chapter 11 to confirm the reorganization plan over the dissent of a minority of creditors.

General Assignment for the Benefit of Creditors. Broadly speaking, a general assignment for the benefit of creditors is a private liquidation under state law. All of the debtor's property must be transferred to the assignee, who then liquidates the property and distributes the proceeds generally in accordance with the same priorities as set out in the Bankruptcy Code. The advantage is a sharp reduction in both cost and time over a Chapter 11. In addition, assignees (who act in a fiduciary capacity for the benefit of creditors) are generally experienced and capable of obtaining top liquidation dollar. The disadvantages are: (1) the debtor's complete loss of control of the liquidation and abandonment of any effort to continue the business, and (2) for an individual, the absence of a discharge of the debts that remain after distribution of the liquidation proceeds.

Chapters 7, 12, or 13. Chapter 7 of the Bankruptcy Code provides for the liquidation of assets of individuals, partnerships and corporations. Because only individuals can receive a discharge in Chapter 7, a voluntary Chapter 7 petition for a partnership or corporation is usually a poor choice. Chapter 12 is available to small farmers (including a corporation, the stock of which is owned by an extended family) to reorganize and continue farming. Chapter 13 is available only to individuals (whose unsecured debts total less than $250,000 and secured debts are, in the aggregate, under $750,000). Although it applies principally to wage earners, it is also available to reorganize a small "mom and pop" business.

Lender Forbearance Agreement. Banks and other institutions extend lines of credit and make loans to companies. The borrower signs a note which is a promise to repay, and the note is often secured by assets of the business. In the case of the developer, the note is secured by real property, including rents that are generated by the property. In the case of an operating business, the note is typically secured by all of the assets of the business, including the equipment, accounts receivable, inventory and work in process.

Lenders will usually be willing to discuss workout proposals. In return for extending payment terms, lenders often demand, however, one or more of the following: part payment, additional collateral and guaranties (with or without security) , turnover of control of cash flow, waiver of lender liability claims, representations as to the validity of the lender's claim and security interest and even a waiver of your right to file Chapter 11. If you find yourself in negotiations with your lender and these demands are made, do not attempt to negotiate without advice of legal counsel.

That is not to say lenders do not have legitimate concerns. They do. For example, they are entitled to assurance that their collateral (such as rents and account receivable collections) is not being syphoned off for unrelated purposes. They are entitled to accurate, complete and timely financial information. Most important, they must be able to trust their borrower. Finally, they are entitled to know how their borrower intends to repay the loan.

Do not try to fill a lender's maw with money in an attempt to placate it. Resist giving up future leverage by waiving defenses and claims. Recognize if the lender has troubles of its own with its regulators, it may be more interested in immediate liquidation of your business than preserving it. Unless success is just around the corner (rare!), satisfying overreaching demands of a lender will rob you of what your business needs most: money with which to operate and generate profits.

Do be candid with your lender. Preserve and maintain your lender's trust. Recognize your lender's legitimate concerns, and make satisfaction of those concerns a top priority.

CHAPTER 4

Benefits and Burdens of Chapter 11

The overall benefit of Chapter 11 is that it enables debtor businesses to be saved, and hopefully, cured of their financial ills. Contrast this enlightened approach with that of most other countries where creditor relief, not debtor protection is paramount.

The specific benefits of filing Chapter 11 fall into two categories: those that assist in the company's initial rehabilitation, and those that enable the company to restructure its financial affairs.

First, the rehabilitating benefits:

Instant Relief. Without doubt, the single most important benefit of Chapter 11 is the automatic stay. Like an injunction, the automatic stay restrains creditors from acts against the debtor or the debtor's property, such as foreclosures and lawsuits. The stay is invoked merely by filing the Chapter 11 petition. No court order is necessary. Violations of the stay are punishable by contempt. For a company that is facing imminent foreclosure or lawsuits to collect debts it cannot pay, the automatic stay is a godsend. While it doesn't solve any problems, it does make them go away temporarily.

No Need to Pay the Piper. For the duration of the Chapter 11 case, the stay allows your company to put all debts on hold. The company need not -- indeed, with few exceptions, may not -- pay any of its pre-petition debts. This in effect is a forced loan by the company's creditors, usually without interest. The combination of the automatic stay and the moratorium on debt payment gives the company a chance to preserve and, if necessary, to recreate a valuable going concern that can operate profitably.

The Fox Stays in the Coop. Management generally remains in control of the business after the Chapter 11 filing. Only in rare cases, where fraud or gross mismanagement can be shown, is management replaced by a trustee.

Instant Credit. Filing Chapter 11 may actually restore a company's ability to borrow money or obtain credit. The reason is that post-petition borrowing must be paid back before any payment can be made to pre-petition creditors. In fact, under appropriate circumstances, a company can secure a borrowing with a lien on assets that is senior to existing liens. This is known as "priming a lien." If the company can operate profitably (when relieved from paying pre-petition debts), chances are good that it will be able to borrow needed operating capital. Moreover, suppliers can often be persuaded to extend credit terms.

After a period of business stabilization (which can last a few months or a few years) a company restructures its financial affairs by proposing a plan that can be confirmed by the court. The company, as a plan proponent, has an awesome array of tools.

Now, therestructuring benefits:

Reinstatement. Installment obligations that have been accelerated because of nonpayment, can be reinstated. For example, a delinquent promissory note or lease can be reinstated over objection. All that is required is that the note or lease be brought and kept current.

Lower Interest Rates. Under a plan, secured and unsecured creditors alike are only entitled to be paid a market rate of interest. The interest rate you are paying on loans made a few years ago is probably above market. Even over objection you can bring this rate down under a plan. Penalty interest, typically charged by lenders on defaulted obligations, may be eliminated.

Assume (and Assign) or Reject Leases and Contracts. Burdensome leases and ongoing contractual arrangements can be rejected. The other party to the lease or contract is then left with a general unsecured claim for damages, and there are limits to what can be claimed. On the other hand, a valuable lease, even when in default, can be assumed if rent payments are brought current within a reasonable time. The lease can even be sold over objection, and after the sale the company escapes liability under the lease in the event the buyer later defaults.

Two Bits on The Dollar - In Installments. Debts can be repaid in installment payments. Under proper circumstances, debts can be discharged by paying only a part of the debt. Taxes must be paid in full, but payments can be extended as long as six years.

Assets Sales. Assets can be sold free and clear of the interest of co-owners and the encumbrances of mortgages and judgment liens. All liens and interests then attach to the sale proceeds. While the purpose of most Chapter 11 reorganizations is to preserve a business and property, it is entirely proper to propose an orderly liquidation as a Chapter 11 plan.

Cramdown. A plan of reorganization can even be confirmed over its rejection by creditors. In graphic bankruptcy parlance, that means a plan can be crammed down the throats of a dissenting class of creditors.

Of course there is a flip side. Now, The Chapter 11 Burdens:

It's No Crime To Be Broke, But It's No Great Honor Either.

The biggest burden invariably encountered by the owners of businesses in Chapter 11 is stress. It is not that anyone shuns them; actually, the stress is self-induced. Embarrassment and uncertainty cause an anxiety that, if not reckoned with, can become debilitating.

Closely related to stress is the all too typical tendency to transfer blame for one's predicament to others. Typical scapegoats are your lender and other creditors, soon your lawyer and other advisors, and, eventually, the Bankruptcy Court and the whole process.

Honesty, candor, willingness to accept responsibility and adaptability to change are essential to combating stress and to a successful Chapter 11.

Fish In a Bowl. There is no privacy during a Chapter 11. Creditors and the Court need to know everything you are doing, including what you are paying yourself (which may be restricted). While you can continue to operate your business, you must seek Court approval of anything you wish to do that is not in the "ordinary course of business." You must begin to operate profitably, pay your operating bills and file financial reports regularly.

Like Fine Wine, It Takes Time. In all likelihood, the duration of your Chapter 11 will exceed initial expectations. If your business is suffering due to a recessionary economy, or cut backs in military/defense spending, or land use over-regulation, your recovery will be tied to conditions you cannot control. You can cut costs and improve efficiency, but until sales pick up so profits are available to pay pre-petition debt, you won't be able to reorganize. Unfortunately, that won't stop creditors and others from complaining that your case is taking too long.

Can You Afford To Be Broke? Chapter 11 is expensive. At a time when a company needs all available cash to operate, it must also pay its lawyer and perhaps expert business consultants. If there is an official creditors' committee, the company also pays the fees of the committee's lawyer. Candid fee discussions and planning with your lawyer are a must. Don't be timid about establishing budgets and negotiating fees. Good lawyers understand that fees must be based both on the value of the services to the business and fair compensation to the lawyer for his or her time.

Why Are They All Shouting At Me? A Chapter 11 is not just one case -- it is many matters all going on at once. There will be disputes to resolve with secured creditors over continued use of their collateral. Unsecured creditors, led by the official creditors' committee, will become increasingly impatient until a plan is proposed. Real property and equipment lessors will want to enforce their rights. The U.S. Trustee will complain loudly if its administrative policy requirements are not met.

Negotiations will be ongoing. You will have to handle the usual operating problems typical in everyday business, and still negotiate with creditors and plan your reorganization. There will be litigation if negotiations break down.

Chapter 11 is constructed so that neither debtor nor creditor has a clear advantage. It encourages negotiated settlements of disputes, as well as negotiated reorganization plans. Good bankruptcy lawyers know that litigation often leads to the worst possible result for both sides. Early on, commit yourself to negotiation and compromise.

CHAPTER 5

Operating Your Business in Chapter 11

Business as Usual? Before 1979, control of a business that had filed for reorganization was generally handed to a trustee. Sometimes the trustee retained management - often not.

The 1979 Bankruptcy Code changed all that. Its provisions left the Chapter 11 Debtor "in possession" of the business, and dispensed with the need for a trustee except in cases of fraud or gross mismanagement. Thus, the term "debtor in possession" was born. Critics likened this change to leaving the fox to guard the coop. In truth, the fox does stay in the coop, but it is a reformed fox, who for good measure is muzzled and leashed. That means the fox must follow strict rules and operate the business profitably for the primary benefit of creditors. A committee of creditors and the U.S. Trustee monitor, and the Bankruptcy Court enforces compliance with the rules.

The debtor in possession may operate in the ordinary course of business, and must do so without further eroding the company's assets with operating losses. No creditors can interfere or sue, and pre-Chapter 11 debt cannot be paid until a reorganization plan is confirmed.

The debtor in possession must keep books, pay operating bills, including taxes, as they come due, and file monthly operating reports.

The debtor in possession has the awesome powers of a trustee to reject contracts and leases and avoid preferential or fraudulent transactions.

Doing anything outside the ordinary course of business requires a Court order.

Against this impressive array of rights, there are any number of restrictions on what a debtor in possession can do. One comes as a rude shock to the uninformed just after the Chapter 11 petition is filed: you can't spend your money.

I Can't What? If I Can't Pay My Employees or Buy Supplies, How Can I Stay in Business? If the income your business needs to operate comes from account receivable or rent collections, and if they have been pledged to secure a loan or a line of credit, you can't spend the income after filing Chapter 11 without either the consent of the lender or a court order. The income, which is the proceeds of collateral that was pledged, is called "cash collateral." Cash flow is the life blood of any business, and when it has been pledged, business vitality has been put at risk.

First, let's look at accounts receivable. Businesses pledge them, often in conjunction with inventory, work in process, equipment and real property, to secure an operating line of credit.

Account Receivable Borrowing Can Be a Progressive, Often Terminal Illness. Business that must borrow money to operate against expected future income are usually operating on the edge of commercial insolvency. The wonder is that account receivable financing is so common. Continued growth of the borrower's business will sustain this kind of borrowing. Conversely, a business downturn usually puts the borrower in default. It is at this point that the borrower often makes a fatal error by agreeing to allocate to the lender, out of account collections, so much that what is left won't cover operating expenses. This works for about six months when most of your accounts payable will be running about 90-120 days. That's when suppliers put you on COD and your lender loses all confidence in your ability to work out of the hole that you have dug. What is the alternative? Just say no! Hang on to your operating income.

Keep Control of Your Rents. When real property, such as apartments, shopping centers and office buildings, is pledged to secure a loan, typically the mortgage or trust deed (or a separate document) contains an assignment of rents, issues and profits. When the loan goes into default, the lender is likely to move quickly to take them over, first by notifying each tenant to pay rent directly to the lender, and soon by seeking the appointment of a receiver to collect the rents pending foreclosure. If the lender won't agree to a standstill, don't wait -- file a Chapter 11 before a receiver is appointed. It will be much easier in Chapter 11 to obtain the right to use the rents to operate, either by agreement or Court order.

Leverage - Don't Negotiate Without It. In negotiating with your lender for the use of your cash flow (account or rent collections) both before and after filing Chapter 11, it is important to know what can be accomplished in Chapter 11 by Court order over the lender's objection. That way, you won't give up more in negotiations than you have to. Actually, it is relatively easy to obtain an order authorizing the use of cash collateral to operate, at least initially. All you need to establish is: (1) the business can't operate without the money (that's obvious), and (2) the value of the lender's collateral will not be diminished. Of course, if you waited too long to file a Chapter 11, things may have deteriorated so badly that you will not be able to persuade the Court to authorize use of cash collateral.

In the negotiations, it is generally not necessary to cave in to the typical lender demands of guarantees, additional collateral, large paydowns, and waivers of lender liability claims and the right to file a Chapter 11.

Can You Afford To Go Broke? Cash is dear, before and during a business reorganization. All too frequently counsel is consulted long after a business has given (not lost -- given) away control of its cash flow.

When sales go down and customers or tenants start stretching out their payments, your cash flow will drop. The natural tendency is to waste what cash you have by sprinkling it like water on the hottest creditor fires. Don't do that, and don't allow your lender to strip you of control over your cash flow. Use your cash to pay current operating expenses only. Recognize that you need a moratorium on debt payment so available resources can be used to keep the business alive. If you cannot achieve that moratorium voluntarily, you can do so over creditor objection with a Chapter 11. When it is time to file the Chapter 11 petition you should be prepared that day to file an emergency motion for an order authorizing use of cash collateral.

Go on a Diet. Having filed Chapter 11, it is a good time to slim down. Sell assets that are not needed. Even assets co-owned or encumbered by security interests can be sold by a debtor in possession, free and clear of liens and interest. Get rid of burdensome leases (such as unnecessary buildings, equipment and cars) and contracts (such as an unwanted franchise or employment agreement) by rejecting them immediately. Stop spending money that doesn't have to be spent. Getting rid of that Mercedes the company leased for you will send a positive message to your creditors. You need a court order to do these things, but it is easy to get one.

Test Your Credit. A short time after filing, if your business looks viable to your suppliers, they may be willing to extend you credit. They (or their competitors) need your business. Just persuade them that ongoing bills will be paid, even though their pre-petition account is on hold.

If you get a court order in advance, you can also borrow. Lenders are willing to lend to a debtor in possession because of the protections they can receive: priority one status as an administrative claim, super-priority status ahead of even priority one administrative claims, security, and even super-lien priority over existing secured claims.

Chapter 11 + Judgment = Success. Almost every tool imaginable is given to you as debtor-in-possession to help you preserve, improve and reorganize your business. Why? Because, according to the U.S. Supreme Court, "the fundamental purpose of [Chapter 11] is to prevent the debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources."

Even so, there is one thing Chapter 11 cannot supply - judgment. It is a combination of knowledge and experience. If you and your lawyer have it, the Chapter 11 process will probably work for you.

CHAPTER 6

Secured Creditors and Chapter 11

In the good old days, no self-respecting law school gave a course in bankruptcy law. What they did offer was "creditors rights" reflecting the bias of the old Bankruptcy Act.

Times have changed. The focus under the new (1979) Bankruptcy Code is rehabilitation, not dismemberment of businesses. Some suggest the pendulum has swung too far, and "creditors' rights in bankruptcy" has become an oxymoron. Perhaps, but sophisticated business people are more inclined to look on Chapter 11 as a business opportunity. For them, keeping or gaining a customer is more important than the emotional satisfaction of forcing a defaulting debtor out of business.

Use 'em or Lose 'em. Creditors do have rights in Chapter 11, but they are, for the most part, not self-executing. As a creditor or a party to a lease or contract with the debtor, you must know what you can and cannot do, and act promptly to protect your interests. This chapter discusses the rights of secured creditors. Chapters 7 and 8, respectively, discuss the rights of unsecured creditors and parties to leases and executory contracts.

Secured Creditor Protection At A Price. The Mob offers protection -- at a price. The Bankruptcy Code also offers protection, called "adequate protection," also at a price. Neither the Mob nor the Code gives you any choice whether to pay the price.

Under the Code, the price the secured creditor pays is delay -- delay in being paid or foreclosing. In return, the Code guaranties "adequate protection" of your "interest" in your collateral. What does that mean?

First, let's discuss the "interest" that is protected. Simply stated, it is the value of the collateral that has been pledged to secure a claim, or the amount of the claim, which ever is less. In other words, if you are over secured, your interest in the collateral is limited to the amount of your claim; if you are under secured, your interest is the value of the collateral. In either case, the Code guaranties protection of the interest so long as you are forced to wait.

Next we look at the concept of "adequate protection." Without being technical, it means the value of your interest in the collateral cannot be allowed to deteriorate.

Three lender examples will illustrate these concepts: first, a $100,000 promissory note secured by real estate valued at $150,000; second, a $100,000 promissory note secured by real estate worth $100,000; and third an $80,000 promissory note secured by a truck worth $50,000.

In the first example, the lender can afford to wait because the value of the collateral exceeds the note balance substantially, and will even cover continuing interest accruals. The excess is called an "equity cushion," and that alone may be adequate protection.

In the second example, the lender is protected by the fact the value of the collateral equals the amount of the note. Oh! but what about the interest that will accrue? Too bad! There is no entitlement to protection of future interest accruals. Even so, this lender is probably not adequately protected without more, such as monthly payments.

In the third example, the debtor who wants to keep and use the truck has a problem. Unlike real estate, personal property generally depreciates in value, particularly trucks in heavy use. If the debtor wants to keep and use the truck, the lender's $50,000 interest in it will have to be protected. As the truck's value goes down, the depreciation will have to be offset by payments to the lender.

Does this mean any lender can be delayed indefinitely so long as the value of the lender's interest in the collateral does not go down? Not at all. The Chapter 11 goal is reorganization, and secured creditors can be delayed only so long as the goal is achievable, and their collateral is necessary to the reorganization.

Cash Collateral - You Can Lose it by Inaction. If your loan to the debtor is secured by cash collateral, you need to act immediately to protect your interests. Debtors are not allowed to spend "cash collateral" without either the creditor/landlord's permission or a court order. Account receivable collections and rent collections are cash collateral. Just because debtors aren't supposed to spend cash collateral without permission doesn't mean they won't. Once spent, you cannot get them back.

Liens on accounts receivable and rents are floating liens. That means the lien can attach to future accounts and rents. Under the Bankruptcy Code, however, these liens stop floating. Think what this does to the collateral. The accounts that exist as of the date of the bankruptcy petition will likely be spent by the debtor, and once spent, they are gone. Secured creditors must act immediately to demand adequate protection in the form of an order granting them a continuing lien on the accounts or rents. It's easy to obtain the order, but it isn't automatic. You must ask for it.

Remember - adequate protection is not automatic. You must ask for it before the debtor is obligated to provide it.

CHAPTER 7

Unsecured Creditors and Chapter 11

Strength in Numbers. Individually, unsecured creditors cannot do much. Collectively, they can exert, for better or worse, enormous power and influence over the progress of the case. Their representative is the Official (unsecured) Creditors' Committee (OCC). When a Chapter 11 case is filed, the U.S. Trustee solicits creditors to accept appointments to it. If at least three say yes, a committee is formed. The first thing the committee does is select a lawyer to represent it. Sad to say, committees function in less then 10% of the cases; and without a committee to keep watch, the debtor is truly the fox left to guard the coop.

Unsecured creditors get paid, if at all, only after secured creditors are taken care of. They have a direct interest in the value of all property in excess of liens. Unsecured creditors also have an interest in future profits of the debtor's business. Conversely, they are hurt as a class if property values go down because of neglect, or operating losses continue to erode the value of the business.

The OCC is given the power to do almost anything. It can support the debtor in resisting secured creditor attacks. It can seek appointment of a trustee to take over a business if it believes the debtor is dishonest or incompetent. It can force liquidation of the business if losses continue. The OCC can even file law suits for the benefit of the estate if the debtor improperly fails or refuses to do so.

Perhaps the best thing the OCC can do is keep the case moving. The debtor has the exclusive right to file a plan of reorganization for 120 days. After the "exclusivity" period expires, and if the OCC believes the business cannot be turned around, it can file its own plan to liquidate all the assets.

Finally, the OCC plays the major role in negotiating the terms of the reorganization plan with the debtor. That means, within the limits of feasibility, the OCC's goal is to negotiate for as much as it can, paid as quickly as possible under the plan; or, if better, to force a liquidation of the business.

Become A Creditor Of A Chapter 11 Debtor. Extending credit or lending money to a Chapter 11 debtor is not such a bad idea if the debtor can operate profitably. That is because suppliers or lenders have a repayment priority ahead of other creditors. Well informed suppliers and lenders are doing business with Chapter 11 debtors - successfully and profitably.

Involuntary Bankruptcy. Uninformed debtors invariably do the wrong things when under financial pressures. They make preferential payments to some creditors. Worse, they often syphon off company assets for the benefit of the company's insiders. They hide assets, and generally try to frustrate creditors.

One of the principles that underlies our bankruptcy system is that all creditors, not just a few chosen by the debtor, should be treated the same. When you are not being paid, the debtor's business is faltering, assets seem to be disappearing and the debtor ignores you, think seriously about putting the debtor involuntarily into Chapter 7 or 11. It will have the effect of preserving what is left for all creditors, and will enable a trustee to recover preferential or fraudulent transfers for the benefit of all creditors. Creditors' ability to file an involuntary petition is a powerful tool.

Yes, unsecured creditors do have rights in bankruptcy! But they are not automatic. You have to assert them.

CHAPTER 8

Parties to Leases and Executory Contracts in Chapter 11

Parties to Leases and Executory Contracts in Chapter 11 have extensive rights, but while some of them seem to be self-executing, in practice they are not. On the other hand, these parties are subject to considerable burdens that cannot be avoided.

Lessors of Non-residential Real Property - a Favored Landlord.

A lessee-debtor must assume or reject a non-residential real property lease within 60 days after the Chapter 11 is filed. Additionally, the debtor is absolutely required to pay rent to the landlord and otherwise perform the lease from the date of the bankruptcy filing on. While these would seem to be real landlord protections, in practice it doesn't work that way. Courts typically extend the time for the debtor to assume or reject a lease if requested to do so. The court won't extend the time however, if the landlord objects on the ground that rent is not being paid. Moreover, a debtor with cash flow problems won't perform its obligations under the lease unless pressure is applied, no matter what the law says.

If the lease is burdensome to the debtor, it will probably be rejected right away, leaving the landlord with simply an unsecured claim, which can be significantly limited. If, however the debtor wants to continue with the lease, it will be assumed, but usually only in connection with confirmation of the debtor's plan of reorganization. In order to assume a lease, the debtor must cure all defaults.

How about personal property equipment leases? They are treated much like real property leases, with two major exceptions. First, the debtor is under no obligation to assume them within 60 days. Second, the debtor is not obligated to make rent payments for the first 60 days.

What if the Debtor Wants to Assume and Assign a Lease or Executory Contract? The general rule is that the debtor can do so as long as defaults are cured and it can prove that the assignee is capable of performing the lease or contract. It does not matter that the lease or contract contains anti-assignment provisions. These provisions are called "ipso facto" clauses, and are void in bankruptcy. An exception to the general rule is a personal services contract. Another exception is a contract to make a loan. Such contracts cannot be assigned over objection.

What's Left if a Real Property Lease is Rejected? Not as much as you might think. The landlord has a claim for damages, for lease rejection is tantamount to a breach of the lease. The amount of the damage claim is limited, however, to either one year of rent or 15% of 3 years of rent.

Remember, the landlord, or a party to an executory contract, cannot be passive and expect to be protected.

CHAPTER 9

Chapter 11 Reorganization Plans

We begin this discussion with the assumption that the Chapter 11 debtor's business is operating efficiently and profitably. Reaching this stage probably took some internal reorganization. Now we are going to talk about a much different sort of reorganization -- external, if you will.

Most businesses file Chapter 11 so the owners of the business (the shareholders of the corporation, the partners of a partnership or a sole proprietor) can keep it. These owners are called equity interest holders, and the creditors will let them keep the business only if they (and the Court) perceive they are being treated fairly. That doesn't mean creditors must be paid in full. It does mean that the plan must be practical, and the creditors must do at least as well under the reorganization plan as they would do in a Chapter 7 liquidation.

A debtor's plan of reorganization is a court approved written contract between the debtor and its creditors. Under a plan, the debtor takes on obligations to pay and do certain things, and in return receives back the business free of all old debt. In bankruptcy parlance, the debtor is "re-vested" with its property and its debts are "discharged."

To accomplish the external reorganization, the plan proponent can dramatically change the character of four things: the company's assets, its debts, its relationships and its equity ownership.

Assets can be sold (free of liens and co-owners' interests if necessary), retained (used, leased and encumbered) or abandoned.

Debts can be extended (stretch out payments over time) or composed (25 cents on the dollar), or both.

Ongoing relationships (called "executory contracts" and "unexpired leases") can be rejected if burdensome, or assumed if beneficial.

Equity interests can be retained, eliminated or altered; and new equity interest can be issued for cash, or in exchange for debt or old equity interests.

Negotiate, Negotiate, Negotiate. There are rules that limit what can be done under a plan if creditors do not consent to it. Some rules favor the debtor and others the creditors. Neither is given a clear advantage. As a result, successful plans are most often negotiated, not "crammed down" (a procedure aptly named, and described in Chapter 10).

A Typical Real Estate Plan. Assume you are the general partner of a limited partnership that owns a shopping center. Tenant improvements were completed for 85% of the center, but then several tenants quit due to financial problems, lowering occupancy to 60%. The reduced rent role made it impossible to keep up payments on the first trust deed note to GO GO Savings Bank (under RTC receivership). Its note is for $10 million, payable over 25 years at a fixed 11% interest. There is a second trust deed note to Gullible Jones. A $1.5 million obligation is owed to Jones, the prior land owner, in connection with the purchase of the property, with 13% interest only payments for 10 years and then a balloon payment. Other creditors include current unpaid operating bills totaling $15,000 and a past due account of $10,000 to the partnership's accountant.

Today, occupancy is up to 75%, and monthly rents cover operating expenses and the first trust deed note payments. There is enough left over to be used to build out anticipated additional tenant improvements and pay leasing commissions.

The first step in formulating the plan is to make some assumptions and run a future cash flow analysis. Assume first that the terms of the Bank's note will remain the same except the interest rate. It will be reduced to a present market rate of 8%.

Bankruptcy law precludes creditors from receiving interest in excess of the market rate. Interest rates have steadily declined over the last few years. That fact provides you with considerable leverage as you negotiate payment terms with the Bank and Mr. Jones.

Next assume occupancy will remain flat for one more year, and then increase to 85% over the following two years. Project rent and expenses for three years, taking cost of living increases into account. The next step is to work out a way to use the projected surplus to pay the Jones' note and the other claims. There will probably be enough surplus immediately to pay interest to Mr. Jones at a market rate, say 10%. That is because you reduced both the Bank's and Gullible Jones' interest rates by 3 points each. As occupancy increases in one year, there will be more surplus funds to pay the other creditors. Don't forget the future tenant improvement expenses and leasing commissions. Provision for payment of them should come first before any other payments.

Under this set of facts you should really have little difficultly in putting a plan together. Note that two things have made the reorganization possible: reduced interest costs and increased rents. The Chapter 11 gave you the time to take advantage of them.

You will notice that the amount of the unsecured debt is relatively low. That is typical in real estate cases, and it makes unsecured creditors relatively easy to deal with.

Perhaps the most significant requirement for confirming a real estate reorganization plan is that it be feasible. That means rent and cost projections must be realistic. Real estate plans generally founder over unrealistic expectations. Overly optimistic projections of rents won't get creditor or court support. Neither will a blase' assumption that the shopping center can be sold in a year for enough to pay all the bills.

A Typical Business Plan. Business cases involve the same issues as real estate cases, plus a whole lot more. The biggest difference is the class of unsecured creditors, which, in a business case, is usually large in both number and amount. Even so, designing the plan will generally boil down to three concerns: Is it feasible? Is it better than Chapter 7? Is it fair?

As with a real estate plan, a business plan begins with the preparation of realistic projections. Of course there are many more variables, making income and expense projections much more difficult. The task is made easier by comparing your company's performance with that of your industry locally, regionally or nationally. Keep your projections within industry norms.

Start by working out the payment of secured debt. If the current payment terms are manageable, leave the creditor unimpaired. If not, reduce (or increase) interest assumptions to current market levels and identify how and over what period of time the debt will be repaid. Remember, the amount of a secured claim cannot exceed the value of the collateral. Any excess is an unsecured claim (that stops bearing interest when the Chapter 11 is filed, but may resume accruing interest when the plan is confirmed).

By now you have already taken a hard look at the value to the company of its leases of buildings and equipment and its long term contracts. Reject in the plan (if you haven't already done so) all leases and contracts that impair profitability. Be prepare to deal with the claims that will result, which will be added to other unsecured claims.

Once payments to secured creditors are worked out, see what is money is left over. Plan on spending the surplus for the next three years by paying unsecured claims. If that will pay them in full, or almost so, then creditors should agree to the plan. If not, and you really want to keep the business going, you may have to think seriously about coming up with a large capital contribution or making your creditors part owners of your business. Remember, creditors will vote for your plan if they want to keep you as a customer, and believe they are being treated fairly under the circumstances.

CHAPTER 10

How to Get Your Chapter 11 Plan Confirmed

The superstitious might perceive danger in the plan confirmation process, for there are 13 requirements to be met to achieve that goal. Fortunately, only 6 of the requirements are tough hurdles to clear.

Best Interests of Creditors. To be confirmed, a plan must be "for the best interest of creditors." That means simply that creditors must be paid at least as much under the plan as they would receive if the debtor's property were liquidated in a Chapter 7, and the proceeds of liquidation were distributed pro rata to them. This can be an especially high hurdle, for a single dissenting creditor can raise the objection successfully, even if every other creditor has accepted the plan. Don't confuse this rule with the "absolute priority" rule, which is discussed below.

Feasibility. To be confirmed, a plan must be feasible. Sounds simple? It's not. Courts and creditors have a real skepticism about a debtor who, having lost money for months or years, promises things will be different. The question you have to answer is how. How will you generate the money necessary to pay creditors? If future operating profits are the way, you will need to project future earnings based on past profitability. That is why, in a typical business case, it takes several months of internal reorganization and demonstrated profitability before a realistic plan can be proposed. You can project future profits if you are now operating profitably, and not otherwise.

Administrative Claims. When Chapter 11 cases take too long and the debtor has been compelled to fight in court repeatedly to keep its property and stay alive, attorney's fees mount. Unfortunately for the debtor, it must pay not only its lawyer, but the attorney for the Official Creditors' Committee, and often counsel for secured creditors and landlords as well. Unfortunately, for unsecured creditors, these fees are administrative expenses that must be paid when the plan is confirmed and before unsecured creditors are paid anything.

There are some ways to reduce administrative fees which are the result of costly litigation: negotiation, mediation and arbitration. Nowhere is alternative dispute resolution more important than in bankruptcy. Good lawyers know that, and good bankruptcy judges have wonderful ways of encouraging parties to settle and agree. Keep that in mind as the case progresses and the problem of paying administrative expenses can become manageable.

Administrative claims also include the fees of other professionals such as accountants, and any operating expenses that remain unpaid. All must be paid in full when the plan is confirmed.

Unsecured Tax Claims. The IRS does not get to vote on your plan, nor does any other taxing agency. A Chapter 11 plan can be confirmed so long as every unsecured tax claim is paid, in installments if necessary, over a period that ends six years after the date the tax was accessed. That is only half the good news. While interest must be paid on deferred payments, the interest will probably be much lower than the IRS charges delinquent tax payers generally.

Disclosure and Solicitation. Creditors vote whether to accept or reject the plan. Before they can be asked to do so, however, a disclosure statement must accompany the request, and it must be approved in advanced by the bankruptcy judge. The disclosure statement is a long, technical document that will be approved only if it is found to contain "adequate information." It must include company history, projections and detailed explanations of the effect of the plan on every class of creditors. It must explain why the plan is better than liquidation, and how the debtor will make payments under the plan.

Plan Acceptance. Finally, a Chapter 11 plan can be confirmed only if it has been "accepted" by every impaired class. A class of creditors accepts the plan if over half the creditors in number and at least 2/3 in amount, who vote, vote to accept.

Cram Down. All of the rules discussed above are absolute requirements except the last -- acceptance by all classes. Actually, a Chapter 11 plan can be confirmed over the rejection by a class (crammed down the dissenters' throats, if you will) if two seemingly simple tests are satisfied. The plan cannot "discriminate unfairly," and it must be "fair and equitable."

The unfair discrimination issue comes up when an unsecured creditor with a very large claim is put in a class separate from the other unsecured (usually trade) creditors. The purpose of separate classification is to keep the dominant creditor from controlling the class vote. This scheme works only if the discriminatory treatment is not "unfair."

"Fair and Equitable" is not so easy to explain. The term has been around a long time, and it has three definitions, only one of which is in the Bankruptcy Code.

First, courts look to the plain meaning of the words "fair" and "equitable." If, for example, the proposed treatment of the creditor is technically OK, but just doesn't seem fair, odds are good that the court will reject the plan.

Second, the term is said to incorporate the "absolute priority" rule -- a moss-covered concept if there ever was one. This rule holds that junior classes may take nothing under the plan until dissenting senior classes are paid in full, and senior classes may not be over paid until dissenting junior classes are paid in full. In the typical case, this means the owners of the debtor's business cannot keep the business unless creditors are paid in full. Remember, most confirmed plans are accepted -- not crammed down. Creditors can and often do agree to accept less than 100 cents on the dollar and to permit the owners to keep the business.

Finally, the Code holds that payments under a plan are fair and equitable only if the stream of deferred payments to each creditor has a present value equal to the amount of the creditor's claim. That is a complicated way of saying each claim must be paid in full with interest.

New Value Exception to the Absolute Priority Rule. The owners of a business can retain their interests (e.g. their stock in the corporation) even when unsecured creditors' claims are not fully paid under the plan, if they contribute "new value." In essence, the shareholders are permitted to buy back their stock. The term, "new value" does not appear in the Bankruptcy Code. The concept was introduced by the U.S. Supreme Court in 1944, but has not yet been adequately clarified by the courts. The author's view of new value is that the contribution, to be sufficient, must be cash in an amount sufficient to assure the feasibility of the Plan. In other words, the question to ask is will the reorganized debtor, following plan confirmation, be sufficiently capitalized so as to assure that the business can be operated profitably and payments under the plan to creditors will be made? If the answer is yes, then the contribution will constitute new value, and the plan can be confirmed over creditor dissent.

Of all of the confirmation requirements, "best interests" and "feasibility" are the most important. They boil down to one question each creditor must ask: Is it a good deal or a bad deal for me, compared to the alternative?

CHAPTER 11

How to Ensure a Successful Chapter 11 at the Least Cost

To determine what it takes to reorganize successfully and economically under Chapter 11, you must first analyze the reasons why many Chapter 11 cases fail and why most of them cost too much. Handled correctly, a well conceived Chapter 11 case will succeed, and at a reasonable cost. Repetition of the typical mistakes made by troubled businesses, however, will guarantee failure, or, perhaps, success but at an excessive cost which will ultimately result in failure of the business.

Dead on Arrival. Some business are dead on arrival at the Bankruptcy Court. In my experience, these constitute a very small minority of cases. These companies are incapable, for whatever reason, of earning more income than they need to cover operating expenses. Perhaps the company insists on continuing to produce a product that is no longer in demand. Its days are numbered. A more likely situation is the company that waited too long to recognize its financial problems and do something about them. While liquidation of these companies may be the only recourse, remember there are many ways to go about liquidating a company.

How to go about liquidating a company depends first on who wants to control the liquidation. If the debtor wants to do it, there are two ways. The first way is to start selling, and when through, distribute the proceeds of sale to creditors and walk away. The second way is to file a Chapter 11 petition and do the same thing following the Chapter 11 process. It is entirely proper for a business to file a Chapter 11 for the purpose of liquidating, and by doing that, the debtor will remain in control of the liquidation.

There are two problems with the first alternative. First, creditors may not permit an orderly liquidation and distribution. The most aggressive will sue and try to tie up assets with attachments and the like. Even if the liquidation is successfully completed and the proceeds distributed, creditors won't understand why they are not being paid. They need closure. Something in the nature of a funeral for the business is necessary before creditors will accept the fact that the business failed and stop looking for scapegoats.

If the debtor is willing to let someone else control the liquidation, there are two alternatives, a general assignment for the benefit of creditors and a Chapter 7 bankruptcy. The former has great merit over the latter, for it is invariably faster and cheaper.

In all likelihood, no matter how it is done, liquidation proceeds will probably be less than the total amount of the claims. If the debtor is a corporation, the unpaid balance owing to creditors will not be discharged, whether or not the liquidation is done in Chapter 7 or 11. Similarly, a general assignment for the benefit of creditors does not result in a discharge of unpaid debt. Of course, the lack of a discharge means nothing to a defunct corporation without assets. It will matter, however, to a sole proprietor or to a corporate officer who has personally guaranteed corporate debt. These individuals may need to file a personal Chapter 7 to discharge the business debts that cannot be paid out of liquidation proceeds. Long before the end comes, these individuals should be consulting counsel for advice and assistance regarding pre-bankruptcy planning.

Overcoming the Presumption of Incompetence or Worse. A sign on a San Diego bankruptcy judge's bench says "Settle, Litigation is Costly" -- an understatement if ever there was one. At the heart of the contentiousness in bankruptcy court is the typical reality that creditors don't trust the debtor. No amount of judicial intervention or statutory tinkering is going to solve this problem. Chapter 11 costs too much because the clients and their lawyers pounce on too many opportunities to object, obstruct and attack.

It need not be this way. Lawyers and their clients do not typically act in bad faith or with evil motives. They act in what they consider to be their best interests. But the more they mistrust each other, the more aggressive they get.

Unfortunately, in our business culture Chapter 11 is not a badge of honor. Rarely does one enter the halls of the bankruptcy court with praise and thanksgiving for the debtor that brought him there.

How then to counter the inevitable mistrust of and loss of confidence in the business debtor? The Bankruptcy Code has solutions, and none of them works, at least not economically.

The first is found in the very structure and content of the entire Code, for it creates enough procedural and substantive rights for all parties that rarely can either the debtor or a creditor claim a clear victory. There are boundless opportunities to litigate all manner of issues in any Chapter 11 case, and few of them relate to the central issue in the case -- reorganization. The idea underlying the Code complexity is that it will force parties to settle when the outcome of contested issues is so much in doubt. Regrettably, they often don't settle until after the cost of continued skirmishing has skyrocketed.

The second solution in the Code is the creation of the office of the United States Trustee. The U. S. Trustee oversees the administration of bankruptcy cases, and acts to protect the interests of creditors who would otherwise often be unrepresented. In practice the U.S. Trustee may often shares creditors' natural suspicions of Chapter 11 debtors, and frequently adds significantly to the litigation burden, the cost of which the debtor's business must bear.

The third Code solution is the provision for the appointment of an official creditors committee (OCC) to represent the interests of all unsecured creditors in a Chapter 11 case. Like the U.S. Trustee, the OCC also often tends to forget it should be the debtor's strongest ally, and instead vents the frustration and mistrust of the creditors by opposing most of what the debtor tries to do.

The final remedy provided by the Code is the appointment of an examiner to see what the debtor really has been up to, or a trustee to take over the business. When mistrust grows unchecked, these appointments are inevitable and effective, but at a terrible cost to the business and to creditors.

I have a better idea, actually two of them

Validation. At the beginning of every Chapter 11 case, or preferably before the case is filed, the business debtor should hire a locally recognized and trusted business turnaround/reorganization consultant. Any competent, experienced Chapter 11 lawyer can recommend one or more to be interviewed. The consultant should be instructed to investigate and assess the viability of the business; that is, whether the business can be reorganized or should be liquidated. If the former is deemed feasible, the consultant should then state what internal business reorganization should take place to restore profitability. Most important, the consultant will tell creditors what the investigation revealed and how he or she believes the problems should be solved. If the consultant is known to be independent, credible, thorough and competent, creditors will believe and rely on the report. Then the hard part is over, and the reorganization, in or out of Chapter 11, should be a downhill hike.

Remember, it is not enough that the business debtors' books and records are accurate and complete, that the debtor is honest and truthful, or that the debtor's recovery plan is sound and will benefit creditors. Frankly, most of my debtor clients fall into this category. Creditors instinctively, however, will not believe that the debtor who isn't paying them really knows what to do. A good turnaround/reorganization consultant can validate what the debtor believes to be true, and provide an invaluable foundation for creditor trust and cooperation. Moreover, the consultant's report and recommendations will carry great weight with the bankruptcy judge when critical issues must be judicially determined.

Turnaround consultants do not work for free, but their cost is a small fraction of the savings that can be realized by avoiding the contentiousness spawned by mistrust.

Mediation. As an alternative to, or in addition to the turnaround consultant, consider the use of a mediator to guide the parties through the plan formulation process. The mediator should be an experienced bankruptcy professional, although need not be a lawyer. He or she should be trained and experienced in mediation. Typically, the debtor's lawyer orchestrates the plan negotiations, often successfully. If it becomes apparent that the plan can't be negotiated with all classes, rather than look to cramdown to achieve plan confirmation, try to convince all parties to agree to mediation. There is a cost for the mediator, but it will likely be much less than the cost and risk of litigation to achieve plan confirmation.

CHAPTER 12

Small Business Debtor Election: A Way to Reduce Chapter 11 Cost and Delay

Chapter 11 cases are complex. Chapter 11 reorganizations are expensive. Parties in a typical Chapter 11 case are numerous and often contentious. This leads to litigation, and that leads to expense. Unfortunately, it is the debtor who has to pay for the costs of litigation, and that includes its own attorney's fees and often the attorney's fees for the other side.

Chapter 11 cases take time. From the day the Chapter 11 petition is filed to the day a reorganization plan is confirmed, at least 8 months will usually have elapsed. The longer the case lasts, the angrier parties become, and that means yet more opportunity for litigation.

In all Chapter 11 cases, there are at least two parties: the debtor and the United States Trustee (who is charged with overseeing the administration of bankruptcy cases). In most Chapter 11 cases, there are many other parties. Every party usually has a lawyer. Sad to say, the more parties there are, the more opportunities there will be for disagreements; and litigation results when the disputes cannot be resolved by negotiation.

The smaller the debtor's business is, the fewer creditors there are generally which will become actively involved in the Chapter 11 proceedings. That means in the typical small Chapter 11 case, there are only three or four actively participating parties: the debtor, the United states Trustee, the Official Creditors Committee ("OCC") and often a secured lender. Unsecured creditors (e.g., trade creditors usually do not participate in the administration of a Chapter 11 case. In fact, when unsecured creditors do not become involved, even to the extent of forming an OCC, the United States Trustee takes a more active role to protect their interests. Even so, 3 or 4 parties is a big enough crowd to guaranty plenty of opportunity to litigate and waste time and money.

How then to reduce the cost of a Chapter 11 case? There are two obvious ways of doing it: first, cut down on the number of parties (and lawyers), and second, speed up the case. A good bankruptcy judge can move a case along, but only so fast. Unfortunately, there is considerable built in delay under the procedural rules. There is nothing the judge can do to limit the number of parties who may want to be heard. That leaves only one alternative if you want to reduce the time and expense of Chapter 11 cases: change the Bankruptcy Code and Rules; and that is what Congress did in 1996 when the Code was amended to add a "Small Business Debtor Election."

The Code defines a Small Business Debtor as a person (i.e., an individual, partnership, corporation, LLC or LLP) engaged in commercial business activity [with one exception] with non-contingent, liquidated, secured and unsecured debts of $2 million or less.

The Code provides that such a small business debtor may, but need not, elect to be treated as a Small Business Debtor. The election is made simply by checking a box on the face of the Chapter 11 petition. What happens if the election is made? Three important things: First, no OCC is appointed. This probably results in the biggest cost saving. Gone with the OCC are many of the endless opportunities for disputes, litigation and delay one sees in the larger cases.

Second, the hearings on the debtor's disclosure statement and on plan confirmation can be combined into one hearing. This simple modification of the usual procedure, which requires separate hearings, eliminates, at a minimum, 45 days or so of built-in procedural delay. In practice, it can reduce the case duration from start to finish by many months.

Third, the debtor has the exclusive opportunity to file its plan and disclosure statement during the 100 days after the Chapter 11 petition is filed; no one else can file a plan during this time period. After 100 days, other parties can file plans, but all plans must be filed within 160 days.

Thus, business that can qualify as a Small Business Debtor can be in and out of Chapter 11 bankruptcy in five months or less, with opportunities for time and expense-wasting litigation substantially reduced or eliminated.

The wonder is that more business debtors do not make this election. The only down side for the small business debtor is the pressure to move quickly to propose a plan and seek its confirmation. That is actually a big advantage to the debtor, for once a Chapter 11 case has been filed, the debtor's dream is to be out of bankruptcy as soon as possible. That happens when the plan is confirmed.

The only small business owner who should not make the small business debtor election is the one who still has not figured out how to make his or her business profitable. Simply stated, you can't reorganize a company that can't make money, no matter how long and hard you try.

There is a perceived down side for creditors, and that is a concern that without an OCC to look out for their interests, the creditors' interests will not be protected. There are two reasons why this need not be a serious concern. First, the United States Trustee, where there is no OCC, will pay extra attention to the case to make sure the debtor complies with the Code and Rules, both in the operation of the debtor's business, and with respect to meeting the requirements of plan confirmation. Second, the bankruptcy judge will not confirm a plan that does not meet plan confirmation requirements, even though no party steps forward to object.

If there is a criticism of the Small Business Debtor Election procedure, it is that it is not available to enough businesses. The $2 million cap on debt is unreasonably low. If it were raised, more business debtors could qualify to make the election, and, in my opinion, the success rate in Chapter 11 cases would rise, while the expense and delay inherent in Chapter 11 would go down.

If your business qualifies as a Small Business Debtor, and if your business can be operated profitably (before allowance for payment of past due debt), you should seriously consider making the Small Business Debtor Election when you file your Chapter 11 petition.

CHAPTER 13

Reflections on the Use and Misuse of Chapter 11

Early Recognition Saves Three Ways. Early recognition of impending insolvency leads to easy remedial measures, and that saves time, effort and money. Remember the definition of insolvency - inability generally to pay bills as they come due. Don't cover up problems by explaining: "We are having a temporary cash flow problem." Above all, don't use money like grease to quiet the squeakiest creditor wheels.

When sales and collections go down, do two things. First, hoard your cash, and spend it only for current operating expenses. Second, take whatever action is necessary to restore profitability. Past due debts get paid, if at all, out of profits, never out of operating capital.

It is always a good idea to consult a business bankruptcy lawyer at an early stage. Never negotiate new credit arrangements with your banker without the advice of counsel. Explore your legal options; you cannot negotiate with your creditors without knowing them.

No company has ever filed Chapter 11 too soon. Most file too late. The rest may reorganize ultimately, but it takes a long time, it is hard work and it is expensive.

Reorganization Uber Alles. Reorganization of businesses, if reasonably achievable, benefits society as a whole far more than liquidating and eliminating them. That is the premise upon which the Chapter 11 process is based. On its face, Chapter 11 is an enlightened cure, to be contrasted with business euthanasia practiced elsewhere in the world.

Some business ills are too far along to be cured by Chapter 11 or any other heroic measure. Too many Chapter 11 cases are filed for the terminally ill. Fortunately, more and more courts are dismissing these cases immediately to prevent unnecessary delay and harm to creditors. More would be dismissed or converted to Chapter 7 if creditors generally understood the Chapter 11 process and its limitations. Creditors as well as debtors need to become more informed about the process.

Can You Afford To Go Broke? The cost of Chapter 11 is high. There are two reasons. First, many cases are unnecessarily contentious, leading to attorneys fees on all sides that are out of all proportion to the results achieved. The contentiousness is a misuse of the process by both litigants and their lawyers. Second, without care, the Chapter 11 process itself becomes too complicated for the average case. Early on, consider retaining an independent business turnaround/reorganization consultant, as recommended in Chapter 9.

The need to simplify the process for small businesses has the attention of Congress. In 1994, it amended the Bankruptcy Code to add special provisions for small business and single asset real estate debtors. Under the amendments, small businesses may be able to reorganize more easily, sooner and at less cost. The real key to speeding up the process and trimming costs is willingness to compromise. It simply does not pay in bankruptcy to be contentious. Chapter 12 of this book explains the benefits and limitations of the Small Business Debtor election, as well as the limitations placed on a Single Asset Debtor.

Account Receivable Financing -- Smart Business or Playing with Fire? Most growing businesses are undercapitalized. The substitute for operating capital is usually borrowed money. Typically, a lender sets up a revolving line of credit for the business. The loan is secured by all of the company's assets, most notably, its accounts receivable. Money is advanced by the lender to cover operating costs that the business does not have the cash to pay. Stop and think what this means. It means that when a business borrows against its accounts receivable, it is paying yesterday's bills with tomorrow's dollars, and it is giving away at least 10% of each of those dollars by paying interest at a rate of prime plus 2 - 5 points.

This way of running a business works only when business is expanding and accounts are increasing. If business stays flat for a time or falls off, the company will go into a death spiral. It's not hard to understand if you look at the typical business profit margin. Rarely is it more than the cost of the borrowed funds unless you can count on business expansion and increasing sales. Even if the business expands initially, the expansion won't go on forever. Of course the borrowing will, for it not only becomes a way of life, it is an addiction that cannot easily be kicked. Ultimately the sales will flatten out and EBIT (earnings before interest and taxes) will vanish.

It doesn't take much to put a company in default under its account receivable financing arrangement. A "technical" default under the loan will invariably occur when sales do not reach expected levels. Remember, loan proceeds are used to buy raw materials and pay salaries to manufacture product anticipated to be sold. If it isn't all sold, accounts receivable will not reach projected levels. Typically, the borrower must maintain accounts receivable at about twice the lending limit. When the ratio of accounts receivable to the loan balance drops, the terms of the borrowing are breached, and the loan is in default. It remains "technical" only so long as the lender does not elect to declare the entire loan balance due and payable.

While lenders usually don't accelerate payment of loans upon a technical default, they do take a keen interest in how the company plans to cure the default. Unless sales increase, the only way to do that is to make the lender more secure. It can be done by paying down the principal balance of the loan, pledging additional collateral to secure the loan, or by having corporate officers guaranty the loan and pledging their homes and other assets to secure the guaranty. Generally, that is the wrong way. When the lender demands a principal pay down, where do you think the money for the pay down typically comes from? Usually, it comes from account receivable collections, which are used to pay the lender instead of trade creditors.

When a business finds itself in this pickle, the right move is to consult legal counsel who is experienced in business reorganization. The wrong but typical, move is to borrow from trade creditors to pay the lender. Six months later, compare the aged accounts receivable of a company that has placated its lender by paying it with operating cash. By no coincidence, the reduction in the loan balance will equal the amount of past due trade accounts payable.

Eventually, current spending of future income by borrowing against expected receivables has to stop, and the company must begin using current income to pay only current operating expenses. The company must come to grips with the need to reorganize internally and externally. Internal reorganization means putting all debts on hold, trimming nonessential expenses, improving productivity and increasing sales to the point profitability is restored. How soon that can be accomplished depends on how far business has deteriorated before corrective action is initiated. External reorganization means developing a plan for dealing with all of the debt that was put on hold. How do you put debt on hold? You do it either with near unanimous trade creditor support, or with a Chapter 11. Most often, both are required where the lender will not cooperate.

That brings me back to the main point of this book: Get Reorganized! Act now! Take appropriate, decisive action soon enough so you retain trade creditor support. Businesses simply can't reorganize without it. Using money that should be used to pay trade debt to meet a lender's overreaching demands does not engender trade creditor support. Use some money instead to pay for some expert analysis and advise. If a Chapter 11 is required, the odds of success of the case will be directly proportional, and the cost of the case will be inversely proportional, to the level of trade creditor trust and confidence.

Sooner is Easier and Cheaper. When a foreclosure is imminent, when you lose a lawsuit for a big number, when suppliers put you on COD, when the bank calls your loan, chances are you waited too long. It may yet be possible to save your business, but it would have been quicker, easier and cheaper to do so before insolvency reached crisis proportions.

Chapter 11 is complicated, but it need not be mysterious. It can save business lives if used promptly and properly. It can make things worse if used too late or improperly.

Get reorganized now! Good luck!

Glossary of Bankruptcy Terms

Absolute Priority Rule. Under the new Bankruptcy Code, to be confirmed over the dissent of a class, a reorganization plan must be "fair and equitable." To be fair and equitable, among other things, a plan must comply with the absolute priority rule. This requirement is a modification and codification of the law that developed under Chapter X of the former Bankruptcy Act. The rule now holds that (i) junior classes may take nothing under a plan until senior classes have been paid in full; and (ii) senior classes cannot be overpaid until junior classes have been paid in full. The consequence of the rule in the typical small-to-medium Chapter 11 is that the equity interest holders (individual debtors, stockholders or partners) cannot retain their ownership interest unless (i) creditors' claims are paid in full, or (ii) each impaired class of claims votes (by more than half in number and two-thirds in amount) to accept lesser treatment.

Act. See Bankruptcy Act.

Administrative Claims. Claims for debts incurred after the bankruptcy case is filed. Where the business of the debtor continues after a Chapter 11 case is commenced, the debts incurred in operating the business are administrative expenses. In addition, the fees and costs of the attorneys, accountants and other professionals who represented the debtor, the official creditors committee, and, if appointed, the trustee or examiner, constitute administrative claims. By the time of plan confirmation, operating debts have usually all been paid as incurred. The fees of the professionals cannot be paid, however, until the Court approves them, and final approval is generally not given until later. Even so, they must be estimated, and provision must be made in the plan for paying them.

Adversary Proceeding. A lawsuit within a bankruptcy case.

All Parties in Interest. The universe of persons and businesses that may be affected by actions proposed to be taken in the Chapter 11 case. Typically included are the debtor and its counsel, the U.S. Trustee, any appointed trustee and/or examiner and their counsel, members of the official creditors committee and its counsel, and all creditors and equity security holders and their counsel.

Application. Under the Federal Rule of Bankruptcy Procedure, the only applications in bankruptcy practice are to employ professional persons, for compensation for services and reimbursement of expenses of professional persons, and for removal of pending actions to the bankruptcy court. All other requests for orders are by written motion. Local rules of some Bankruptcy Courts expand the use of the term.

Automatic Stay. A statutory prohibition against the commencement or continuation of acts against the debtor or its property that becomes effective automatically upon the commencement of the case under the Bankruptcy Code. Relief from the stay (e.g. terminating, annulling, modifying or conditioning it) may be sought by motion.

Bankruptcy Act. The Chandler Act or Bankruptcy Act (11 U.S. Code) as it existed before it was replaced by the Bankruptcy Code (still 11 U.S. Code) effective October 1, 1979.

Bankruptcy Code. Title 11, United States Code.

Bankruptcy Rules. See Federal Rules of Bankruptcy Procedure

Best Interests Test. Under Chapter XI of the Act, a plan, to be confirmed, had to be "for the best interests" of creditors. That meant the creditors were entitled to receive under the plan at least as much as they might receive under a straight bankruptcy liquidation. This requirement is contained in the Code, and is still referred to as the "best interests" tests, although the term is not used in the Code.

Case. There is only one case: the Chapter 11 (or 7, 9, 12 or 13) case.

Claim. A right to payment, as of the date the petition is filed, whether or not the right is reduced to judgment, liquidated, contingent, matured, disputed or secured.

Code. See Bankruptcy Code.

Confirmation. After a plan has been proposed and then voted on by creditors, it is presented the Bankruptcy Judge for approval. If the plan and the plan proponent have met all the requirements to the satisfaction of the judge, an order is entered "confirming" the plan. Several things happen as a consequence of plan confirmation:

First, debts that arose before the date of the confirmation order are discharged;

     Second, all of the property of the Chapter 11 estate is vested in the debtor
     (meaning the debtor owns all of its property free and clear of other interests
     and liens) except as otherwise provided in the plan;

Third, the automatic stay disappears, but is replaced by an injunction that
prohibits creditors from trying to collect pre-plan confirmation debts;

Fourth, the debtor becomes bound contractually and by order of the court
to perform the plan and pay the debts undertaken in the plan;

     Fifth, every creditor becomes bound by order of the court to act in
     accordance with the provisions of the plan, whether or not the creditor
     accepted the plan; and

Sixth, either the debtor or any creditor can ask a court to enforce the
provisions of the plan.

Cramdown. A Chapter 11 plan can be crammed down the throat of an unwilling class (i.e., confirmed over the objection of the class) if it is determined to be "fair and equitable."

Debtor in Possession. In cases under the pre-1979 Bankruptcy Act, receivers and trustees were appointed and debtors were typically not allowed to remain in possession of the estate assets , or to operate the business, except as permitted and directed by the receiver or trustee. The procedure under the Code is just the opposite. A debtor is allowed to remain in possession unless cause is shown why a trustee should be appointed. As a result of being allowed to remain in possession, the "debtor in possession" is imbued with most of the rights and duties of a trustee. This means that the debtor in possession has fiduciary obligations with respect to the estate.

Discharge. When a debt is paid it is said to be discharged. That means it is extinguished; the debtor no longer owes the debt. In Chapter 11, when the reorganization plan has been confirmed, all of the debtor's debts incurred up to the time of the entry of the order confirming the plan are discharged, except as otherwise provided in the plan. The debtor no longer owes pre-plan confirmation debts. Instead, the debtor is obligated to pay only the debts or perform the obligations undertaken in the plan. After plan confirmation, creditors cannot collect from the debtor on account of any debt owed to the creditor except to the extent the plan obligates the debtor to do so.

Drop Dead Date. A date established by order, by stipulation or otherwise, on which a party will have some sort of relief from the automatic stay; e.g., the debtor agrees and the court orders that a secured creditor may proceed with foreclosure if the secured property has not been sold and the creditor is not paid by a certain date. In the vernacular, the debtor must perform or "drop dead" by a specified date.

Equity Interest Holder. The owner of a debtor. In the case of a debtor partnership, the partners, general or limited, are equity interest holders. In the case of a corporation, the stockholders are the equity interest holders. In the case of a sole proprietorship, the owner of the company is the equity interest holder.

Estate. A Chapter 11 estate is created by the filing of Chapter 11 petition. It consists of all of the debtor's property, and a number of other rights as well, such as the right to recover preferential or fraudulent transfers and to have certain liens declared to be invalid. During the Chapter 11 case, the estate is held in trust by the debtor in possession or a trustee for the benefit of creditors.

Fair and Equitable. Only plans that are fair and equitable can be crammed down, or confirmed over objection. The term was used and interpreted in cases under the pre-1979 Bankruptcy Act. It is contained in and partially defined by current Bankruptcy Code. Courts in cases under the Code look to three things in determining what is fair and equitable: the literal meaning of the words, Act and Code cases, and the language of the Code. Among other things, "fair and equitable" means compliance with the "Absolute Priority Rule."

Feasible. Under Chapter XI of the pre 1979 Bankruptcy Act, a plan to be confirmed had to be "feasible." This requirement, although not the term, is now embodied in the Code and is referred to as the "feasibility" test.

Federal Rules of Rules of bankruptcy procedure adopted and modified from Bankruptcy Procedure time to time by the United States Supreme Court, as authorized by Congress.

Impairment. A reorganization plan may impair or not impair classes of claims. With one exception, a class is not impaired if the legal, equitable and contractual rights of the members of the class are unaltered under the plan. The exception is that acceleration clauses need not be observed. To understand the exception, consider a class consisting of a secured creditor with a promissory note that contains an "acceleration" clause that makes the entire note due and payable upon a default in a single payment. If the plan proposes to cure any defaulted payment(s), and then pay the note in accordance with its original terms, the class is unimpaired. In other words, a debtor in its plan may "de-accelerate" a defaulted obligation. Unimpaired classes are not permitted to vote on the plan.

Insolvency. This word has two meanings. Insolvency in the "bankruptcy sense" means the value of the debtor's assets is exceeded by the amount of creditors' claims. Insolvency in the "commercial sense" means the debtor is generally not paying its bills as they come due. Insolvency is not a condition to the right to file a Chapter 11 case. Commercial insolvency, however, is usually what propels businesses into bankruptcy.

Ipso Facto Clause. Promissory notes, contracts and leases frequently contain a clause to the effect that the debtor is automatically in default under the note, contract or lease if the debtor files a Chapter 11 case. These clauses are known as ipso facto clauses, and they are void and unenforceable.

Motion. Any request for a court order, other than an application or adversary proceeding.

Notice and Hearing. Sections throughout the Code refer to actions that may be taken "after notice and hearing." This phrase means after such notice of and such opportunity for a hearing, as may be appropriate. No actual hearing is required if the requisite notice is given and no hearing is requested.

Order for Relief. The Bankruptcy Code provides: "The commencement of a voluntary case ... constitutes an order for relief ...." There is no written order for relief. The date of the order for relief is the date the petition is filed. Among other things, the order for relief results in imposition of the automatic stay.

Petition. There is only one petition in a Chapter 11 case - the initiating petition. All subsequent proceedings which seek a court order or judgment are commenced by application, motion or adversary proceeding.

Plan. A proposal (usually made by the debtor, but occasionally by a creditor) for reorganizing the debtor financially. When confirmed by the court, it becomes a binding contract between the debtor and its creditors. The plan must classify claims and equity interests, specify the treatment of each class, and provide the means for implementing the plan. The ultimate goal in Chapter 11 is the confirmation of a plan.

Prime a Lien. To obtain court authorization to borrow and give a security interest to the lender that is senior to existing liens on the property.

Priority Claim. Certain types of claims are given favored treatment under the Code. In order of priority, the most important are administrative claims, employee wage and benefit claims and tax claims. In a Chapter 7 liquidation, the highest priority claims must be paid in full before lower priority claims are paid, and all priority claims must be paid in full before general unsecured claims may be paid. In Chapter 11, the situation is quite different. Priority one administrative claims must be paid in full in cash on the effective date of the reorganization plan. Likewise, employee wage and benefit claims must be paid in cash in full on the effective date of the plan, unless the class of wage or benefit claims consents to be paid over time, and in that event interest must be paid as well. Tax claims may be paid with interest in installments over a period that begins on the effective date of the plan and ends six years after the date of assessment of the tax. It is not necessary to delay payment of general unsecured claims until tax claims are paid in full. All that is required is that the tax claims be paid in full with interest during the six year period.

Secured Claim. A claim which is allowed by the Court as: (i) duly secured in accordance with the laws of the State of California, and which is not subject to avoidance under California law or Chapter 5 of the Bankruptcy Code; and (ii) calculated in accordance with the provisions of Section 506(b) of the Bankruptcy Code. The amount of the secured claim cannot exceed the value of the security. Any excess of the claim amount over the value of the security is an unsecured claim. The secured claim may include post-petition interest and fees only to the extent the value of the security exceeds the amount of the claim.

Single Asset Debtor. A debtor that owns and operates real estate only, with debts secured by the real estate of not more than $4 million. An example is a limited partnership that owns and operates an apartment building that is worth less than $4 million.

Small Business Debtor. Congress, in 1994, amended the Bankruptcy Code in an attempt to streamline Chapter 11 cases involving small businesses. A Small Business is a commercial (not a real estate) enterprise with debt that does not exceed $2 million. Any business that fits this definition can elect to be treated as a small business. If the election is made, the Court may order that a creditors committee not be appointed. Additionally, the plan confirmation process may be both simplified and accelerated. The advantage of making the election may be a substantial saving in time and money. The disadvantage is the need to achieve plan confirmation within a very short period of time.

Strong Arm. This graphic expression refers to the trustee's power to avoid certain liens.

United States Trustee. A branch of the United States Department of Justice. Its function is to monitor the administration of bankruptcy cases. In Chapter 11 cases, U.S. Trustee Guidelines must be observed, and the debtor in possession must comply with its Operating and Reporting Requirements.

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