Chapter 11 of the US Bankruptcy Code

[Originally published in Skrine’s Legal Insights Issue 3/2013]

Lehman Brothers. WorldCom. General Motors. Enron. These companies are among the largest bankruptcies in US history and they held a total of US$900 billion in assets at the time of filing for protection under Chapter 11 of the US Bankruptcy Code.

While a company seeking relief under Chapter 11 is often seen as entering ‘bankruptcy’ or insolvency, it will be shown that the Chapter 11 process is more akin to a debt restructuring mechanism rather than liquidation. The aim of this process is to allow the company to have some breathing space to reorganise its affairs and to then exit its financial distress.

This article will touch on some of the interesting features of the Chapter 11 framework while also drawing parallels with the debt restructuring mechanism of a scheme of arrangement under section 176 of the Companies Act 1965 (“Act”).

PROCEDURE

A typical Chapter 11 process is initiated through the debtor company filing a petition with a bankruptcy court setting out a list of its creditors and a summary of its assets and liabilities. The debtor has a legal right to initiate the procedure subject to the court determining that the petition was filed in ‘good faith’ primarily for the purposes of reorganising its debts.

Technically, there is no requirement of ‘insolvency.’ For instance, in 1995, the Dow Corning Corporation filed for Chapter 11 protection from creditors when it faced massive personal injury suits involving silicone-gel breast implants. It emerged from Chapter 11 only after nine years.

DEBTOR IN POSSESSION

Unlike liquidation which involves a liquidator taking over the management of the company, in a Chapter 11 scenario, the control of the debtor remains with its management through the concept of ‘debtor in possession.’ A trustee is rarely appointed to oversee the debtor’s operations. The rationale behind this concept is the belief that the management represents the most economical and efficient means to reorganise since they would have the most knowledge of the company’s affairs.

As a safeguard, the debtor will be subjected to oversight by the bankruptcy court and the United States Trustee (a representative of the Department of Justice responsible for overseeing bankruptcy cases). Generally, a committee of creditors would also be appointed to act in a supervisory role.

MORATORIUM

Upon the filing of the Chapter 11 petition, an automatic moratorium would stay legal proceedings against the debtor and enforcement of judgments and security without leave of the bankruptcy court. The stay is effective during the entire time the petition is pending but creditors and other parties may apply to lift or modify the stay.

This is similar to the moratorium enjoyed under a restraining order granted pursuant to section 176(10) of the Act although there is no automatic grant of a restraining order. Instead, the requirements under section 176(10A) must be met for the grant of a time-limited restraining order as well as for any extension of this order.

PROPOSALS TO CREDITORS

Under Chapter 11, the debtor has the exclusive right to formulate the plan of reorganisation for 120 days from the date of filing and this exclusivity period can be extended up to a maximum of 18 months.

In contrast, in a scheme of arrangement, the company, any creditor, any member or the liquidator (where the company is being wound up) can apply to the High Court to initiate the scheme of arrangement process.

DISCLOSURE STATEMENT

Before the debtor solicits approval for the restructuring plan, it must provide creditors with a disclosure statement that has been approved by the bankruptcy court as containing adequate information to allow a reasonable hypothetical creditor to be able to consider the plan.

This is very similar to the scheme of arrangement requirement of the explanatory statement under section 177 of the Act. The explanatory statement must provide the creditors with sufficient or material information to make a meaningful decision. However, the explanatory statement is not subject to the added safeguard of requiring approval by the Court before its issuance to the creditors.

CLASSIFICATION OF CREDITORS AND VOTING

Chapter 11 requires creditors to be classified into classes on the basis that claims that are substantially similar should be classified together. This is similar to a scheme of arrangement scenario.

The creditors of each class would need to vote in favour of the plan by a majority in number and two-thirds in amount of those actually voting (while in a scheme of arrangement, the approval threshold is higher in that a majority in number and three-fourths in value is required). The minority is bound by the class vote.

UNDUE PREFERENCES

Similar to winding up, the US Bankruptcy Code gives a debtor certain powers to avoid or recover certain transfers of property. Generally, a debtor can avoid such transfers made within 90 days before the filing of the petition to a creditor on account of a pre-existing debt if such a transfer allows the creditor to receive more than it would have received compared to other creditors. These are called preferences.

A debtor can also avoid fraudulent transfers made within one year before the filing of the petition. In this context, a fraudulent transfer is one which is made with the intent to hinder, delay or defraud a creditor.

CHERRY-PICKING

Under the US Bankruptcy Code, the debtor generally has the power to pick which contracts or leases by which it wants to be bound following its reorganisation. Further, under certain circumstances, the company can adopt its favourable contracts and then assign them regardless of whether the contracts themselves prohibit such an assignment.

The Bankruptcy Code prescribes deadlines within which different types of contracts may be rejected. The debtor is not required to perform the obligations under the rejected contracts but will be liable for “rejection damages” that arise from its non-performance of the obligations under such contracts.

Chapter 11 therefore provides the debtor with wide-ranging powers with which it can reject, adopt or assign contracts. This power, especially when combined with the ability to sell assets and borrow money, enables the company to address its operational needs.

INCENTIVES FOR LENDER FINANCING

The Bankruptcy Code gives lenders incentives to provide financing to the debtor (called Debtor in Possession or DIP financing). DIP financing is unique from other financing methods in that it usually has priority over existing debt, equity and other claims. The lender may be given a lien over assets that are not pledged to other lenders. The bankruptcy court may also authorise liens superior to certain priority claims in the bankruptcy process or even grant new senior liens on collateral already pledged to another party.

‘QUICK-RINSE’ BANKRUPTCY

The term ‘quick-rinse’ bankruptcy generally describes a pre-packaged bankruptcy where the debtor has negotiated a plan and solicited votes even before the filing of the Chapter 11 petition. An example of this is Chrysler in 2008, where it entered and exited Chapter 11 in less than two months with the sale of most of its assets to a new entity. Similarly, General Motors in 2009 exited Chapter 11 in just over a month, having also sold most of its assets to a new General Motors entity and shedding almost US$90 billion in debt.

CONCLUSION

The Chapter 11 procedure allows a great deal of flexibility for the resuscitation of a financially distressed company with the breathing space of a moratorium. However, criticisms have been levelled against the fact that the persons who caused the company to petition for relief continue to be the same ones in control; akin to leaving the fox in charge of the hen house.

The Companies Bill 2013

The Companies Commission of Malaysia (CCM) has issued its Public Consultation document enclosing the present draft of the Companies Bill 2013. The Bill, if passed in its present form, will greatly expand the present Companies Act 1965 where the Bill contains more than 631 sections compared with the 374 of the present Act.

For those who read the Bill, it is advisable to also read it together with the Final Report of the Corporate Law Reform Committee of the CCM issued back in 2008. This report formed the basis and contained the recommendations which were largely adopted within the Bill.

It will take a while for all the practitioners to digest all of these new provisions. My quick observation, from an insolvency practitioner point of view, is that the new Bill contains welcomed-additions to attempt to clarify the law of receivership while introducing more flexible corporate rescue mechanisms such as judicial management and the corporate voluntary arrangement.

I hope to share some of my thoughts on the Bill once I have had a bit more time to read through it all.

Federal Court Rules on Plagiarism Claim

Arising from an earlier Federal Court decision involving Kian Joo Holdings Sdn Bhd and its liquidators (see my earlier post on the decision), the dissatisfied contributories had filed an application to review this decision  on the grounds that the Federal Court grounds of judgment had substantially reproduced the written submissions filed by solicitors for the liquidators. The allegation was that there was insufficient consideration by the Federal Court of the Majority Contributories’ case.

I have now read off the Bernama website that this application has been dismissed on 22 May 2013. It is reported that in the Grounds of Judgment read out by Chief Justice Tun Arifin Zakaria, it was held that the adoption of counsel’s submissions as the court’s ground of judgment in itself was not a sufficient ground for the Federal Court to set aside its earlier judgment. Nonetheless, the Court did not encourage such practice as it had a tendency to invite negative perception, which would go against the presumption of judicial impartiality and accountability.

Chief Justice Tun Arifin Zakaria said scrutiny of the court’s grounds of judgment revealed that not all the submissions made by the liquidators’ counsel were adopted by the court.

He said out of the 189 paragraphs of the submissions, only 70 paragraphs were adopted by the court.

“And in so doing, the court inserted their own words in parts of the judgment.

“All these could not be done without the learned judges in fact applying their minds to the issues raised in the appeal,” said Arifin in a judgment delivered today.

In his 37-page judgment, Arifin said there had been due process as the case had gone through the full appeal process before the Court of Appeal and the Federal Court and that both the grounds of the High Court and Court of Appeal judgments were before the Federal Court.

Arifin said the 25 applicants were also given full liberty to make their oral submissions at the hearing before the Federal Court which was stretched over a period of two days, adding that written submissions were also filed.

“In fairness to the panel (three-member Federal Court panel), we have to assume that they must have considered the judgments of the courts below and the submissions of the parties, both oral and written, before arriving at their decision,’ he said.

The judiciary’s top judge (Arifin) said the adoption of counsel’s submissions as the court’s ground of judgment in itself was not a sufficient ground for the Federal Court to set aside its earlier judgment.

He cited a minority decision of a British Columbia Court of Appeal in the case of Cojocaru vs British Columbia Women Hospital and Health Centre which held that there was nothing inherently wrong with adopting the submissions of a party in whole or in part as reasons for judgment so long as those submissions truly and accurately reflect the judge’s own independent analysis and conclusion.

Arifin however said the court did not encourage such practice as it had a tendency to invite negative perception, which would go against the presumption of judicial impartiality and accountability.

What is still pending before the Federal Court are the application by the liquidators to cite these contributories and their lawyer, Datuk V K Lingam, for contempt of court for alleging plagiarism in the Federal Court judgment and the application to set aside this contempt application.

TT International Dispute Rumbles On

I had written earlier about the Singapore Court of Appeal decision in TT International No. 2 and how it set out important guidelines on the disclosure of fees of a scheme manager in a scheme of arrangement. In particular, a Value-Added Fee (“VAF”) arrangement had not been disclosed where the greater the amount of the creditors’ debt that is written off or extinguished, the greater the quantum of the remuneration received by the scheme manager’s firm (nTan). By that stage, it was estimated that the quantum of the VAF was between S$15 million to $30 million.

It has now been reported (click here) that nTan has been allowed to admit a Queen’s Counsel, Michael Beloff, to act in a hearing before the Court of Appeal scheduled for October 2013. nTan is seeking to set aside the TT International No. 2 judgment which effectively voided the fee arrangement agreed between nTan and TT International and also strongly criticised the firm.

nTan is arguing that it is unprecedented for an independent financial adviser’s fee arrangement to be decided in this manner. It also says that the judgment was made without proper jurisdiction, as nTan was never a party to the proceedings before the Court of Appeal; it also says it was deprived of natural justice as it never had the chance to challenge the assertions and evidence on which the judgment was based.

This will be an interesting case as I have been following the developments in the TT International dispute quite closely. It is also noteworthy that Singapore has seen more and more QCs gaining ad-hoc admission to argue cases in Singapore.

 

Protecting an Unguarded Pocket

[Originally published in Skrine’s Legal Insights Issue 2/2013]

The Singapore Court of Appeal in The Royal Bank of Scotland NV (formerly known as ABN Amro Bank NV) and Others v TT International Ltd and another appeal [2012] SGCA 53 revisited its earlier decision in The Royal Bank of Scotland NV (formerly known as ABN Amro Bank NV) and Others v TT International Ltd and another appeal [2012] SGCA 9 (“TT International No. 1”) (my earlier commentary on TT International No. 1 is found here) and laid down important guidelines on the disclosure of fees to be paid to a scheme manager in a scheme of arrangement.

BACKGROUND FACTS

Arising from the decision of TT International No. 1, the Court had ordered for meetings of the creditors to be called. At these meetings, the creditors approved a scheme of arrangement (“Scheme”) which was thereafter sanctioned by the Court. Under the terms of the Scheme, a Monitoring Committee made up of representatives from some of the major creditors was set up to oversee the implementation of the Scheme by the appointed Scheme Manager (“Scheme Manager”).

Close to a year after the sanction, during the implementation of the Scheme, the Monitoring Committee discovered that the company had prior to the sanction of the Scheme, entered into a success fee arrangement with the Scheme Manager’s firm. The Scheme Manager would be paid for the time costs incurred as well as a Value-Added Fee (“VAF”) which was a success-based fee. Under the VAF component, the greater the amount of the creditors’ debt that is written off or extinguished, the greater the quantum of the remuneration received by the Scheme Manager’s firm. By that stage, it was estimated that the quantum of the VAF was between S$15 million to $30 million.

The Monitoring Committee informed the Court of Appeal of the existence of this success fee arrangement and requested that the Court direct that the VAF be assessed in court. The key issue before the Court of Appeal was whether the VAF should have been disclosed to the creditors and/or the Court prior to the sanction of the Scheme.

COMPANY’S DUTY TO DISCLOSE MATERIAL INFORMATION

The Court of Appeal emphasised that transparency in the affairs of a distressed company through making available all material information that could impinge on the financial interests on creditors was essential. This duty of disclosure on the company has been emphatically declared to be an independent principle of law entirely distinct from the disclosure requirements mandated by statute.

The Court of Appeal took into consideration the prevailing practice of success-based fee remuneration of scheme managers both in Singapore and abroad. It was found that it was not uncommon for some scheme managers or financial advisers to include a success-based element in their fees for the debt restructuring work which they carried out. There was also no established practice in Singapore of such success-based fees of scheme managers being voluntarily disclosed to the creditors or the courts. Nonetheless, the Court of Appeal held that a commercial practice, no matter how widespread, does not have the force of law if it is contrary to legal principle.

In considering the legal issues, the Court of Appeal held that the company’s obligation to disclose all material information should cover liabilities such as the VAF which it had incurred immediately prior to the sanction of the Scheme. The VAF was a contingent liability incurred by the company which would have crystallised the moment the Scheme was successfully implemented. Ordinarily, such contingent liabilities would have been disclosed but the Scheme Manager’s firm was found to have been conveniently classified as an excluded creditor and therefore did not have to submit a proof of debt.

The Court did not view favourably the current practice of companies making use of the device of “excluded creditors” in order to not reveal to other creditors the actual or contingent liabilities, which may be very substantial. That practice would permit directors of an insolvent company to commit the company to a substantial contingent financial commitment that will come from an unguarded pocket. It held that the law does not allow such a practice as it can be used to conceal all kinds of financial arrangements which may prejudice the interests of the scheme creditors.

Therefore, it was held that the company was under a legal obligation to disclose all material information to the scheme creditors to enable them to make informed decisions on whether or not to support the Scheme. The company breached this obligation by failing to disclose the VAF to the scheme creditors. Furthermore, this information should have also been disclosed to the Court at the sanction stage.

SCHEME MANAGER’S DUTY OF DISCLOSURE

In referring to TT International No. 1, the Court of Appeal emphasised that it has been held that the Scheme Manager has to act in good faith towards the scheme creditors and must not mislead the scheme creditors or suppress material information.

In this case, the Scheme Manager had placed itself in a position of conflict, where the quantum of the VAF which would accrue to the Scheme Manager’s firm was dependant on the value of the debts which would be adjudicated upon by the proposed Scheme Manager himself. The Court of Appeal held that this conflict could only be resolved by the informed consent of the scheme creditors. There was no such informed consent because of the Scheme Manager’s (and also the company’s) failure to inform the scheme creditors of the VAF.

The Court of Appeal considered that the parties with a genuine interest to ensure that the proposed Scheme Manager is being reasonably remunerated would be the scheme creditors who would determine whether the scheme is commercially viable (and preferable to liquidation). It was therefore only fair, reasonable and right that both the company and the Scheme Manager disclose to the scheme creditors and the Court the terms of the proposed Scheme Manager’s appointment prior to the sanction of the Scheme.

REMUNERATION FOR INSOLVENCY PRACTITIONERS

In considering the above points, the Court of Appeal also considered that the issue of potentially exorbitant fees for insolvency practitioners was a matter of public interest. Central to this problem is the fact that their fees come from an unguarded pocket that in reality belongs to the creditors and not the financially distressed company.

The Court of Appeal found that the wildly divergent interests of the stakeholders often allow insolvency practitioners almost carte blanche to determine (without rigorous oversight) their levels of remuneration even for the most mundane tasks.

The Court of Appeal held as a matter of general principle, the determinative consideration as to the fair and reasonable remuneration for financial advisors/scheme managers should be the value contributed to the process in terms of tangible results for the creditors and the company, as opposed to the mere quantum of debt involved or the time spent.

CONSEQUENCES OF THE BREACH OF DUTY

As the company and the Scheme Manager were in breach of their common law duty of disclosure, the Court of Appeal found that ordinarily, the Scheme should be set aside and put to a fresh vote because it might not have been approved by the scheme creditors if they had known about the VAF. However, as the Scheme had been implemented for more than two years, the Court found that it was not practical to set it aside without causing more harm to the company and the scheme creditors.

Therefore, the Court of Appeal ordered the relevant parties to the dispute to try to reach an agreement on the proper amount of professional fees to be paid out. It also ordered that, if parties are unable to reach an agreement, then the fees would be assessed by a High Court Judge.

If the matter were to proceed to assessment, then the Court of Appeal laid down the following guiding principles. The Court would first consider the value (in this case the benefits, from a holistic and not mathematical standpoint, accruing to the company and the creditors) contributed by the Scheme Manager’s firm. Other factors would include the nature of the work involved, the time spent, the assistance provided, the scope of work and reasonable disbursements incurred.

CONCLUSION

Financial advisers or scheme managers in Malaysia may also include success-based components in their fee arrangements and there is no mandatory requirement to disclose such fee arrangements in the scheme papers.

Although decided in a Singapore context, the principles outlined in this decision should be equally applied here. The onus is on both the company and the scheme manager to disclose the fee arrangements of the company’s financial advisers or the proposed scheme manager to the scheme creditors and to the Court in a scheme of arrangement. This ensures that the informed consent of the scheme creditors is obtained and underlines the uncompromising need for transparency in relation to material information.

The aforesaid common law duty of disclosure imposed on the company and the proposed scheme manager would strike a sound balance between valuing the work done by financial advisors/scheme managers and safeguarding the interests of the creditors.

The decision is also significant in giving some guidance on the principle that should guide the determination of remuneration for such financial advisors/scheme managers in a scheme of arrangement. Rather than a mathematical scale based on the quantum of debt or time spent, the primary factor should be the value contributed to the process in terms of results for the creditors and the company.

Stay of Execution of Judgment May Be Insufficient To Prevent Winding Up

The Court of Appeal in Juara Inspirasi (M) Sdn Bhd v Tan Soon Ping [2012] 1 MLJ 50 considered an appeal against the grant of a winding up order based on a judgment debt. The primary finding was on the respondent company’s failure to file an Affidavit in Opposition (see the oft-cited decision of Crocuses & Dafodils).

The interesting point was that the Appellant (the debtor company in the High Court) raised the argument that there was an ad interim stay of the judgment at the time of the winding up order. As the company’s solicitors had not exhibited the stay order, there was no direct evidence before the High Court and it could be said that the High Court proceeded to make obiter findings.

The Court of Appeal nonetheless agreed with the High Court that a stay of execution of a judgment would not necessarily extend to staying or preventing a winding up because winding up is not a form of execution.

Strictly speaking, that is true in that winding up is not an execution proceeding. The forms of execution are spelled out in the Rules of High Court 1980 (and now the Rules of Court 2012) and it is well accepted that procedures like winding up and bankruptcy are not forms of execution. However, where there is a stay of execution of the judgment, for all intents and purposes, no further proceedings should be taken based on the judgment. The judgment debtor need not pay the judgment sum over to the judgment creditor with the stay of execution in place.

The strict application of this Court of Appeal decision would mean that even where there is a stay of execution of a judgment, the judgment creditor could still issue a 218 notice against the judgment debtor company. The debtor may then have to go through the process of applying for an injunction to restrain the presentation of the petition. It may then be debatable whether such an injunction can be obtained since the question is whether there is any bona fidedispute of debt. If the petition were to be filed and proceeded to hearing, the debtor may find itself at a real risk of being wound up notwithstanding the stay of execution. Just like in this case, the Court found that the debtor company was insolvent and there were other supporting creditors for the petition.

This shows the importance of ensuring that the wording of the stay of execution application and the eventual Order is drafted as wide as possible to include a stay of execution and to prevent or stay any further step in any winding up proceedings. So for instance in the unreported decision of Poh Loy Earthworks Sdn Bhd v Mascon Sdn Bhd, the High Court stayed the hearing of the Petition as there was a stay order drafted in general terms “staying the judgment” rather than specifically staying the execution of the judgment.

Receiver and Manager Can Co-Exist with a Liquidator

The Court of Appeal in Yayasan Bumiputera Sabah & Anor v Apoview Wood Products Sdn Bhd [2012] 7 CLJ 593 (see here for the Grounds of Judgment of the Court of Appeal) considered the issue of whether a receiver and manager (“R&M”) could continue with an action on behalf of a company when a winding up Order was granted and a Liquidator appointed. In this case, the action was in respect of machineries owned by the company.

The Court of Appeal held that a winding up of a company after the appointment of the R&M only terminated the R&M’s personal powers but not his in rem power in that the R&M continues to retain possessory rights conferred by the Debenture to take custody and control of all assets charged under the Debenture, as well as the right to institute an action in the company’s name for the recovery of such charged assets. In this case, the machineries had been charged under the Debenture. The R&M’s right to the machineries therefore did not disappear when they were wrongfully disposed of to a third party.

The winding up of the company would only deprive the R&M of any power to carry on the business of the company as its agent so as to create debts as against its unencumbered assets.

Hence, the R&M and the court appointed liquidator in winding-up can exist side-by-side and each exercised separate duties and powers under the Companies Act 1965, in particular s. 236 and the Debenture.