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1.4 Chapter 11 bankruptcy—the players
Publication date: 31 Oct 2022
us Bankruptcy & liquidation guide
The debtor is at the center of a Chapter 11 proceeding. It is the entity that seeks to be reorganized and will either emerge from the process with greatly improved chances for its continued existence or have its assets liquidated for the complete or partial satisfaction of its obligations. The considerations for the debtor's continued existence involve determining whether it is likely that the emerging entity can operate without the need for further financial reorganization.
In most cases, the debtor becomes a "debtor-in-possession" following the filing of the petition for bankruptcy. This term refers to a debtor that will keep possession and operational control of its assets in the ordinary course of business while continuing to manage the business and, if necessary, the liquidation process, albeit supervised by the Court during the bankruptcy proceedings. The debtor-in-possession has certain fiduciary duties, as set forth in the Bankruptcy Code and Federal Rules of Bankruptcy Procedure, including accounting for property, examining and objecting to claims, and filing informational reports as required by the Court. The debtor-in-possession also has many of the powers and duties of a trustee, including the right, with the Court's approval, to engage attorneys, financial advisors, accountants, appraisers, claims agents, or other professionals to assist it during its bankruptcy case. Other responsibilities include filing any other financial reports required by the Court following the proceedings, such as a final accounting.
Question BLG 1-1
How does a debtor-in-possession manage an entity in bankruptcy?
How does a debtor-in-possession manage an entity in bankruptcy?
PwC response
While the law allows management of an entity in bankruptcy to continue to manage its business during the proceedings, there are differences from how the business was operated before the bankruptcy. For example, the debtor must separate its liabilities into those occurring before and after the bankruptcy filing. Those that existed prior to the filing, also known as prepetition liabilities, cannot be paid without specific Court approval. In most cases, the debtor also must open new bank accounts and perform other duties to separate the business arrangements that arose prior to the filing—creating new customer accounts for utilities, for example. Often, the debtor will mark its correspondence during the proceedings to identify itself as a “debtor-in-possession.” Management also has limited authority to perform duties that it might have considered to be in the ordinary course prior to the filing, such as a purchase or sale of significant assets or approval of certain compensation arrangements. In many cases, these activities will require Court approval, as the Court will decide whether there will be a benefit to the ongoing entity or an expense to the detriment of the creditors of the debtor.
In some cases, the Court may assign a case trustee to manage the property of the estate and operate the debtor's business during the proceedings, but these assignments are rare. Case trustees are usually assigned only for cause, which may include fraud, dishonesty, incompetence, or gross mismanagement. Examiners can also be appointed to assist with investigations, if needed.
The Court accepts the petition for bankruptcy and rules on all aspects of the proceedings. Eventually the Court confirms the final plan of reorganization, or approves alternative actions, and closes the proceedings.
The US Trustee is the administrative arm of the Court and is responsible for overseeing the bankruptcy process by monitoring the compliance of the debtor-in-possession with the applicable reporting requirements, bankruptcy laws, and procedures. The US Trustee also monitors the debtor's operation of the business and has the ability to object to the debtor-in-possession's motions before the Court.
The creditors generally fall into four main classes—secured, administrative, priority unsecured, and general unsecured. However, the actual number of classes included in a debtor's reorganization plan may be greater depending on the debtor's particular facts and circumstances. The four main classes are described in Figure BLG 1-2, and listed in the usual order of priority for payment in a typical Chapter 11 bankruptcy proceeding.
Figure BLG 1-2
Main classes of creditors in a typical bankruptcy proceeding
Main classes of creditors in a typical bankruptcy proceeding
Class | Description |
Secured creditor | Holds claims secured by validly perfected security interests in assets of the debtor to the extent of the value of the related collateral |
Administrative creditor | Holds claims to full payment for services provided to the debtor during the post-petition period of the bankruptcy proceedings—also includes vendors who have delivered inventory to the debtor within 20 days of the filing |
Priority unsecured creditor | Holds claims in areas specifically entitled to priority over other unsecured claims such as wages, benefits, critical supplies, and some tax claims |
General unsecured creditor | Holds claims in all other areas for debts arising prior to the petition date, such as general trade payables and other unsecured debts |
The determination of the different classes of creditors is significant, as is the process of collecting and evaluating claims. No payments can be made to a subordinate class unless the prior class has been paid in full or otherwise settled in an equitable manner as determined by the Court. This is known as the absolute priority doctrine.
A creditor committee is typically formed to represent the rights of one or more classes of creditors for the purpose of achieving the maximum recovery for the unsecured creditors. This committee is formed by the US Trustee and generally includes the holders of the largest unsecured claims and may include other claim holders as necessary to form a representative group. Some of a creditor committee's responsibilities include:
- Consulting with the trustee or debtor regarding the case administration
- Monitoring the debtor's operations and suggesting any changes
- Considering the desirability of the debtor's continued operations over asset sales or liquidation
- Participating in the formulation of the reorganization plan and facilitating the creditors' voting process to accept or reject the plan
- Performing other services that are in the interest of the creditors
- Requesting the appointment of a case trustee or examiner when necessary
In some cases, committees also may be formed to represent other interested parties, such as employees, secured debt holders, or equity holders. Committees may petition the Court to change the course of the bankruptcy proceedings with the intent to better protect the rights of the interests they represent. For example, committees may be able to use their influence to convert a costly Chapter 11 reorganization into a liquidation proceeding or asset sale that would be more advantageous to committee members' interests. Whatever action is taken, committees have significant influence over the proceedings and have fiduciary duties to protect those they represent.
The equity holders hold the equity in the debtor at the time of its bankruptcy filing. While the equity holders may have a residual claim to the assets of the debtor, their interests are usually eliminated during a bankruptcy proceeding.
Legal counsel, accountants, and other advisors are critical to the debtor during the bankruptcy process. In most cases, the debtor and each of its committees have separate representation, all at the expense of the debtor. As the bankruptcy plays out in the Court system, counsel will advise its client as to proper process and assist in the negotiations between the debtor and the other various parties in interest. In addition, accountants are often engaged to assist the debtor with its preparation of the monthly financial reports and the various accounting and valuation challenges that occur prior to, during, and upon emergence from the bankruptcy proceedings. Tax advisors are often involved in assisting the debtor with contemplation of certain bankruptcy-specific income tax planning considerations, including the tax treatment of debt extinguishment and the post-emergence use of existing tax attributes.
Professionals engaged to assist in bankruptcy must be disinterested parties approved by the US Trustee prior to performing work for the debtor. The application for retention filed with the Court needs to include the nature of services to be provided to the debtor, the proposed fee structure, any payments received from the debtor within the 90-day period prior to bankruptcy and any prior relationship with the debtor or the interested parties. Each billing for their services, which often has to be detailed in 1/10th of an hour increments, will be subject to Court approval prior to payment.
Advisors that specialize in restructurings and other areas of the bankruptcy process often play a critical role in helping the debtor navigate the process. In many cases, a chief restructuring officer is retained to work alongside management and assist in the development and execution of the debtor's reorganization strategy. Financial advisors are usually engaged to prepare cash flow forecasts as prioritizing payments and determining cash needs is critical to the restructuring process. Advisors can also assist with arranging debtor-in-possession financing, as it is common for an entity in bankruptcy to need additional financing to continue its operations, particularly in a lengthy bankruptcy proceeding.
Debtor-in-possession financing is arranged by an entity while under the Chapter 11 bankruptcy process and is often structured as a revolving line of credit or term loan payable upon emergence from bankruptcy. Debtor-in-possession financing is unique from other financing in that it usually has priority over existing debt, equity and other claims. Debtor-in-possession lenders regularly receive one or more protections, including a "super priority" administrative claim (e.g., an administrative expense claim with priority over all other administrative expense claims), a lien on assets that were previously unencumbered, or a junior lien on encumbered assets. Debtor-in-possession lenders may also receive a "priming" lien (e.g., a security interest that is "senior or equal" to an existing lien).
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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