The Creditor in Possession

During the legislative process that resulted in the BRA, Chapter 11 and the general principle of reorganization of financially distressed businesses was recognized as a beneficial process that resulted in increased value as well as serving the public interest. The BRA adopted the paradigm of reorganization as had been developed and, while incorporating many of the underlying reorganization principles of Chapter 10, it expanded and clarified protections intended to enable the debtor to rehabilitate and reorganize. An objective of the BRA was to encourage and facilitate the reorganizations of distressed business entities by permitting use of creditors' collateral security, granting of priorities and liens to encourage extensions of credit on all postpetition borrowings, adopting the debtor in possession as the primary executor and fiduciary for the administration, operations and management of a debtor's business and assets, prohibiting the appointment of receivers, relaxing the absolute priority rule, providing limited exclusivity to the debtor for the filing of a plan of reorganization, and for expanded discharge to implement the debtor's fresh start. The BRA's intent was to motivate distressed entities to seek relief under the new Chapter 11 before their resources were expended and rehabilitation became futile.

It has now been almost 24 years since the BRA became effective. During that period, there have been four major amendments to the Bankruptcy Code. Each amendment has added restrictive provisions in favor of specific creditor interests and contracted provisions that were intended to protect and enable distressed debtors to rehabilitate and effectuate reorganization. Special interest groups have been very effective in causing the enactment of legislation to service their parochial interests, including secured creditors (363(c), (d) and (e) and 364(c) and (d)), shopping center owners (section 365(b)(3)), commercial property owners (365(d)(4)), equipment lessors (section 365(d)(10), asbestos manufacturers (section 524(g)), and aircraft manufacturers, lessors and financiers (section 1110)

The question now arises as to whether the pendulum has swung so far in the favor of creditor rights and, in particular, the rights of secured creditors as to endanger the original objectives of the BRA to the point that secured creditors, in effect, may veto rehabilitation and force the sale of a debtor's assets thereby converting Chapter 11 primarily to a liquidation proceeding.

Emergence of Creditors' Control

As large business failures became an ordinary event of the economy, the organization of sophisticated creditors evolved, particularly among financial institutions. The universal adoption of the Uniform Commercial Code, which facilitated the granting of all encompassing security interests and liens, in conjunction with the evolution of sophisticated credit agreements that contemplate financial distress and provide remedies to be exercised on behalf of a large group of secured creditors by the agent financial institution, have dramatically altered debtor/creditor relationships. The exercise or the potentiality of the exercise of remedial rights given secured creditors upon the occurrence of default, in effect, puts those creditors in control of the debtor/borrower. Failure by the distressed debtor to comply with demands imposed by the agent

representative may result in loss of cash necessary to operate the business and potential liquidation. It is at that point that the debtor must consider the protections that might be available to it under Chapter 11. However, because of the evolution of the law and the scope and extent of the security interests and liens of the secured creditors, the options available under Chapter 11 may be very limited. The outset of a Chapter 11 case is the most traumatic period for any debtor. The debtor is faced with a Hobson's choice. It must either challenge the validity and enforceability of the lenders' liens, a process that is a further drain on limited resources and fraught with danger, or it must enter into an agreement with the secured lenders governing the use of cash and other collateral. Given its fragile state, the decision is predetermined and the negotiations are one-sided. Both in and outside of Chapter 11, the debtor may be compelled to accede to provisions that, in effect, pass control of the debtor's business and assets to the secured creditors.

The provisions that are often included in cash collateral agreements and debtor in possession financing arrangements under section 364 may include:

• The appointment of a Chief Restructuring Officer who reports to the secured creditors, and is often vested with executive powers independent of the Chief Executive Officer;
• Budget approval by the lenders and their appointed accountants and other agents;
• Requirement for sale of assets by fixed dates;
• The fixing of dates for the filing of certain motions and a plan of reorganization;
• Requiring pre-approval of any proposed plan of reorganization;
• Requiring the payment in full of the lenders' claims;
• Requiring the payment of current interest and the reimbursement
• of expenses including attorneys, financial advisors, forensic account-ants, etc.;
• Prohibiting payment of pre-Chapter 11 claims without prior approval; and
• Requiring all cash to be collected each day and maintained in the agent's bank with rights to seize such cash upon an event of default without further order of the Bankruptcy Court.

Without access to other credit, in the face of the pervasive liens and encumbrances granted under the applicable credit agreements, the debtor is unable to continue operations that might lead to its rehabilitation and reorganization. As the process proceeds, the ever-increasing creditor protection provisions incorporated in the credit agreements put the debtor in a position where it has little or no choice but to accede to the lenders' demands, both in and outside of Chapter 11. Thus, the secured creditor has essentially assumed the position of the floating lien creditor under the United Kingdom insolvency laws.

Other Factors Contributing to the Crumbling of Debtor Protections

Over the past 10 or more years, the following circumstances also have contributed to the shrinking ability of a debtor to be a major participant in its rehabilitation or the reorganization process under Chapter 11:

Globalization and Demise of the Firm. The enormous advances in technology governing the administration and government of a business and the integration of a global economy have dramatically changed the way businesses operate. They are no longer limited to specific geographic areas. Firms may produce goods all over the world or outsource the production of goods and distribution to other entities, with the result that the enterprise may essentially be an administrative organization whose primary assets are people, desks, and, perhaps, intellectual property. Symbiotic relationships with long-term customers and suppliers have been replaced with a constant search for cheaper means of production and administration. To the extent that the debtor may have any hard assets, they are often fungible, and may be used by other business entities. As a consequence, there is often a marketplace for such hard assets. The creation of this marketplace has eroded the concept of reorganization to preserve going concern values. The theorists will argue that the marketplace establishes the true value of these assets and there is no going concern value to preserve.

Globalization has also resulted in the consolidation of the buy-and-sell side operations of the business. Very often, there is a single source of supply, and the number of potential customers of a business has dramatically contracted. For example, in the retail industry, an inability to sell to dominant retailers such as Wal-Mart, Target, Lowe's and Home Depot may be critical to a manufacturer. On the buy side, there may be only one contractor or source of raw materials and often that organization is foreign-based and will require letters of credit to do business with the debtor, another facet placing the debtor in control of secured financial institutions.

Distressed Debt Traders and Section 363(b) Sales. The recognition of debt as a commodity has dramatically changed the debtor/creditor environment. The active market in distressed debt securities that has greatly expanded over the last 15 years has resulted in a changing creditor universe to one which is primarily and often solely interested in a substantial and quick return on its investment. Distressed debt traders have different motivations from commercial creditors providing goods and services to a debtor. Distressed debt is purchased to reap profits and not to maintain a continuing business relationship. The objective of a distressed debt trader is to cause a quick resolution of the structuring or reorganization to realize significant returns. As a consequence, the opportunity to rehabilitate a business entity by establishing new or improved business operations and testing the effectiveness of those changes has been severely limited. Distressed debt traders often are organized and exert substantial influence upon the debtor through dominance of creditors' committees and in Chapter 11 cases, sheer voting power.

The popularity of section 363(b) and the ability to sell all or substantially all of the assets or the debtor aids the distressed debt trader in realizing a fast, substantial return on its investment. More and more Chapter 11 cases are premised upon an expeditious sale of all or major assets pursuant to section 363(b) with the result that the Chapter 11 reorganization case ends with a plan of liquidation.

Recidivism. As demonstrated by recent analysis and articles by academicians and others, the rate of recidivism of Chapter 11 debtors is very high, in some districts 42% of the reorganized debtors return to further Chapter 11 relief.

The return to Chapter 11 despite the requirement under section 1129(a)(1) of the Bankruptcy Code that any confirmation of a Chapter 11 must be supported by a finding that the confirmation, “is not likely to be followed by the liquidation, or the need for further financial reorganization … ” is being used to support the argument that Chapter 11 is an ineffective reorganization tool, and, perhaps, should be eliminated. The analysis as to the cause of recidivism is far from complete.

Often, as a result of the secured creditors' controls and the interests of the debt traders in an expeditious emergence, the debtor faces significant pressures to propose, negotiate and prosecute a Chapter 11 plan. The Bankruptcy Court is then faced with a proposed consensual plan of reorganization in which all of the stakeholders support the plan as feasible. The debt provisions of the plan, ie, the new debt to be carried in service by the reorganized entity, is imposed by the creditors as a condition to confirmation and is included as part of the plan of reorganization to serve as a protection to the creditors if there is to be another Chapter 11 case. This debt often is overly burdensome and difficult to service. Despite the foregoing, recidivism is being used as an argument that debtor reorganization under Chapter 11 is ineffective and wasteful.

Conclusion

Restructurings and Chapter 11 have gone through an evolutionary process since the enactment of the BRA. A changing world has upset the original balancing of interests contemplated by the BRA to a more creditor oriented and secured creditor controlled process. Return on investment and the reaping of substantial returns by distressed debt traders has become resonant on restructurings and reorganizations. As assets have become fungible, the need for the reorganization of a firm to protect the value of those assets has largely dissipated. In that framework, the railroad reorganization paradigm appears to have lost its value. The protection of employment opportunities and the public interest are no longer viable elements of reorganization. In the face of expanding creditor controls, a service-based economy and globalization, Chapter 11 no longer provides the relief and protection that were intended by the BRA in 1978. As a consequence, despite a recessionary economy over the past 3 years, the number of Chapter 11 cases filed has steadily decreased. The question remains whether this new dynamic and the decreased effectiveness and utilization of Chapter 11 is in the best interests of the nation.

A hallmark of United States bankruptcy law has been the principle that a debtor should be provided with an opportunity to use the bankruptcy to get a “fresh start.” That principle, initially applicable to individuals, was carried forward as an underlying premise of business reorganizations and coupled with the belief that reorganizations preserved going concern values. The value of reorganization as compared with liquidation in cases of major business failures was first realized in connection with the reorganization of railroads during the latter part of the 19th century that continued into the 20th century. In the context of the current economic environment, the underlying premise of railroad reorganizations of preserving going concern value may no longer be viable.

Background

Railroad reorganizations, initially, were not predicated upon a bankruptcy statute. Federal courts exercised their equity jurisdiction to prevent dismemberment of the railroad; appoint a receiver(s); oversee the operations of the entire railroad system across state and federal district lines; enable interim financing through sale of receivers' certificates; and allow the negotiation and implementation of a plan of reorganization; all for the purpose of providing the railroad with a fresh start and enhancing value for the economic stakeholders. As the U.S. moved into the 20th century and the dire economic consequences of the Great Depression of 1929 began to emerge, the railroad equity receivership became the paradigm for saving the economic foundation of the U.S. industrial complex. The basic principles were codified by the enactment of the emergency legislation of 1933 that added sections 77 (railroad reorganization) and 77b (business reorganizations) to the Bankruptcy Act of 1898 and then by the more comprehensive Chandler Act of 1938. Between 1938 and the enactment of the Bankruptcy Reform Act of 1978 (BRA), the principles of debtor protection, rehabilitation and reorganization under court supervision permeated U.S. law. The use of Chapter 11 expanded as a primary reorganization vehicle for private and public corporations and other business entities. With judicial support and consequently adopted federal rules of bankruptcy procedure, Chapter 11 provided a debtor with injunctive protection against creditor actions and unlimited exclusivity as to the proposal of a plan, among other benefits.

During the legislative process that resulted in the BRA, Chapter 11 and the general principle of reorganization of financially distressed businesses was recognized as a beneficial process that resulted in increased value as well as serving the public interest. The BRA adopted the paradigm of reorganization as had been developed and, while incorporating many of the underlying reorganization principles of Chapter 10, it expanded and clarified protections intended to enable the debtor to rehabilitate and reorganize. An objective of the BRA was to encourage and facilitate the reorganizations of distressed business entities by permitting use of creditors' collateral security, granting of priorities and liens to encourage extensions of credit on all postpetition borrowings, adopting the debtor in possession as the primary executor and fiduciary for the administration, operations and management of a debtor's business and assets, prohibiting the appointment of receivers, relaxing the absolute priority rule, providing limited exclusivity to the debtor for the filing of a plan of reorganization, and for expanded discharge to implement the debtor's fresh start. The BRA's intent was to motivate distressed entities to seek relief under the new Chapter 11 before their resources were expended and rehabilitation became futile.

It has now been almost 24 years since the BRA became effective. During that period, there have been four major amendments to the Bankruptcy Code. Each amendment has added restrictive provisions in favor of specific creditor interests and contracted provisions that were intended to protect and enable distressed debtors to rehabilitate and effectuate reorganization. Special interest groups have been very effective in causing the enactment of legislation to service their parochial interests, including secured creditors (363(c), (d) and (e) and 364(c) and (d)), shopping center owners (section 365(b)(3)), commercial property owners (365(d)(4)), equipment lessors (section 365(d)(10), asbestos manufacturers (section 524(g)), and aircraft manufacturers, lessors and financiers (section 1110)

The question now arises as to whether the pendulum has swung so far in the favor of creditor rights and, in particular, the rights of secured creditors as to endanger the original objectives of the BRA to the point that secured creditors, in effect, may veto rehabilitation and force the sale of a debtor's assets thereby converting Chapter 11 primarily to a liquidation proceeding.

Emergence of Creditors' Control

As large business failures became an ordinary event of the economy, the organization of sophisticated creditors evolved, particularly among financial institutions. The universal adoption of the Uniform Commercial Code, which facilitated the granting of all encompassing security interests and liens, in conjunction with the evolution of sophisticated credit agreements that contemplate financial distress and provide remedies to be exercised on behalf of a large group of secured creditors by the agent financial institution, have dramatically altered debtor/creditor relationships. The exercise or the potentiality of the exercise of remedial rights given secured creditors upon the occurrence of default, in effect, puts those creditors in control of the debtor/borrower. Failure by the distressed debtor to comply with demands imposed by the agent

representative may result in loss of cash necessary to operate the business and potential liquidation. It is at that point that the debtor must consider the protections that might be available to it under Chapter 11. However, because of the evolution of the law and the scope and extent of the security interests and liens of the secured creditors, the options available under Chapter 11 may be very limited. The outset of a Chapter 11 case is the most traumatic period for any debtor. The debtor is faced with a Hobson's choice. It must either challenge the validity and enforceability of the lenders' liens, a process that is a further drain on limited resources and fraught with danger, or it must enter into an agreement with the secured lenders governing the use of cash and other collateral. Given its fragile state, the decision is predetermined and the negotiations are one-sided. Both in and outside of Chapter 11, the debtor may be compelled to accede to provisions that, in effect, pass control of the debtor's business and assets to the secured creditors.

The provisions that are often included in cash collateral agreements and debtor in possession financing arrangements under section 364 may include:

• The appointment of a Chief Restructuring Officer who reports to the secured creditors, and is often vested with executive powers independent of the Chief Executive Officer;
• Budget approval by the lenders and their appointed accountants and other agents;
• Requirement for sale of assets by fixed dates;
• The fixing of dates for the filing of certain motions and a plan of reorganization;
• Requiring pre-approval of any proposed plan of reorganization;
• Requiring the payment in full of the lenders' claims;
• Requiring the payment of current interest and the reimbursement
• of expenses including attorneys, financial advisors, forensic account-ants, etc.;
• Prohibiting payment of pre-Chapter 11 claims without prior approval; and
• Requiring all cash to be collected each day and maintained in the agent's bank with rights to seize such cash upon an event of default without further order of the Bankruptcy Court.

Without access to other credit, in the face of the pervasive liens and encumbrances granted under the applicable credit agreements, the debtor is unable to continue operations that might lead to its rehabilitation and reorganization. As the process proceeds, the ever-increasing creditor protection provisions incorporated in the credit agreements put the debtor in a position where it has little or no choice but to accede to the lenders' demands, both in and outside of Chapter 11. Thus, the secured creditor has essentially assumed the position of the floating lien creditor under the United Kingdom insolvency laws.

Other Factors Contributing to the Crumbling of Debtor Protections

Over the past 10 or more years, the following circumstances also have contributed to the shrinking ability of a debtor to be a major participant in its rehabilitation or the reorganization process under Chapter 11:

Globalization and Demise of the Firm. The enormous advances in technology governing the administration and government of a business and the integration of a global economy have dramatically changed the way businesses operate. They are no longer limited to specific geographic areas. Firms may produce goods all over the world or outsource the production of goods and distribution to other entities, with the result that the enterprise may essentially be an administrative organization whose primary assets are people, desks, and, perhaps, intellectual property. Symbiotic relationships with long-term customers and suppliers have been replaced with a constant search for cheaper means of production and administration. To the extent that the debtor may have any hard assets, they are often fungible, and may be used by other business entities. As a consequence, there is often a marketplace for such hard assets. The creation of this marketplace has eroded the concept of reorganization to preserve going concern values. The theorists will argue that the marketplace establishes the true value of these assets and there is no going concern value to preserve.

Globalization has also resulted in the consolidation of the buy-and-sell side operations of the business. Very often, there is a single source of supply, and the number of potential customers of a business has dramatically contracted. For example, in the retail industry, an inability to sell to dominant retailers such as Wal-Mart, Target, Lowe's and Home Depot may be critical to a manufacturer. On the buy side, there may be only one contractor or source of raw materials and often that organization is foreign-based and will require letters of credit to do business with the debtor, another facet placing the debtor in control of secured financial institutions.

Distressed Debt Traders and Section 363(b) Sales. The recognition of debt as a commodity has dramatically changed the debtor/creditor environment. The active market in distressed debt securities that has greatly expanded over the last 15 years has resulted in a changing creditor universe to one which is primarily and often solely interested in a substantial and quick return on its investment. Distressed debt traders have different motivations from commercial creditors providing goods and services to a debtor. Distressed debt is purchased to reap profits and not to maintain a continuing business relationship. The objective of a distressed debt trader is to cause a quick resolution of the structuring or reorganization to realize significant returns. As a consequence, the opportunity to rehabilitate a business entity by establishing new or improved business operations and testing the effectiveness of those changes has been severely limited. Distressed debt traders often are organized and exert substantial influence upon the debtor through dominance of creditors' committees and in Chapter 11 cases, sheer voting power.

The popularity of section 363(b) and the ability to sell all or substantially all of the assets or the debtor aids the distressed debt trader in realizing a fast, substantial return on its investment. More and more Chapter 11 cases are premised upon an expeditious sale of all or major assets pursuant to section 363(b) with the result that the Chapter 11 reorganization case ends with a plan of liquidation.

Recidivism. As demonstrated by recent analysis and articles by academicians and others, the rate of recidivism of Chapter 11 debtors is very high, in some districts 42% of the reorganized debtors return to further Chapter 11 relief.

The return to Chapter 11 despite the requirement under section 1129(a)(1) of the Bankruptcy Code that any confirmation of a Chapter 11 must be supported by a finding that the confirmation, “is not likely to be followed by the liquidation, or the need for further financial reorganization … ” is being used to support the argument that Chapter 11 is an ineffective reorganization tool, and, perhaps, should be eliminated. The analysis as to the cause of recidivism is far from complete.

Often, as a result of the secured creditors' controls and the interests of the debt traders in an expeditious emergence, the debtor faces significant pressures to propose, negotiate and prosecute a Chapter 11 plan. The Bankruptcy Court is then faced with a proposed consensual plan of reorganization in which all of the stakeholders support the plan as feasible. The debt provisions of the plan, ie, the new debt to be carried in service by the reorganized entity, is imposed by the creditors as a condition to confirmation and is included as part of the plan of reorganization to serve as a protection to the creditors if there is to be another Chapter 11 case. This debt often is overly burdensome and difficult to service. Despite the foregoing, recidivism is being used as an argument that debtor reorganization under Chapter 11 is ineffective and wasteful.

Conclusion

Restructurings and Chapter 11 have gone through an evolutionary process since the enactment of the BRA. A changing world has upset the original balancing of interests contemplated by the BRA to a more creditor oriented and secured creditor controlled process. Return on investment and the reaping of substantial returns by distressed debt traders has become resonant on restructurings and reorganizations. As assets have become fungible, the need for the reorganization of a firm to protect the value of those assets has largely dissipated. In that framework, the railroad reorganization paradigm appears to have lost its value. The protection of employment opportunities and the public interest are no longer viable elements of reorganization. In the face of expanding creditor controls, a service-based economy and globalization, Chapter 11 no longer provides the relief and protection that were intended by the BRA in 1978. As a consequence, despite a recessionary economy over the past 3 years, the number of Chapter 11 cases filed has steadily decreased. The question remains whether this new dynamic and the decreased effectiveness and utilization of Chapter 11 is in the best interests of the nation.