Creditor Committees in 'Meltdown' Chapter 11 Cases

After Chapter 11 is filed by a distressed business, unsecured creditors and the committees that represent their interests are thrust into a case with a secured lender that is completely underwater. This is very different from most pre-recession situations where collateral values were arguably close enough for unsecured creditors to have an immediate stake in the case, even if the lender appeared to be potentially undersecured. However, now in a great deal of Chapter 11 cases, secured lenders are so undersecured that they naturally dominate the cases and have been taking over the role that committees have traditionally played in keeping debtor excesses in check (and keeping lenders in check for that matter).

Committees and their advisers, therefore, can now find themselves struggling to have a voice in an ever increasing number of these “melt down” Chapter 11 cases and are facing additional factors that are restricting them from even obtaining the voice needed to adequately represent their constituencies.

Cash Collateral and the Statutory Dilemma

A recent trend in such cases has started to emerge, where lenders are unwilling to grant any sharing of a “carve-out” under cash collateral authorization and/or postpetition financing arrangements with the professionals retained by creditor committees (or even in some cases not permitting any carve-out for the debtor's professionals). Essentially, what this does is hamstring a committee and prevent it from carrying out its statutory duties under section 1103(c) of the Bankruptcy Code, which charges committees with the duty to conduct the appropriate investigation of the debtor's affairs and its relationship with its lender. Such a trend is an alarming development for committees and possibly even the Chapter 11 system as a whole. The legality of permitting a debtor's use of cash collateral when there is “disparate treatment” of the committee and its professionals is questionable and some bankruptcy courts around the country even have local rules prohibiting or greatly restricting disparate treatment of committees through cash collateral authorizing or postpetition financing arrangements. For example, the Southern District of Florida has Guidelines for Motions Seeking Authority to Use Cash Collateral and Motions Seeking Approval of Postpetition Financing which provides parties with specific rules for provision of carve-outs and dictates limited availability of cash collateral under financing orders that discriminate against parties, especially statutory committees. In 1998, then Chief Judge Peter J. Walsh of the U.S. Bankruptcy Court for the District of Delaware issued his Letter of the Honorable Peter J. Walsh to Delaware Bankruptcy Counsel, dated April 2, 1998 (the “Walsh Letter”) on the very same subject. The Walsh Letter provided detailed and in-depth guidance to practitioners, setting forth requirements for cash collateral authorization and/or postpetition financing in the Delaware Bankruptcy Court. What these courts recognize is the “pay to play” concept that has traditionally existed in Chapter 11 cases. The “pay to play” concept means that to achieve a result for secured creditors in Chapter 11 case, administrative expenses must be paid, including those related to adequate representation for creditors through a statutory committee. As set forth in the Walsh Letter requirements or the Delaware Bankruptcy Court to date:

[c]arveouts for professional fees should not be limited to the debtor's professionals, but should include the professionals employed by any official committee. While the careveout for professionals of any official committee may appropriately exclude work related to the prosecution of an objection to the prepetition secured position of the lender, that exclusion should not encompass any prechallenge investigative work of professionals. The carveout for committee professionals and the limited period to challenge the lender's prepetition secured position is important. In my view it is the price of admission to the bankruptcy court to obtain the benefits of preserving the assets of the estate, which preservation typically first benefits secured parties.

Walsh Letter, at 5 11 & 12. (emphasis added)

Some courts have opined that, beyond merely restricting the activities of a committee, broad systemic issues are raised by restricting the tasks to be undertaken by the committee's professionals. The Bankruptcy Court for the Southern District of New York has stated that:

A failure to provide a reasonable sum for professionals has, in other cases before this Court, left estates, creditors' committees and trustees without the assistance of counsel and the Court without the adversary system contemplated by Congress in 1978 when it, in enacting the Bankruptcy Code, recast the role of bankruptcy judges principally to one of resolving disputes.

See In re Ames Dep't Stores, 115 B.R. 34, 40 (Bankr. S.D.N.Y. 1990).

Similarly, to permit a debtor's professionals to be paid fees and expenses incurred in Chapter 11 while not providing for payment to committee professionals is most likely a violation of section 726(b) of the Bankruptcy Code and certainly raises the spectre of administrative insolvency of a bankruptcy estate:

One overarching object of the Bankruptcy Code is equality of distribution to like situated creditors. An expression of this policy is found at 11 U.S.C. ' 726(b), which provides in essence that all claimants, including administrative claimants, whose claims are accrued in the same Chapter 11 shall be reimbursed pro rata. Consistent with this policy, all administrative expenses are on parity as to payment.In other words, to allow [d]ebtor's counsel to collect more than the other administrative claimants is a violation of the equality of distribution required under 11 U.S.C. ' 726(b). There is no priority among administrative claimants.

In re Specker Motor Sales Company, 289 B.R. 870, 827 (Bankr. D.N.J. 2003) (quoting Central States, Southeast and Southwest Areas Pension Fund v. Robbins (In re Interstate Motor Freight System IMFS, Inc.), 71 B.R. 741, 744 (Bankr. W.D. Mich. 1987)).

The remedy for a failure to comply with section 726(b) is disgorgement by professionals and other parties that receive payment of postpetition claims, while other similar claims were not paid. See Id. at 872-873; see also In re Channel Master Holdings, Inc., 309 B.R. 855, 860 (Bankr. D. Del. 2004). In Channel Master, the court held that the existence of a cap in a postpetition financing order on committee professional fees did not limit the allowance of payment of fees to such professionals. Channel Master, 309 B.R. at 860. “A court has the inherent power to direct disgorgement of fees by any professional and to redistribute those disgorged fees among all professionals in order to assure that none receives more than its pro rata share.” Id.; see also In re Lockwood Corp., 216 B.R. 628, 636 (Bankr. D. Neb. 1997) (explaining that interim compensation is subject to disgorgement when estate is administratively insolvent).

All of this begs the question, that if the Bankruptcy Code requires equal treatment and the courts have the power to order disgorgement of professional fees paid in order to achieve such equal treatment, what is the point of approving use of cash collateral and/or postpetition financing that approves disparate treatment of creditor committees? Furthermore, if a debtor's estate cannot provide for payment of its administrative expenses at the outset of a case, then it is administratively insolvent and should not be in Chapter 11. Secured lenders will always have their state law rights with respect to their collateral package and they can enforce such rights in state court. However, if secured lenders want to enjoy the benefits of the Bankruptcy Code, such as waivers of collateral surcharge rights under section 506(c) of the Bankruptcy Code and the economy of having everything resolved in one jurisdiction, then they must incur the burdens as well. Creating restrictions on statutorily appointed committees by controlling the purse strings of a case to discriminate against a committee and impede it from carrying out its statutory duties is dangerous precedent and unnecessarily threatens the goals and objectives of Chapter 11 and the Bankruptcy Code.

Conclusion

The landscape has changed such that in a great many more circumstances in Chapter 11s, the only party to gain is a secured creditor, most of which are increasingly unwilling to share the expenses incurred creating benefits gained from Chapter 11. Committee's and their professionals need to be ever vigilant against secured creditor and debtor over-reaching and develop creative ways to obtain value for unsecured creditors in these most difficult cases. Furthermore, all parties need to be cognizant of the fact that there may be some cases now that do not and cannot further the goals of Chapter 11 and the parties need to be prepared to take the necessary steps to deal with such cases.

Joshua Klein is an attorney in the Philadelphia office of Fox Rothschild LLP Financial Restructuring & Bankruptcy practice group. His practice encompasses a variety of areas related to insolvency and bankruptcy issues. He may be reached at 215-299-2723 or [email protected].

Due to a number of forces, most importantly the global recession and the resulting global macroeconomic conditions, creditor committees are now having difficulty in finding their role in many Chapter 11 cases.

Many factors, including rapid declines in asset values, means that many secured lenders find themselves holding loans that are vastly under-collateralized. At the same time, the credit markets have all but dried up and companies in distress are being left with virtually no opportunities to refinance their debt, even if they haven't experienced a significant decline in the value of their assets. When this is coupled with the loss of cash flows that many businesses are experiencing as a result of the global recession, a great number of companies that would have previously survived difficult times are left with little choice other than to seek protection under Chapter 11. Exacerbating these circumstances is that many banks and other lenders have found that now is the most opportune time to shed underperforming loans regardless of the loss they incur in order to clean up their balance sheets. This means that certain lenders are more inclined to want to just get out, regardless of the losses realized.

A poignant example of this are real estate developers and home builders. The rapid decline in property values and the sharp decrease in homebuyers has led many developers to drastically reduce the prices of the homes they are building and selling. However, builders must still pay mortgage releases to their lenders under construction loans that were entered into when property values were much higher. Thus, their margins disappear rapidly and they end up with negative cash flows in a very short period of time.

After Chapter 11 is filed by a distressed business, unsecured creditors and the committees that represent their interests are thrust into a case with a secured lender that is completely underwater. This is very different from most pre-recession situations where collateral values were arguably close enough for unsecured creditors to have an immediate stake in the case, even if the lender appeared to be potentially undersecured. However, now in a great deal of Chapter 11 cases, secured lenders are so undersecured that they naturally dominate the cases and have been taking over the role that committees have traditionally played in keeping debtor excesses in check (and keeping lenders in check for that matter).

Committees and their advisers, therefore, can now find themselves struggling to have a voice in an ever increasing number of these “melt down” Chapter 11 cases and are facing additional factors that are restricting them from even obtaining the voice needed to adequately represent their constituencies.

Cash Collateral and the Statutory Dilemma

A recent trend in such cases has started to emerge, where lenders are unwilling to grant any sharing of a “carve-out” under cash collateral authorization and/or postpetition financing arrangements with the professionals retained by creditor committees (or even in some cases not permitting any carve-out for the debtor's professionals). Essentially, what this does is hamstring a committee and prevent it from carrying out its statutory duties under section 1103(c) of the Bankruptcy Code, which charges committees with the duty to conduct the appropriate investigation of the debtor's affairs and its relationship with its lender. Such a trend is an alarming development for committees and possibly even the Chapter 11 system as a whole. The legality of permitting a debtor's use of cash collateral when there is “disparate treatment” of the committee and its professionals is questionable and some bankruptcy courts around the country even have local rules prohibiting or greatly restricting disparate treatment of committees through cash collateral authorizing or postpetition financing arrangements. For example, the Southern District of Florida has Guidelines for Motions Seeking Authority to Use Cash Collateral and Motions Seeking Approval of Postpetition Financing which provides parties with specific rules for provision of carve-outs and dictates limited availability of cash collateral under financing orders that discriminate against parties, especially statutory committees. In 1998, then Chief Judge Peter J. Walsh of the U.S. Bankruptcy Court for the District of Delaware issued his Letter of the Honorable Peter J. Walsh to Delaware Bankruptcy Counsel, dated April 2, 1998 (the “Walsh Letter”) on the very same subject. The Walsh Letter provided detailed and in-depth guidance to practitioners, setting forth requirements for cash collateral authorization and/or postpetition financing in the Delaware Bankruptcy Court. What these courts recognize is the “pay to play” concept that has traditionally existed in Chapter 11 cases. The “pay to play” concept means that to achieve a result for secured creditors in Chapter 11 case, administrative expenses must be paid, including those related to adequate representation for creditors through a statutory committee. As set forth in the Walsh Letter requirements or the Delaware Bankruptcy Court to date:

[c]arveouts for professional fees should not be limited to the debtor's professionals, but should include the professionals employed by any official committee. While the careveout for professionals of any official committee may appropriately exclude work related to the prosecution of an objection to the prepetition secured position of the lender, that exclusion should not encompass any prechallenge investigative work of professionals. The carveout for committee professionals and the limited period to challenge the lender's prepetition secured position is important. In my view it is the price of admission to the bankruptcy court to obtain the benefits of preserving the assets of the estate, which preservation typically first benefits secured parties.

Walsh Letter, at 5 11 & 12. (emphasis added)

Some courts have opined that, beyond merely restricting the activities of a committee, broad systemic issues are raised by restricting the tasks to be undertaken by the committee's professionals. The Bankruptcy Court for the Southern District of New York has stated that:

A failure to provide a reasonable sum for professionals has, in other cases before this Court, left estates, creditors' committees and trustees without the assistance of counsel and the Court without the adversary system contemplated by Congress in 1978 when it, in enacting the Bankruptcy Code, recast the role of bankruptcy judges principally to one of resolving disputes.

See In re Ames Dep't Stores, 115 B.R. 34, 40 (Bankr. S.D.N.Y. 1990).

Similarly, to permit a debtor's professionals to be paid fees and expenses incurred in Chapter 11 while not providing for payment to committee professionals is most likely a violation of section 726(b) of the Bankruptcy Code and certainly raises the spectre of administrative insolvency of a bankruptcy estate:

One overarching object of the Bankruptcy Code is equality of distribution to like situated creditors. An expression of this policy is found at 11 U.S.C. ' 726(b), which provides in essence that all claimants, including administrative claimants, whose claims are accrued in the same Chapter 11 shall be reimbursed pro rata. Consistent with this policy, all administrative expenses are on parity as to payment.In other words, to allow [d]ebtor's counsel to collect more than the other administrative claimants is a violation of the equality of distribution required under 11 U.S.C. ' 726(b). There is no priority among administrative claimants.

In re Specker Motor Sales Company, 289 B.R. 870, 827 (Bankr. D.N.J. 2003) (quoting Central States, Southeast and Southwest Areas Pension Fund v. Robbins (In re Interstate Motor Freight System IMFS, Inc.), 71 B.R. 741, 744 (Bankr. W.D. Mich. 1987)).

The remedy for a failure to comply with section 726(b) is disgorgement by professionals and other parties that receive payment of postpetition claims, while other similar claims were not paid. See Id. at 872-873; see also In re Channel Master Holdings, Inc., 309 B.R. 855, 860 (Bankr. D. Del. 2004). In Channel Master, the court held that the existence of a cap in a postpetition financing order on committee professional fees did not limit the allowance of payment of fees to such professionals. Channel Master, 309 B.R. at 860. “A court has the inherent power to direct disgorgement of fees by any professional and to redistribute those disgorged fees among all professionals in order to assure that none receives more than its pro rata share.” Id.; see also In re Lockwood Corp., 216 B.R. 628, 636 (Bankr. D. Neb. 1997) (explaining that interim compensation is subject to disgorgement when estate is administratively insolvent).

All of this begs the question, that if the Bankruptcy Code requires equal treatment and the courts have the power to order disgorgement of professional fees paid in order to achieve such equal treatment, what is the point of approving use of cash collateral and/or postpetition financing that approves disparate treatment of creditor committees? Furthermore, if a debtor's estate cannot provide for payment of its administrative expenses at the outset of a case, then it is administratively insolvent and should not be in Chapter 11. Secured lenders will always have their state law rights with respect to their collateral package and they can enforce such rights in state court. However, if secured lenders want to enjoy the benefits of the Bankruptcy Code, such as waivers of collateral surcharge rights under section 506(c) of the Bankruptcy Code and the economy of having everything resolved in one jurisdiction, then they must incur the burdens as well. Creating restrictions on statutorily appointed committees by controlling the purse strings of a case to discriminate against a committee and impede it from carrying out its statutory duties is dangerous precedent and unnecessarily threatens the goals and objectives of Chapter 11 and the Bankruptcy Code.

Conclusion

The landscape has changed such that in a great many more circumstances in Chapter 11s, the only party to gain is a secured creditor, most of which are increasingly unwilling to share the expenses incurred creating benefits gained from Chapter 11. Committee's and their professionals need to be ever vigilant against secured creditor and debtor over-reaching and develop creative ways to obtain value for unsecured creditors in these most difficult cases. Furthermore, all parties need to be cognizant of the fact that there may be some cases now that do not and cannot further the goals of Chapter 11 and the parties need to be prepared to take the necessary steps to deal with such cases.

Joshua Klein is an attorney in the Philadelphia office of Fox Rothschild LLP Financial Restructuring & Bankruptcy practice group. His practice encompasses a variety of areas related to insolvency and bankruptcy issues. He may be reached at 215-299-2723 or [email protected].