COVID-19 and Quick 363 Bankruptcy Sales

By Kenneth A. Rosen

The federal bank regulators overseeing banks have issued a statement endorsing workouts prompted by the coronavirus. Loans that would typically be classified as Troubled Debt Restructurings (TDRs) might not receive such classification under certain conditions. For instance, if the workout was necessitated by the pandemic and the loan was in good standing as of December 31, 2019. The government's clear intent is to emphasize the benefits of workouts or restructurings over liquidation or litigation, as value is often severely diminished in bankruptcy or liquidation scenarios.

However, a significant issue arises. In recent years, Chapter 11 has increasingly transformed into the sale chapter of the bankruptcy code rather than the reorganization chapter. This shift could have far-reaching implications, especially considering the expected wave of bankruptcies due to the economic shocks caused by COVID-19.

Contrary to the government's statements that restructurings, a primary goal of Chapter 11, are beneficial for the national economy, the trend suggests that unsecured trade creditors may receive considerably less than anticipated from Chapter 11 cases involving their customers. This is particularly concerning for vendors supplying goods to department stores, food service products to restaurants, or raw materials to manufacturers, especially those facing challenges in receiving payments.

The root of the problem lies in Section 363 of the bankruptcy code, originally designed as a mechanism for debtors to sell assets outside the ordinary course of business, particularly when quick action is essential to prevent asset depreciation, such as perishable goods in a supermarket.

However, even before our current economic challenges, debtors have been pressured by lenders to justify accelerated 363 sales. Lenders, usually banks, find it more advantageous to promptly convert debt to equity, credit bid for assets, and restore value without sharing it with other creditors, or to quickly convert collateral to cash and relend the money. Courts, influenced by the perceived need for swift action, have been approving accelerated 363 sales even when critical questions remain unanswered.

For creditors grappling with their own financial challenges during the pandemic shutdown and beyond, this situation is alarming.

How Section 363 Deviated

Traditionally, in reorganizations, creditors could anticipate a dividend resulting from debtor reorganization efforts, such as downsizing, debt reduction, eliminating unprofitable product lines, or exiting specific geographic markets. However, with the surge in accelerated 363 sales processes to accommodate lenders, this is no longer the case. On day one of the bankruptcy proceedings, or soon after, debtors present a distressing narrative, emphasizing substantial pre-bankruptcy losses. However, rather than pursuing a comprehensive reorganization, the debtor opts for a quick sale.

For instance, the case of General Motors (GM) set a precedent, highlighting that 363 sales of substantial going concern assets are permissible even in a "mega" case. GM's assets were sold to "newco," followed by a liquidating plan of reorganization. This pattern has become typical in Chapter 11 cases.

Bankruptcy judges are often presented with limited information and asked to believe that a quick sale is essential to preserving jobs. Unfortunately, they are reluctant to question a lender's or debtor's urgency, resulting in an increasing number of accelerated 363 sales.

Overlooking Chapter 11's Objectives

It's crucial to recall that Chapter 11 is an alternative to a secured creditor's exercise of state law remedies and is designed to facilitate obtaining greater value for collateral than what the lender would achieve through foreclosure. Some argue that if a lender opposes a genuine reorganization that could benefit unsecured creditors, the lender should pay a price by carving out a recovery for unsecured creditors. However, this is unlikely to occur, especially in an economic downturn.

Despite the challenges, there are ways to enhance the situation. Judges, along with attentive creditors' committees, can act as watchdogs to prevent debtors from exploiting Chapter 11 without pursuing genuine reorganization efforts. Additionally, lenders can incorporate the risks of Chapter 11 into the pricing of their loans or by requiring the initiation of Chapter 11 cases sooner.

Bankruptcy judges should prioritize the statutory goals of Chapter 11 and acknowledge the federal government's desire for restructurings. They should delve deeper into understanding why the debtor couldn't be downsized within Chapter 11, why expenses couldn't be further reduced, or why Chapter 11 tools couldn't facilitate reorganization. Until such changes occur, unsecured creditors should be vigilant, as they are likely to receive minimal recovery when companies they serve end up in Chapter 11.