SUMMARY OF CHAPTER 11 PROCEDURES AND PROCESS

Presented to

The Virginia Bar Association 11th Annual Corporate Counsel

Fall Forum

By David K. Spiro, Esquire

Robert S. Westermann, Esquire Sheila deLa Cruz, Esquire

www.hf-law.com

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SUMMARY OF CHAPTER 11 PROCEDURES AND PROCESS

This Executive Summary discusses the significant procedural requirements in a case

under Chapter 11 of the United States Bankruptcy Code and the Chapter 11 process. It is intended to provide a review of general legal principles and business practices as a basis for further discussion and inquiry.

TABLE OF CONTENTS

I. OVERVIEW

II. COMMENCEMENT OF THE CASE

III. EFFECT ON OPERATIONS AND FINANCES

A. Preservation of the Status Quo

B. Continuation of Business in the Ordinary Course

C. Adverse Consequences of the Commencement of a Chapter 11 Case

IV. THE DEBTOR IN POSSESSION

V. OTHER MAJOR PARTICIPANTS IN THE CASE

A. Secured Creditors

B. Lessors and Parties to Executory Contracts

C. The United States Trustee

D. The Creditors’ Committee

E. Other Committees

F. The Chapter 11 Trustee and Examiner

G. Governmental Entities

VI. SPECIAL SITUATIONS AND CONSIDERATIONS

A. Employee Relations

B. Relief From Stay

C. Financing Post-Petition Operations

D. Key Vendors

E. Executory Contracts and Leases

F. Commercial Real Property and Equipment Leases

G. Preferences and Fraudulent Transfers

H. Pending Litigation

I. Taxes

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VII. PLAN OF REORGANIZATION AND CONFIRMATION

A. Confirmation of a Plan

B. Plan Components

C. Plan Distribution Schemes

D. Plan Funding

E. Confirmation Standards

F. Confirmation Without Acceptance by an Impaired Class (“Cramdown” Plan)

G. Issuance of Securities

H. Effect of Confirmation

I. Modification of a Plan

J. Post Confirmation Events

VIII. CHAPTER 11 CASE CHRONOLOGY

IX. SUMMARY

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I. OVERVIEW

A Chapter 11 case is governed by the United States Bankruptcy Code, a federal statute,

and is heard in the United States Bankruptcy Court which is a federal court. The objective of most Chapter 11 cases is to realize the maximum economic value of a business enterprise, usually by the restructure of its debt and business operations, and to distribute that value to holders of claims and interests.

Some of the most successful Chapter 11 cases are those commenced for the purpose of implementing a restructuring that has been agreed to by the major parties in interest prior to the commencement of the case. However, many Chapter 11 cases are commenced by businesses faced with situations that threaten the survival of the enterprise and for which there is no immediate, agreed-upon solution. A Chapter 11 case can provide management with the opportunity to maintain business operations under the legal protections and restriction of Chapter 11 while working solutions to the problems that caused the filing.

The goal of most Chapter 11 cases is confirmation by the Bankruptcy Court of a plan of reorganization that incorporates a feasible business plan and implements a new capital structure by the distribution of cash, notes, or stock on account of prior creditor claims and shareholder interests. A Chapter 11 plan may provide for the continued operation of the business enterprise or the liquidation of the assets and operations of the debtor and a distribution of the proceeds. If the plan is accepted by the requisite classes of creditors and shareholders and is confirmed by the court, it is binding on all creditors and shareholders whether or not they have accepted the plan of reorganization.

II.

COMMENCEMENT OF THE CASE

A voluntary Chapter 11 case is commenced by the filing of a Chapter 11 petition with the United States Bankruptcy Court which is an adjunct of the United States District Court. All Chapter 11 cases are automatically referred by the District Court to the Bankruptcy Court under a local rule or general order. Within certain time limits, a party in interest, including the debtor, may seek a withdrawal of the reference and a return or the entire case, or of a specific proceeding or matter in the case, to the District Court. Such requests are rarely granted.

As a general matter, corporations, partnerships and individuals which have a domicile, place of business, or property in the United States are eligible for Chapter 11 relief. The Chapter 11 case may be commenced in the district where the debtor has its domicile, residence, principal place of business, principal place of assets or where an affiliates case is pending. Certain enterprises are not eligible for Chapter 11 relief, including insurance and banking institutions, stock brokers, and commodity brokers. A judicial determination of eligibility for Chapter 11 relief is not required for the commencement of a voluntary Chapter 11 case; only a board resolution is required. A business does not need to be insolvent to file a voluntary Chapter 11 petition but, typically, the enterprise is experiencing or anticipates difficulty in satisfying its obligations as they come due.

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An involuntary Chapter 11 case may be commenced against a business entity not engaged in farming by the filing of an involuntary petition by three or more creditors. An involuntary petition may be contested by the debtor but the fact of the filing materially restricts its ability to conduct business. If a Chapter 11 case is inevitable, there are advantages to commencing the case by voluntary petition rather than waiting for the filing of an involuntary petition by creditors. A Chapter 11 petition filed by or on behalf of a partnership without the consent of all general partners is treated as an involuntary petition.

III.

EFFECT ON OPERATIONS AND FINANCES

Upon the filing of a voluntary Chapter 11 petition, the operations, assets, and liabilities of the debtor entity are subject to the control of the Bankruptcy Court, consistent with the provisions of the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure. These provisions are intended to preserve the status quo, to permit the continued operation of the business in the ordinary course, to protect the interests of creditors, and, where feasible, promote a rehabilitation of the debtor.

A. Preservation of the Status Quo

There are four major parts of the Bankruptcy Code which contribute to the preservation of the status quo: the automatic stay, the prohibition of payment of pre-petition debt, the preservation of certain legal rights and causes of action, and the ability to avoid certain pre-petition transfers.

1. The filing of the Chapter 11 petition operates as an automatic stay of almost all actions against the debtor and its property, including lawsuits, lien enforcement by secured creditors and repossession by lessors, and other creditor action, whether or not such actions would have been taken in a court proceeding or out of court. The automatic stay is intended to protect the debtor and its property from all collection efforts, creditor harassment, foreclosure actions, and seizures of property and to preserve the status quo pending formulation and confirmation of the plan of reorganization. The automatic stay remains in effect for the duration of the reorganization process unless modified or terminated by order of the Bankruptcy Court aver notice and a hearing. A secured creditor may request the Court to require adequate protection which may include cash payments, the giving of substitute collateral or other actions by the debtor as a condition to maintaining the automatic stay. The automatic stay of pending litigation can significantly reduce the burden on management during the reorganization process and make possible the more efficient resolution of litigation and claims. In most cases litigation will be resolved in the Bankruptcy Court as part of the claim allowance process. Only the debtor is protected by the automatic stay; affiliates, guarantors, officers, directors and shareholders are not protected, although in rare cases such persons or entities may be protected temporarily by a retraining order. The automatic stay does not apply to a criminal action against the debtor or to certain other actions, including governmental, police or regulatory actions.

2. The second part of the Bankruptcy Code which contributes to the preservation of the status quo is the prohibition of payment of obligations and debts incurred for goods received

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or services rendered before the Chapter 11 petition. Such obligations are payable only in accordance with the terms of a confirmed plan of reorganization. The only exceptions to this general prohibition are payments that are authorized by an express prior order of the Bankruptcy Court, payments made in connection with assumed executory contracts (see Part VI.E. below), and the payment of certain obligations secured by liens upon assets of the Chapter 11 estate (see subsection B, below).

3. An important part of the preservation of the status quo is the preservation of certain legal rights and causes of action. For example, contract provisions for automatic or optional termination of the contract in the event of a bankruptcy filing (so-called “ipso facto clauses”) are not generally effective. Statutes of limitation with respect to causes of action (existing as of the filing date) are automatically extended for a limited period of time. Finally, the automatic stay may be held to bar the termination of a contract even where it has been breached by the debtor.

4. Finally, consistent with the equality of treatment policy, the Bankruptcy Code contains provisions which permit the debtor or trustee to avoid certain pre-petition transfers or obligations (see Part VI.G. below).

B. Continuation of Business in the Ordinary Course

Unless the court orders otherwise, the debtor is authorized to conduct its business in the ordinary course. This authorization permits the payment or satisfaction of obligations or debts for goods received or services rendered (other than by professionals) after the commencement of a Chapter 11 case. It also permits, but may not require, the payment of obligations and debts incurred before the Chapter 11 petition was filed if such obligations are secured by liens upon assets of the estate and if the value of the collateral exceeds the amount of the debt. Payments due under contracts entered into prior to the petition may be made only to the extent that post petition goods and services have been received under those contracts. Any pre-petition obligations under such contracts are treated as any other unsecured obligation and may not be paid without express court authorization.

The authorization of the debtor to conduct its business is subject to restrictions which protect the interests of creditors and their rights to payment by requiring prior Bankruptcy Court approval of certain transactions. The following are examples of the types of transactions that are not considered to be within the ordinary course of business and should not take place without prior court approval: Borrowing money; signing promissory notes, deeds of trust, or mortgages; retaining or paying attorneys, accountants, brokers, or other professionals; renewing, assigning, or terminating leases or license agreements; purchasing or selling significant capital assets; granting security interests or signing financing statements (form UCC-1) or continuation statements for existing security interests (form UCC-2); permitting secured creditors or lessors to repossess equipment or other property; settling lawsuits; abandoning assets; assuming, assigning, or rejecting leases or license agreements; and other transactions out of the ordinary course of business. Failure to comply with these restrictions may subject the debtor to sanctions such as the dismissal of the Chapter 11 case, conversion of the case to a case under Chapter 7 of the Bankruptcy Code (under which a trustee takes title to, and liquidates, the assets), or the appointment of a Chapter 11 trustee or examiner.

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C. Adverse Consequences of the Commencement of a Chapter 11 Case

Untroubled enterprises do not commence Chapter 11 cases. Often the commencement of a Chapter 11 case is little more than the final public acknowledgment of the financial distress already recognized by the trade, customers and the media. Nonetheless, the legal and business consequences that Chapter 11 may trigger as a public acknowledgment of this situation should be anticipated and be the subject of careful planning.

For example, the filing of a Chapter 11 petition will be an event of default under most contractual and financial arrangements including lines of credit, mortgages, customer and vendor agreements, real and personal property leases, and guaranties. The automatic stay and other provisions of the Bankruptcy Code are intended to prevent the enforcement of remedies on account of such defaults but do not require creditors or lenders to extend new credit or financial accommodations. Thus, as discussed more fully below, a common problem in many Chapter 11 cases is maintaining the cash flow required for operations. This cash flow problem is sometimes alleviated by post-petition financing (see Part VI.C. below).

Upon the commencement of the Chapter 11 case, the debtor suddenly experiences “life in the fishbowl”, its operations and finances are subject to outside scrutiny, review and criticism. The debtor is required to file monthly operating reports and to provide information regarding assets, liabilities, and operations. Intercompany transactions and cash management practices normally considered routine may be restricted, require specific court approval, or need substantial modification. A creditors’ committee may inquire into the debtor’s operations and demand justification for the actions being taken and may ultimately oppose requests for court approval of proposed actions or seek orders limiting the debtors operations.

There are risks and costs associated with the commencement or a Chapter 11 case by a business enterprise. These range from the loss of control, as represented by the operational and financial restrictions discussed above, to interaction with one or more official creditors’ or equity security holders’ committees, and, possibly, to the appointment of an examiner with broad investigative authority or the appointment of a Chapter 11 trustee with complete control of the rights, operations and assets of the debtor.

Chapter 11 cases usually require substantial legal and other professional services at the expense or the debtor. Each official committee will ordinarily be authorized to employ its own professionals, subject to court approval. These professionals will include attorneys and may include accountants, appraisers, investment bankers, or consultants, all of whom must be paid by the debtor from funds of the Chapter 11 estate. Their fees, as well as fees and expenses of the debtor’s professionals, are expenses of administration which must be paid in cash no later than upon confirmation of a Chapter 11 plan, although interim payments are usually made pursuant to court order. Normally, the debtor is not liable for the fees of attorneys representing unsecured creditors, other than official committee counsel, unless the debtor is solvent. Fees for counsel for secured creditors may also have to be paid if the value of their collateral exceeds the debt that it secures.

While interest on unsecured claims is ordinarily suspended in a Chapter 11 case and ultimately not paid, where the estate is solvent it may be necessary to pay all accrued interest.

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Under certain circumstances interest may have to be paid in connection with the Chapter 11 plan where a class of claims rejects the plan.

After a voluntary Chapter 11 case is filed, it cannot be dismissed unless the Court finds that cause exists or that dismissal would be in the best interests of the debtor and creditors. A Chapter 11 case may be subject to a motion to dismiss on the grounds that the case was brought in bad faith or for an improper purpose.

A failed Chapter 11 case is often converted to a Chapter 7 case or results in the appointment or election of a trustee in Chapter 11 who will take control of company assets and operations. Most Chapter 7 cases are non-operating liquidations conducted by a court-appointed or creditor-elected trustee with little knowledge of the operation of the business of the debtor. Such cases rarely result in a return to equity holders and may take an extended period of time before there is any return to creditors. Debtors and their counsel should be aware that, in the event of conversion of a Chapter 11 case to Chapter 7 or the appointment of a Chapter 11 trustee, the attorney-client privilege may be lost.

IV.

THE DEBTOR IN POSSESSION

Upon the commencement of a Chapter 11 case, absent circumstances that would warrant the appointment of a trustee, the management of the debtor retains control or the debtor’s assets and operations and is expected to continue normal business activities subject to the restrictions of the Bankruptcy Code, Bankruptcy Rules and the orders of the Bankruptcy Court. The debtor entity becomes the “debtor in possession” and management becomes a fiduciary for the benefit of creditors and must conduct itself accordingly. The policy of the Bankruptcy Code is to retain existing management and board of directors of a Chapter 11 debtor, but the court may limit the authority of management to act or may appoint a trustee or examiner if good cause is shown.

The power and the authority of management and the board of directors to direct the conduct of business is an important aspect of a Chapter 11 case. Unless otherwise ordered by the Court, the debtor in possession is authorized to maintain business operations. On matters within the ordinary course of business, management has discretion to exercise its reasonable business judgment in good faith. As a practical matter, the Court will be reluctant to impose its business judgment over that of management absent a clear showing of cause.

The debtor in possession has all the rights, powers, functions and duties (with certain limited exceptions) of a Chapter 11 trustee. Thus without further order of the Court, the debtor in possession may:

1. Operate the business;

2. Receive the benefits of the automatic stay;

3. Except for cash collateral, enter into transactions including the sale or lease of its property in the ordinary course of business and use its property in the ordinary course of business;

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4. Obtain unsecured credit and incur unsecured debt in the ordinary course of business;

5. Commence or prosecute actions to recover property or avoid liens on property of the estate; and

6. Receive benefits of the extension of time of various periods of limitation.

A debtor in possession is obligated to perform certain specified duties, including:

1. File a list of creditors and other required financial information;

2. Appear and submit to examination under oath at the official meeting of creditors;

3. Maintain money of the estate in debtor-in-possession or “D.I.P.” accounts;

4. Comply with laws regarding withholding, collection, and payment of taxes;

5. Be accountable for all property received by the estate;

6. Examine proofs of claim and object to allowance of improper claims;

7. Furnish information concerning the case and its administration as requested by a party in interest;

8. File with the Court and appropriate taxing agencies periodic reports of the operation of its business, including a statement of receipts and disbursements;

9. Make a final report and file a final account of the administration of the estate;

10. File tax returns;

11. File, as soon as practicable, a plan, or recommend conversion to Chapter 7 or dismissal of the case; and

12. File reports after confirmation of a plan as necessary or as ordered by the Court.

Additional duties may be imposed on the debtor in possession pursuant to court order, the Office of the United States Trustee, local rule or practice. For example, except as authorized by special court order, the Chapter 11 debtor is required to close bank accounts and books on the date of the filing and open new accounts and books as “debtor-in-possession”.

In a Chapter 11 case the responsibility of the board of directors expands to include the interests of creditors. As noted, a number of transactions that are normally within the discretion of management or the authority of the board will require prior court approval and/or notice to creditors. The management of the debtor in possession is responsible for the conduct of the business affairs of the estate. To the extent that a transaction is outside the ordinary course of business or involves a matter that requires court approval, such as the property of the estate, or

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other actions described in Part III.B. of this memorandum, court approval must be sought and obtained before the transaction may proceed.

The rights of shareholders to be represented by directors of their own choice and to thus control corporate policy is not always recognized in Chapter 11 cases. Some Bankruptcy Courts have refused to require annual meetings while others have required strict compliance with state and federal corporate and securities laws. Equity owners are on the bottom rung of the priority ladder and this is often reflected in the decisions of the Bankruptcy Court on operational and financial matters.

V.

OTHER MAJOR PARTICIPANTS IN THE CASE A. Secured Creditors

Creditors who have obtained valid pre-petition liens on or security interests in assets of the debtor are entitled to special treatment during the Chapter 11 case. Pre-petition liens granted by the debtor to secure obligations or obtained by creditors by legal process are usually valid in the Chapter 11 case. The automatic stay is intended to prevent the exercise of secured creditor remedies such as the repossession or sale of collateral except as expressly authorized by an order of the Bankruptcy Court. The Bankruptcy Code permits the debtor to avoid any transfer or lien that is not adequately perfected before bankruptcy by the proper filing of UCC-1 financing statement, the recording of a lien, or other appropriate steps under state or federal law.

The debtor may use collateral (other than “cash collateral”) of a secured creditor in the ordinary course of business unless the court requires the debtor to provide adequate protection by prohibiting or conditioning the use of collateral. Adequate protection may take the form of periodic cash payments to cover depreciation and interest, replacement collateral, or other treatment. Where the collateral is “cash collateral” it may not be used unless the creditor consents or the Bankruptcy Court approves the use. For purposes of this discussion, “cash collateral” includes cash, checks, instruments, and other cash equivalents that the creditor has a security interest in or that may be proceeds of property subject to the lien, including accounts receivable, rents, or lease revenue. The use of cash collateral is often essential to the continuation of business operations and will have to be addressed in the first few days of a Chapter 11 case. The Bankruptcy Court tends to be particularly careful in authorizing the use of cash collateral since it is the “highest and best” form of collateral.

B. Lessors and Parties to Executory Contracts

Parties who have provided services, property or premises to debtor pursuant to an executory contract or unexpired lease are subject to special restrictions and protections under the Bankruptcy Code. As a general rule, persons who have leases or other contractual relationships with the debtor may not terminate those relationships without court authorization or specific statutory authority under the Bankruptcy Code. So long as the debtor meets certain requirements of the Bankruptcy Code, it may retain the benefit of leases and most contracts and require

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performance by lessors and other contract parties, although exceptions exist. If an operating lease or an employment contract is rejected, the claim for damages will be limited by statute.

C. The United States Trustee

The United States Trustee is an administrative officer who performs administrative functions such as appointing the members of the creditors’ committee, reviewing the employment of attorneys and other professionals, appointing a Chapter 11 trustee (if ordered to do so by the Court), and monitoring the compliance of the debtor with local rules and reporting requirements. The level of activity and involvement of the United States Trustee varies widely among geographic areas and from case to case.

D. The Creditors’ Committee

The Official Creditors’ Committee represents the interests of all unsecured creditors and is appointed by the United States Trustee. The committee, which usually consists of the holders of the seven largest unsecured claims who are willing to serve, can be authorized by the court to employ lawyers, accountants, and other professionals as an expense in the case to be paid by the debtor. The committee, through its professionals, can investigate the financial condition, operations, and the circumstances which led to the filing of the Chapter 11 case. The committee is usually consulted on all matters that require court approval and can be helpful in expediting the administration of the case. The committee will consult with management on the formulation and proposal of a plan of reorganization and, in some cases, may assist in the formulation of corporate policy.

One of the major factors which can contribute to a successful reorganization is a cooperative, open relationship between the debtor and the committee. However, a frequent source of conflict is the desire of the committee for information, advice, and consultation and the need of management to solve problems efficiently consistent with its business objectives and interests.

E. Other Committees

In cases where circumstances warrant and the administrative expenses can be justified, the Bankruptcy Court may order the appointment of other committees, such as committees to represent equity security holders, lessors and tort claimants. The relationships among committees may range from cordial to acrimonious.

F. The Chapter 11 Trustee and Examiner

The appointment of a Chapter 11 trustee usually is the result of the failure of management to sustain the confidence of the court or creditors as to its competence or integrity. A Chapter 11 trustee is usually a stranger to the debtor’s business selected by the United States trustee when the court concludes that there are significant going-concern values to be preserved but management is incapable or unworthy of fulfilling its fiduciary obligations to the estate and other parties in interest. In effect, the Chapter 11 trustee replaces management and the board of directors and seeks to carry out the objectives of Chapter 11. Control and title to all assets,

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operations and rights of the corporation, including the control of attorney-client privilege, passes to the Chapter 11 trustee upon appointment.

The appointment of an examiner is a step short of the appointment of a Chapter 11 trustee. The duties of an examiner do not ordinarily include management of operations, and are usually limited to investigation and reporting to the court although on occasion the examiner may be given expanded duties. An examiner is often appointed in cases where there is suspicion of management misconduct or in cases with substantial public debt or equity.

G. Governmental Entities

Notice of most significant events occurring in the Chapter 11 case must be sent to the Internal Revenue Service and state taxing authorities. If the debtor has issued public debt or has public shareholders, notice is also sent to the Securities and Exchange Commission and state corporate securities agencies. Federal, state and local environmental protection agencies may actively participate in the case.

VI.

SPECIAL SITUATIONS AND CONSIDERATIONS

Every Chapter 11 case is affected by the particular dynamics and circumstances of the specific business enterprise that led to the filing of a petition. Although not present to the same degree in every case, there are certain matters that merit special consideration and planning in most Chapter 11 cases. These matters include employee relations, rights of lienholders, post-petition financing, treatment of key vendors, executory contracts, pre-petition transactions subject to avoidance, significant pending litigation, and tax obligations.

A. Employee Relations

The proper handling of employee relations can be critical to the success of the reorganization effort. Employees who are to be retained after the commencement of the Chapter 11 case need reassurance that they will be paid and that business operations will continue. Post-petition wages and benefits may be paid in the ordinary course, but pre-petition amounts cannot be paid without express court approval. Bankruptcy Courts tend to recognize the important contribution of employees to the reorganization effort and upon a proper request will often authorize payment of wages and benefits accrued immediately prior to the filing which were unpaid as of the petition date up to the maximum statutory priority. Such an authorization can permit the pre-petition payroll account to remain open and continue to function to avoid disruption of employee payroll.

If the debtor is subject to collective bargaining agreements, including multi-employer bargaining units, or other labor arrangements governed by the National Labor Relations Act, action may be taken in the Chapter 11 case to modify, or, in proper instances, to terminate such agreements or policies with court approval. If such relief is contemplated, it must be discussed and carefully planned to comply with the strict statutory requirements for relief.

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Certain employee claims have priority treatment in bankruptcy. Any pension plan that is guaranteed under the Employees Retirement Income Security Act (ERISA) or covered by the Multi-Employer Pension Plan Amendments Act (MEPPA) will require special treatment in a plan. There are procedural and substantive restrictions on the ability of the debtor to modify benefits for retirees and former employees, including those not subject to collective bargaining agreements.

B. Relief From Stay

As noted above, secured creditors are subject to the automatic stay which prevents lien enforcement, foreclosure, or repossession of the property of the debtor. A secured creditor may request relief from the stay to enforce its lien rights. In considering a request for relief from stay, the court will balance the interests of the secured creditor against the interests of the debtor and other creditors to determine whether the stay should be terminated, conditioned, or modified, as is necessary to provide adequate protection to the secured creditor. In most cases, it is prudent to anticipate probable requests for relief and to negotiate court-approved interim agreements to avoid the uncertainty, delay, and expense of prolonged relief from stay disputes.

C. Financing Post-Petition Operations

It is not unusual to have all liquid assets and near-term cash flow be cash collateral that may only be used with the consent of the secured party or by order of the court. The use of cash collateral has much of the same effect as a forced loan. In most cases, it is prudent to contact secured parties with an interest in the cash collateral prior to filing and to negotiate the right to use cash collateral in exchange for additional liens, replacement liens, payment of interest, and other consideration. The agreement for use of cash collateral often includes the grant of a lien on replacement properly acquired post-petition and a super-priority claim for the secured creditor.

An alternative to use of cash collateral is to obtain a line of credit from the existing lender or from a new lender to finance post-petition operations. A number of financial institutions have developed a business of providing post-petition financing on a secured basis, sometimes called “DIP Lending”. Post-petition financing will avoid having the operations of the business hampered by the variations in cash flow, but will almost always require compliance with strict covenants regarding collateral, ratios and disbursements. Post-petition financing requires both the agreement of the lender and the approval of the Court and usually requires the payment of significant fees and an above-average interest rate. Ordinarily the unpaid balance on post-petition financing must be paid in cash at the time of confirmation.

On occasion, circumstances or tactical considerations may not permit pre-petition discussions with creditors holding an interest in cash collateral. If so, other possible sources of operating capital should be explored to prevent a disruption in operations due to a cash shortfall while the issue is being negotiated post-petition.

D. Key Vendors

For purposes of this discussion, a key vendor is one who controls a critical product or service necessary for the conduct of the debtor’s business. Examples include suppliers of proprietary goods, services, or technology, sources that are capacity or quota controlled, utilities,

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and vendors who are difficult to replace, such as current insurance carriers. Often, key vendors require special reassurance that the debtor intends to maintain business operations and to avoid business interruptions may be brought current pre-petition and, in some cases, pre-paid.

Providers of utility services including power, water, and telecommunications are entitled to receive special treatment in the form of adequate assurance of future payment for post-petition utility services. This assurance often is provided in the form of special billing and remittance procedures or deposits. The debtor is required to provide assurance of payment within the first twenty days of the petition or may suffer termination of utility services.

Key vendors, like any other unsecured obligation, may not be paid for pre-petition goods or services after the commencement of the Chapter 11 case without specific court approval. In extreme cases, under compelling circumstances, the debtor may seek authorization from the court to pay a pre-petition obligation, but such requests may not be approved. If a significant problem is anticipated and cash is available to do so before the Chapter 11 case is filed, the debtor may consider making a prepayment or a deposit to key vendors in order to avoid a disruption in business operations. The effect of a possible disruption must be weighed against the adverse effects on cash balances and reaction of other creditors.

E. Executory Contracts and Leases

For purposes of this discussion, an executory contract is an agreement to which the debtor is a party that contains obligations of future performance on both sides. Examples include land sale contracts, option contracts, employment agreements, license and trademark agreements, and most litigation settlement agreements.

Most executory contracts and unexpired leases may be rejected, assumed, or assigned during the pendency of the Chapter 11 case. Contracts for financial accommodations may not be assumed and personal service contracts may not be assigned and in some cases also may not even be assumed. Rejection of an executory contract or unexpired lease terminates the debtor’s obligation to perform, and creates a claim for damages for breach of contract. The damage claim is given the priority of an unsecured pre-petition obligation, although unpaid post-petition amounts, such as rent, may have the priority of an expense of administration.

Assumption of an executory contract or lease affirms the obligation which is then binding on the debtor. To assume, the debtor must satisfy the court that it can cure any past defaults and that there is adequate assurance that the debtor will be able to perform its obligations in the future. Upon assumption, the debtor’s obligations become administrative claims subject to treatment as priority claims. In most instances, a contract may be assigned to a third party after it is assumed.

Contract provisions that automatically cancel or terminate contracts or leases merely because a petition is filed (known as “ipso facto” clauses) or because the debtor has become insolvent are not effective and do not bar assumption or assignment if other requirements are met. There are special protections for shopping center leases, airport facilities leases, certain airplane and vessel leases or liens, installment contracts for real estate purchases, debtor leases to tenants, debtor sale of timeshare interests labor union contracts, and intellectual property

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transfers. Unpaid pre-petition obligations due under executory contracts and leases cannot be paid except upon court approval, usually at the time of the assumption of the specific executory contract or lease. Goods and services provided post-petition can be paid for on a current basis even if they are provided pursuant to the terms of a pre-petition contract. Frequently the debtor will want to defer the decision to assume or reject an executory contract or unexpired lease until the direction of future operations is established. However, the other party to the contract may request an earlier determination and force a court decision on the issue. The Chapter 11 Plan may provide for assumption or rejection of contracts and leases and contracts not rejected under the Plan are deemed assumed.

F. Commercial Real Property and Equipment Leases

Special provisions apply to commercial real property and equipment leases. Leases of non-residential real property are automatically rejected at the end of sixty days after the commencement of the Chapter 11 case unless the time is extended by order of the court. The court can extend the sixty-day time period for the debtor to assume commercial (non-residential) real property leases, if a timely and proper request is made. In addition, the debtor must timely perform all obligations arising under a commercial real property lease after the commencement of the case unless the Court extends the time for performance for a period that may not exceed sixty days.

Under unexpired leases of personal property (other than personal property leased to an individual primarily for personal, family, or household purposes), unless the Court orders otherwise, the debtor must perform all obligations that arise sixty days after the commencement of the Chapter 11 case until such time that the lease is assumed or rejected.

G. Preferences and Fraudulent Transfers

Consistent with the bankruptcy policy of providing equal treatment for similarly-situated creditors, the Bankruptcy Code provides for the recovery of preferences and fraudulent transfers, and the avoidance of certain other interests in the debtor’s property.

A preference is a payment or, or the granting of a lien on account of, a prior unsecured debt that results in the recipient recovering a greater part of its debt than other similarly-situated creditors. The payment or transfer must have occurred within ninety days before the bankruptcy filing or, if the transfer is to an “insider,” within one year before the bankruptcy filing.

There are two types of fraudulent transfers which may be avoided. The first is where the debtor has made a transfer or incurred an obligation within one year before the bankruptcy filing with “actual intent to hinder, delay, or defraud creditors.” The second is where the debtor has received less than reasonably equivalent value for the transfer or incurred obligation at a time when its liabilities exceeded the value of its assets or it was left with unreasonably small capital or unable to pay its debt as they mature. Examples of transactions which may constitute fraudulent transfers or obligations include one-sided sale transactions, gifts, and guaranties for no consideration. Depending upon the applicable state law, in addition to the one year provided by the Bankruptcy Code, the debtor may seek to avoid fraudulent transfers made a number of years before the date or bankruptcy petition.

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It is not uncommon for a debtor to have made transfers that may be avoidable. The debtor and the creditors’ committee in a Chapter 11 case will investigate and disclose material transactions that may be subject to avoidance. Whether or not the actions are pursued may depend on the circumstances of the Chapter 11 case and the desires of the creditors committee and other parties in the case.

H. Pending Litigation

The commencement of a Chapter 11 case also operates as an automatic stay of all pending civil litigation as to the debtor. While the stay is effective without notice, prudence requires that notice of the Chapter 11 case and the automatic stay be given promptly to all parties in litigation with the debtor. Special consideration must be given to cases which are on appeal when the bankruptcy petition is filed.

The automatic stay protects only the debtor. Thus, co-defendants such as corporate subsidiaries, guarantors, general partners, joint venturers, and individuals, including officers and directors, are not protected by the stay. Under appropriate circumstances, it is possible to seek injunctive relief to protect co-defendants during the reorganization effort. If such a need is anticipated, the specific circumstances and objectives should be carefully reviewed.

I. Taxes

There are special tax statutes and rules that are intended to govern the procedural and substantive lights of federal taxpayers who have filed Chapter 11. The tax liability and certain tax attributes of the debtor can be determined by the Bankruptcy Court. Pre-bankruptcy state and federal taxes may be, and all post-petition taxes are, entitled to priority treatment. The tax situation and attributes of the debtor should be reviewed early in the case and may require the assistance of accountants or special tax counsel. The directors and officers of a corporation should be aware that failure to pay or collect certain taxes, such as withholding taxes and, in many states, sales and excise taxes, whether accrued pre petition or post petition, is likely to result in personal liability of officers and directors for the taxes and, in some cases, substantial penalties.

VII.

PLAN OF REORGANIZATION AND CONFIRMATION

The usual goal of a Chapter 11 case is the financial rehabilitation of the debtor and the satisfaction of creditor claims by confirmation of a plan of reorganization. The plan is a contract between the debtor and its creditors by which the debtor deals with its obligations. The plan must be accepted by at least one class of impaired creditors and confirmed by the court. The plan confirmation order is a binding federal court order which determines all issues relating to the plan.

Unless the Court shortens the time or appoints a trustee, only the debtor may propose a plan during the first one hundred twenty days of a case (the “period of exclusivity”). After the expiration of the period of exclusivity, any party in interest including the debtor may file a plan.

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It is possible to request that the period of exclusivity be extended although some courts will not extend the period beyond the first one hundred twenty days. Accordingly, in some cases creditors file and seek confirmation of a plan.

A. Confirmation of a Plan

The process of confirmation of a plan begins with the filing of a plan and a disclosure statement. A hearing is held approximately thirty days after the filing of the disclosure statement to determine whether it provides “adequate information” for creditors, shareholders and other parties to make an informed decision to accept or reject the plan.

If the Bankruptcy Court approves the disclosure statement as providing adequate information, the court fixes a date for a hearing to consider confirmation of the plan. The disclosure statement, the plan and a ballot are then mailed to all creditors, shareholders, and other interested parties. The date for the hearing on confirmation is usually set for thirty to forty-five days after the date the disclosure statement is approved.

At the hearing on confirmation, the Court will receive evidence to determine if the requirements for confirmation have been met. If the requirements are met, the court will confirm the plan, which is then binding on the debtor, creditors and shareholders. A plan may include a delayed effective date to assist in the orderly implementation of the plan after confirmation.

B. Plan Components

A Chapter 11 plan for a debtor continuing in business should be based on a sound business plan that takes into account the reasonable financial and operational prospects of the business, the legal rights of creditors and shareholders and the technical requirements of the Bankruptcy Code. Plans vary widely in form and complexity, but all plans must contain at least four major components:

1. The designation of classes of claims and interests;

2. Identification and description of the treatment of any classes of claims or interests whose rights are impaired;

3. Adequate means for the implementation of the plan.

A plan may also contain other provisions consistent with the plan objectives and the Bankruptcy Code. A Chapter 11 Plan also may provide the sale of the debtor as a going concern or for a liquidation of the debtor.

C. Plan Distribution Schemes

Plans can be based upon a variety of cash distribution schemes as well as the distribution of value in the form of notes and stock.

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1. A Fixed Fund or Fixed Formula Plan

A fixed fund or fixed formula plan, sometimes called a “pot plan,” provides for a predetermined value to be distributed in full satisfaction of one or more classes of creditor claims. An example of a fixed fund plan is where the Debtor proposes to pay $20 million in final satisfaction of all creditor claims in a class regardless of whether the final amount of claims is $30 million or $50 million. In a formula plan the debtor would pay a percentage of its net after-tax profits or excess cash flow over a period of time in full satisfaction of creditor claims in a class. A major advantage of the fixed fund or fixed formula plan is the ability to fix liabilities to creditors independent of the final amount of those claims. The task of objecting to the allowance of claims is usually shifted from the debtor to a representative of creditors, such as a “plan trustee.”

2. A Fixed Dividend

A fixed dividend plan provides for a predetermined recovery by each creditor on account of its claim. A simple example of a fixed dividend plan is where the debtor proposes to distribute consideration equal to a 60% recovery to each unsecured creditor on account of its allowed claim. The consideration may be distributed in the form of cash, notes, or securities, or a combination thereof. A major advantage of the fixed dividend plan is that it enables the individual creditor to determine the amount of its recovery under the plan which can be appealing to creditors voting on the plan. The risk of the final amount of allowed claims remains with the debtor.

3. A Combination Plan

A combination plan incorporates elements of both fixed fund and fixed dividend plans. An example of a combination plan is where the debtor sets dual parameters on its plan obligations, such as when the debtor proposes to pay the lesser of $10 Million or 60% of the allowed amount of all claims in full satisfaction of creditor claims. Combination plans are more complex but may help reconcile the inconsistent interests of the debtor and its creditors.

4. Other “Property”

Distributions to holders of unsecured claims and equity interests may be in “property” other than cash payments, including notes, stock, warrants, and other securities.

D. Plan Funding

Cash or other property to be distributed under the plan can be derived from a variety of sources, including the proceeds of a full or partial liquidation of the debtor’s assets, the merger or acquisition of the debtor with another entity, income derived from future operations, capital infusions, the issuance of new debt or equity securities, the restructure or replacement of existing secured obligations, litigation recoveries, or any combination of the above. Funding may occur upon confirmation or may extend over a period of months or years. In general, a plan that provides for a cash distribution to be funded upon or immediately after confirmation is easier to confine under the “feasibility” and “best interests” tests of the Bankruptcy Code, than a plan that

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calls for an extended period for funding from future operations. However, circumstances frequently preclude the proposing of a plan which will be fully funded at the time of confirmation.

E. Confirmation Standards

For a plan to be confirmed and to become binding on all creditors and shareholders, the Bankruptcy Court must determine that all of the following confirmation standards under the Bankruptcy Code have been satisfied with one possible exception:

1. The plan complies with the provisions of the Bankruptcy Code. 2. The plan proponent has complied with the provisions of the Bankruptcy Code. 3. The plan has been proposed in good faith and not by any means forbidden by law. 4. Any payment made or to be made by the plan proponent for services or costs in

connection with the Chapter 11 case or the plan has been or is subject to approval by the Bankruptcy Court as reasonable.

5. The plan proponent has disclosed the identity of any individual to serve after confirmation as an officer or director of the debtor.

6. Any rate change provided for in the plan has been approved, or is subject to approval by the regulatory commission with jurisdiction over such rates.

7. The holder of each claim or interest in each class of impaired claims or interests has accepted the plan or will receive under the plan not less than that holder would receive if the debtor were liquidated under Chapter 7 (the “best interests” test).

8. Each class of claims or interests has either accepted the plan or is not impaired by the plan. (A claim is not “impaired” where the claimants rights are unaltered or where any default is cured.) (Note the discussion below concerning confirmation of a plan where this standard has not been met as to one or more classes of claims or interests.).

9. Claims with priority under the Bankruptcy Code will receive cash in the full amount of the claim on the effective date of the plan unless the holder has agreed to different treatment (except for certain tax obligations which may be extended for up to six years after the date of assessment).

10. At least one impaired class of claims has accepted the plan after excluding the votes of insiders.

11. Confirmation is not likely to be followed by liquidation or need for further financial organization of the debtor unless such liquidation or further reorganization of the debtor is proposed in the plan (commonly called the “feasibility test”).

12. Any fees payable to the Office of the United States Trustee have been paid or will be paid by the effective date of the plan.

13. The plan provides for the continuation of all retiree benefits as they existed on the filing date or as modified by an order of the Bankruptcy Court during the Chapter 11 case.

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If the issue is raised by a governmental entity, the Bankruptcy Court must also find that the avoidance of taxes or the avoidance of the securities laws of the United States is not the principal purpose of the plan.

F. Confirmation Without Acceptance by an Impaired Class (“Cramdown” Plan)

An important provision of the Bankruptcy Code enables the plan proponent to confirm the plan even though one or more classes of impaired claims or interests votes to reject the plan or receives no distributions under the plan and, therefore, is deemed to have rejected the plan. The required treatment for a dissenting impaired class of secured claims, unsecured claims, or shareholder interests is as follows:

1. Secured Claims: The holders of allowed secured claims in the class (a) must retain their lien and receive deferred cash payments with a present value equal to at least the value of the collateral; or (b) if the collateral is sold, must receive a lien attaching to the proceeds of any sale, unless the sale is made subject to the lien; or (c) must receive the “indubitable equivalent” of their claim. In certain circumstances, undersecured creditors may elect to treat their entire claim as secured (the so-called “1111(b) election”). Non-recourse secured debt will be treated as recourse debt under the plan unless the collateral is sold or the undersecured creditor makes the 1111(b) election.

2. Unsecured Claims: The holders of allowed unsecured claims in the class must receive property (which can be stock as well as a cash or a debt instrument) of a value equal to their allowed claim or no junior claim or equity interest can receive or retain any property under the plan.

3. Shareholders: The holders of allowed interests in the class must receive or retain property of a value equal to the greater of any fixed liquidation preference to which the holders are entitled, or the fixed redemption price to which the holders are entitled, or the value of the interest, or no junior interest can receive or retain any property under the plan.

The foregoing treatment is required to confirm a plan in the event of rejection of a dissenting class of impaired claims or interests. A class of claims or interests may vote to accept less favorable treatment. If the holder of a claim or interest has voted to reject the plan, but the holder’s class has voted to accept the plan, the holder is bound by the vote of the class. However, each holder of a claim or interest is entitled to insist that the plan comply with the “best interests” test (see Part VII.E.7. above), under which each holder of a claim or interest must receive at least what such holder would receive in a Chapter 7 liquidation on the effective date.

G. Issuance of Securities

Equity and debt securities issued under a plan are exempt from securities law registration requirements due to the judicial supervision of the issuance process. There is also a “safe harbor” for persons who solicit acceptance or rejections of the plan in good faith.

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H. Effect of Confirmation

If the plan is confirmed, its terms and conditions will be binding on all creditors, all security holders and all shareholders unless the plan or confirmation order provides to the contrary. Unless the plan is a liquidation plan, a corporate debtor will be discharged from all liabilities and the discharge will be effective as to each claim regardless of whether the holder of a particular claim filed a proof of claim, whether the claim is allowed by the Bankruptcy Court, or whether the holder of the claim voted to accept the plan, provided that the holder of the claim had knowledge of the Chapter 11 case and the deadline for filing claims. Except as provided in the plan or the confirmation order, upon confirmation the debtor will be revested with all its property free of the claims and interests or creditors, equity security holders, and general partners.

I. Modification of a Plan

Only the proponent may modify the plan and any modification must comply with disclosure requirements of the Bankruptcy Code. After the plan has been accepted but before confirmation, only modifications that do not adversely change of treatment of the claim of any creditor or interest of any equity security holder who has not accepted the modification are permitted without a solicitation of new votes. After confirmation, the plan proponent may modify the plan before substantial consummation, in accordance with the provisions of the Bankruptcy Code.

J. Post Confirmation Events

After confirmation, the debtor or other entity charged with performance of the obligations under the plan will proceed to consummate the plan. The assets and operations of the post-confirmation debtor or successor entity will be free of liens and claims of creditors except as provided for under the plan and the ownership and management of the debtor or successor entity will be governed by the plan. Except for the obligation to carry out the plan and to comply with the court’s confirmation order, the debtor or successor entity will be free of all Bankruptcy Code restrictions on operations and reporting requirements. Most plans provide for a delayed effective date to permit an orderly transition from Chapter 11 status to normal operations. Applicable state law will usually excuse compliance with corporate governance actions such as corporate resolutions or shareholder votes in carrying out the plan.

Substantial professional and management time and effort may be expended post-confirmation to put the plan into effect, examine and object to filed claims, and pursue avoiding powers and other causes of action if retained by the debtor under the plan. If the plan is not consummated after confirmation, the creditors may move to dismiss the case, convert to a Chapter 7 liquidation, or seek other relief as provided in the plan.

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VIII. CHAPTER 11 CASE CHRONOLOGY

The circumstances and sequence of events in a Chapter 11 case are varied. Assuming the most favorable of circumstances, a Chapter 11 case commenced solely for the purpose of binding creditors to a plan already accepted pre-petition by creditors, sometimes called a pre-packaged plan, may achieve confirmation within thirty to sixty days after the filing of the petition. Such cases normally require substantial time and effort for negotiation and documentation before the Chapter 11 case is commenced. In contrast, some Chapter 11 cases may be pending for several years awaiting the formulation of a business plan and the other requirements for proposal of a plan and confirmation. Most Chapter 11 cases require six months to a year or longer to achieve confirmation of a plan and to consummate it.

The following is a possible chronology of significant events in a Chapter 11 case.

Day 1 Chapter 11 petition with supporting documentation filed. Absent a contrary court order, management exercises the powers of the debtor in possession. All active bank accounts and books closed and new bank accounts and books opened by the debtor in possession. Payroll account may remain in operation if authorized by court order.

At Any Time During the Case

The debtor may bring motions or adversary proceedings necessary to facilitate the case, recover assets, dispose of assets or to determine liabilities. Secured creditors may seek a relief from the stay to foreclose or to obtain payments on account of their lien claims. Creditors may seek dismissal of the case, appointment of a trustee or a conversion to Chapter 7.

First Month During the first month of the case the debtor will seek court authorization for certain activities of the debtor in possession, including use of cash collateral or the obtaining of credit. If no creditors’ committee was organized prior to the filing, the United States Trustee will appoint a committee of those creditors willing to serve to represent the interests of all creditors and to consult with the debtor regarding the issues in the case.

Day 15 The Statement of Financial Affairs and Schedules must be filed (unless time is further extended by court order).

Day 20 The debtor must provide adequate assurance of payment for post-petition utility services to avoid termination of services.

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Day 21 to Day 40 A meeting of creditors (a “341 Meeting”) is held at the direction of the United States Trustee. The meeting is a formal presentation under oath by the debtor in possession regarding its assets, liabilities, current operations, and prospects for reorganization. Creditors may attend and ask questions of the debtor regarding matters reasonably related to the assets, liabilities operations and prospects of the debtor.

At a Time Fixed By the Court

Creditors must file their claims within a time fixed by the Bankruptcy Court (a “Bar Date”) unless an exception applies.

Day 61 Debtor must commence performance on commercial equipment lease obligations, unless the Court orders otherwise.

Day 90 Last day for debtor to remove most pending litigation to the Bankruptcy Court.

Day 120 Unless the Bankruptcy Court orders otherwise for cause shown, the exclusive right of the debtor to propose a plan ends. Thereafter, any party in the Chapter 11 case (including the debtor) may propose a plan. Last day for the debtor to assume commercial real property leases, unless the time is extended.

Day 180 Last day to obtain acceptance of a consensual plan unless the debtor’s exclusive period to do so is extended. Some Bankruptcy Courts read this language as extending the time to confirm any plan filed during the exclusive period.

Day 300 Last day for a “small business debtor” to file a plan.

IX.

SUMMARY

Each Chapter 11 case is unique and the course of events will depend on the business needs of the debtor, its debt structure, and the attitudes and objectives of the parties in interest. In addition, the venue of the case, the views of the particular Bankruptcy Judge, and the skills, experience, and dedication of the professionals employed by the parties in interest will be important in determining the results obtained.