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South Texas College of Law Houston
East, W. David

Business Bankruptcy

Debtor in Possession: The debtor in a Ch11 case in which no trustee is serving. Unless the court orders otherwise, the debtor in possession has almost all the rights and duties that a trustee would have if one were appointed: 1107(a).

Why dos the law allow the same people who got the debtor into financial distress to continue to manage the business in Ch11? (1) In many cases, the debtor changes managers before filing the Ch11 petition. (2) If the managers of a troubled company immediately lost their jobs when a Ch11 petition is filed, the management team would be reluctant to recommend a petition be filed until the very brink of collapse. (3) The debtor is in a precarious financial condition with a need for immediate corrective action, and a trustee appointed to take over the business would not be familiar with it. (4) In theory, the debtor in possession is supervised by the US trustee and the unsecured creditors’ committee.

Appointing a Trustee: 1104. (a)(1) For cause (including cause, dishonesty, incompetence, or gross mismanagement, or similar cause, but not including the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor), or (a)(2) if such appointment is in the interests of creditors, any equity holders, and other interests of the estate (without regard to the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor).

~ Dalkon Shield, p. 263. I: When the court found the debtor in civil contempt when debtor violated an order barring debtor from selectively paying off prepetition debts without prior court approval, was the court obligated to appoint a trustee? H: No.

~ Cardinal Industries, p. 267. I: 1104(a)(1)? H: Yes. Reasons: (1) Loss of confidence in debtor by creditors when debtors failed to respond timely or accurately to data requests, failed to keep accurate or complete financial records or corporate books, continued to lose cash, and unduly delayed marketing assets or providing appropriate documentation for assets sought to be sold; (2) appearance of certain conflicts of interests; (3) lack of a strong direction or objective assessment of future plans for specific segments of the business; (4) the debtors not only fired the legal counsel who had contributed significantly to some positive developments, but also paid a retained to replacement counsel at a time when other professionals were not being paid on a current basis. Court looked at the factors collectively, and found cause. They also found 1104(a)(2).

~ A strong presumption exists that the debtor should maintain control over the estate.

~ Qualities of a trustee: Familiarity with the debtor’s business.

~ If a trustee is appointed: (1) trustee must be compensated; (2) significant delay; (3) trustee must get up to speed.

~ Courts have discretion over what cause IS, but once it is found they SHALL appoint a trustee. Same with interests of creditors.

~ 1104(a)(2) inquiry: (1) Is debtor insolvent; (2) creditors need objective party; (3) more accurate and timely financial reports; (4) justified loss of confidence. Cardinal.

Replacing Officers and Directors:

Use, Sale, or Lease of Property of the Estate: In a Ch11 case, the business is usually kept going.

363: Ask: (1) Is the use of property in or out of the ordinary course of business? (2) Is the property “cash collateral” or property other than cash collateral?

In the ordinary course of business:

~ General rule: A debtor may use the property of the estate, if the business is authorized to be operated, without a court order and without the consent of any affected secured creditor.

~ Whether or not the transaction is in the ordinary course of business (when there isn’t cash collateral being used) is, therefore, a critical question.

~ Roth American, p. 256. I: Ordinary course of business? Test: (1) Horizontal: Whether, from an industry-wide perspective, the transaction is of the sort commonly undertaken by companies in that industry; (2) Vertical (aka creditor’s expectation test): From the vantage point of a hypothetical creditor, whether the transaction subjects a creditor to economic risk of a nature different from those he accepted when he decided to extend credit.

~ East: It is not that useful to focus on what the debtor has done before because now they are in distress and that is different.

~ Normally the court will not scrutinize or entertain objections to ordinary course transactions nor will the court substitute its judgment of business risk for that of the debtor. Even for 363(b).

~ Exception: Unless its c

t value, then the court should determine if it has the power to undo the sale, and if it does, it should exercise its discretion to pick that or another remedy.

Obtaining Credit: 364. (a) If unsecured and ordinary course of business, then OK w/o court approval, and the creditor will take an administrative expense (but court may order debtor not to). (b) If unsecured and not ordinary course of the business, then court approval is needed, and the creditor will take an administrative expense. (c) If debtor unable to obtain unsecured financing, then the court may approve as an administrative expense (1) a super priority lien, (2) a lien on property with no lien, or (3) a junior lien on property. (d)(1) priming lien: court may order a priming lien (which is a senior or equal lien on property of the estate which is subject to a lien) ONLY IF (A) the debtor is unable to obtain such credit otherwise, AND (B) there is adequate protection for the existing lien. (d)(2) Trustee has burden of proof on adequate protection. (e) protection for good faith creditors. (f) special rules for non-equity stocks.

~ Order: 1st: (a) or (b); 2nd: (c) only if not (a) or (b); 3rd: (d) only if not (a), (b) or (c).

~ Note that (d) does not give an administrative expense.

~ “Adequate protection” before a priming lien: Like in the automatic stay. Equity cushion, replacement lien.

~ Classic priming lien case: Half built real estate asset where the construction lender is reluctant to supply additional financing to complete the thing.

~ Is a powerful tool for debtors: Threaten to get a priming lien and maybe get current creditors to do more financing.

~ Cross-collateralization: Two types: (1) pre-petition debt secured with post-petition collateral; (2) post-petition debt secured with pre-petition collateral. (2) is allowed, (1) the courts are split over.