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Business Bankruptcy
South Texas College of Law Houston
Worley, John J.

I. INTRODUCTION TO SOME LEGAL AND BUSINESS CONCEPTS

Background to Business Bankruptcy

Prisoner’s Dilemma

Don’t Confess (A)

Confess (A)

Don’t Confess (B)

-1/-1

-5/0

Confess (B)

0/-5

-3/-3

· Round 1: Confess (A) x Confess (B) = -3/-3 à both lose
· Round 2: Don’t (A) x Confess (B) = 0/-5 à B walks and A gets 5 yrs
– Dominant Strategy
o Confess b/c 0 better than -1 if other doesn’t confess
o Confess b/c -3 better than -5 if other does confess
– Problem is that when both choosing optimal option both get third best
o If acting rationally then both should pick don’t confess; least jail time
o Coordination Problem
§ Each party decision affects another’s interest
– Common Pool Problem
o Tragedy of Commons (e.g., shared fishing pool)
o Individual owner more likely to preserve the resource
o Common owners have no incentive to act with restraint
– Problems relate to creditors aggressively pursue any action against an insolvent debtor
o Leads to the debtor being unable to continue business
o Harms the group as a whole and possibly individual creditors
– Policy for Bankruptcy Law
o To encourage creditors and debtors to act in manner beneficial to all related parties
o Look at problem as a whole so all creditors benefit
§ However, if liquidation value higher than going concern value, no reason not to

Reading Financial Statements
– Financial Statements
o Statements are prepared in-house and usually audited by external, independent accountants
o Note: bankruptcy insolvency is balance sheet insolvency
o Balance Sheet
§ Snapshot of the company’s financial position at one point in time
§ Assets (A) = Liabilities (L) + Shareholders’ Equity (SE)
§ Creditors entitled to assets ahead of shareholders
§ Book Value
· Value as recorded in the balance sheet / books
· Purchase price minus depreciation [accounting] · FMV could differ because of obsolescence, change in market value
§ Current Assets
· Cash/other assets reasonably expected to be realized in cash, sold, or consumed by the business within a year (or during the normal operating cycle of the business)
o E.g., cash in bank, product waiting to be shipped
o Non-current: everything else (e.g., machine, patent)
o Statement of Operation
§ AKA Income Statement (usually when actually have income)
§ For specific time period
§ Helpful to determine if business can generate a profit in the future
· I.e., Going Concern > Liquidation
§ Accrual Basis
· Attempt to match up (for same time period) the revenues with expenses
· Allows managers to determine if product is making a profit
o Accounting Methods
§ FIFO (First-In, First-Out):
· Think of one-way hall with first product pushed through first ones shipped
§ LIFO(Last-In, First-Out):
· Think of closet and keep replacing the widgets from the front of the closet

Business Failure: Business and Financial Aspects
– Problem 5-1 (pg 231)
o What are causes of Foam’s financial difficulty?
§ Growing to quickly
§ Negative cash flow – have to borrow money to compensate
§ Statement of Operations – spending more than making
· General and Admin Expenses are 8mil of only 30mil in Net Sales
– Altman Z-score
o Model to predict business failure
o Used in front-end, to determine if there are problems
o Also useful to determine if reorganization will be successful
§ Some lawyers use in plan confirmation phase, but more could benefit
§ Might be used to show bankruptcy judge feasibility of restructure
– Problem 5-2
o Part A: Z-score = 0.21
o Part B: With reorganization Foam would be in the safe zone
– Problem 5-4 (pg 242)
o Solvency/insolvency is a balance sheet question
o Viability – whether business is capable of making profit/money in the future
§ Not just building more debt
§ Z-score is bad for foam, but if expenses reduced and future revenue prediction high, then good future potential for the business

II. COMMENCEMENT OF THE CHAPTER 11 CASE

Eligibility, Venue, Authorization, and Parties

– Two Kinds of Bankruptcy Proceedings
o (1) Liquidation (Chapter 7)
§ Liquidation of D’s financial affairs
§ Applies both to individuals & businesses
§ Accumulate all assets owned by D & take them & pay out to creditors as much as possible
· Secured creditors get paid out of collateral, and
· Unsecureds gets paid out of what is left
· D gets discharged; business gets dissolved
o (2) Reorganization
§ Chapter 13
· Only for individuals w/ regular income (i.e., humans)
· Limitation à individual not eligible if it has debts in too great an amount
· Advantage à develop a reorg plan where debtor pays back some portion of debts
· Creditors have no vote of whether plan gets approved
§ Chapter 11
· Creditors get to vote on approval
· D negotiates w/creditors or creditors representative
· A lot of negotiation, compromise & settlement
§ Chapter 12
· Family farmers (mirrors Ch7 & Ch11)

– Eligibility for Chapter 11: § 109
o § 109(a): Who may be a debtor
§ “Only a person that resides or has a domicile, a place of business, or property in the US, or a municipality,” may be a debtor
· (1) Person residing in U.S.
· (2) Person domiciled, place of business, or assets in U.S., OR
· (3) Municipality
o § 109(b): Who may be debtor under Chapter 7
§ A person if not a RR, domestic ins co, savings bank, cooperative bank, S&L Ass’n, credit union, c

t venue
§ E.g., Enron filed for BR in S.D.N.Y; NY attys hired; they file for transfer of venue
§ Worley Cynical View
· Lawyers don’t want to send away a business/$$$
· Atty fees higher in NY & fees must be approved by judge, want to be in NY ct
– Filing the Petition and Accompany Forms
o Along with the petition, debtor must file—
§ Rule 1007(a): List containing the name and address of each creditor
· Unless petition accompanied by a schedule of liabilities
· Permits the court to send notice to the creditors of the filing
§ Rule 1007(d): List containing name, address & claim of holders of 20 largest unsecured claims excluding insiders (Official Form 4):
o Within 15 days after filing of petition, debtor must file—
§ Schedules (Official Form 6) and
§ Statement of Financial Affairs (Official Form 7)
o Compliance
§ Allow for plenty of time to comply w/ the filing requirements
· Especially if the debtor’s records are in poor shape
§ If fail to provide required info, US trustee may move for dismissal or conversion to Ch7
– “Debtor in Possession” (DIP)
o Filing entity and one that continues to make business and bankruptcy decisions
§ *When you read provision saying “a trustee” it also means “a DIP”*
o § 1107(a):
§ DIP shall have all the rights & powers, & shall perform all the functions & duties, of a trustee serving in a case
· Other than the right to compensation
· DIP has almost all of rights trustee would have (includes right to operate business)

Retention of Professionals

– § 327(a): Employment of Professional Persons
o Trustee, w/ ct’s approval, may employ one or more attys, accountants, appraisers, auctioneers, or other professional persons that—
§ Do not hold or represent an interest adverse to the estate, AND
§ Are disinterested persons, to represent or assist the trustee in carrying out the trustee’s duties
o Test
§ (1) Not Adverse Interest, AND
· No material adverse interest
· Standard à evidence suggests the likelihood of some actual dispute, strife, discord
§ (2) Disinterested Person
· Not a Creditor, Director, etc.
– “Disinterested”
o Majority à Bright Line Test
§ Whiteglove
· DIP’s atty w/outstanding fees as of petition date is a creditor
· Therefore not “disinterested”
§ § 327(d) Exception:
· DIP can be Atty / Acct
Must