LBO: Prepackaged Bankruptcies

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

The emergence of Southland Corporation from Chapter 11 after six months in the bankruptcy court brings to the fore an old, but until the late 1980s little used, strategy of bankruptcy practice: the so-called "prepackaged plan." (In Southland, since the prepackaged plan had to be resubmitted post-bankruptcy, it is actually an example of a pre-negotiated plan.)

The tactic involves the formulation of a plan of reorganization for a financially distressed entity before the formal filing under Chapter 11. The debtor may circulate the plan for a vote prior to filing (a prepackaged plan) to garner as much acceptance from creditor groups as possible, or the plan may be submitted to the bankruptcy court upon filing sans creditor votes but with a vote scheduled shortly after filing (a pre-negotiated plan). In either case, the objective is the same: Submission of the plan to a formal creditor vote within a relatively short period of time, thereby rendering the bankruptcy proceeding orderly, inexpensive, quick, and efficient. [1]

The usage of prepackaged plans was clearly contemplated by the drafters of the Bankruptcy Code. Section 1126(b) provides that a pre-petition acceptance or rejection of a plan by a creditor or shareholder will be deemed to be postpetition if certain disclosure which complies with applicable non-bankruptcy law is made. (If no such law applies, "adequate information" as defined in § 1125(2) must be provided.) In addition, Section 1102(b)(1) contemplates that the official creditors' committee may be organized before commencement of the Chapter 11 case. Nonetheless, prepackaged plans face certain obstacles.

Thus, disclosure requirements under Section 1126(b) can be quite extensive and costly for a number of debtors. For instance, the 1934 Act and, in particular, the proxy rules thereunder, govern the exchange of publicly held securities; and the registration provisions of the 1933 Act may apply to the new securities issued in exchange therefore. Even if the federal securities laws are inapplicable, "adequate information" for a substantial business debtor may be quite expensive. [2]

For debtors with large numbers of diverse creditors, the pre-filing negotiations may be so time-consuming that the debtor is forced to file for protection under Chapter 11 before acceptances can be obtained. Only if the claims of trade creditors (to single out one group which, because of its general lack of sophistication, often balks at prepackaging attempts) are left relatively unimpaired is the [3] pre-bankruptcy solicitation likely to succeed [4] As a result, prepackaged bankruptcies work best for holding companies, single-asset companies and other entities with limited classes of creditors and few or no trade creditors. [5]

Further, the possibility exists that judges, in possession of substantial discretionary equitable powers, will derail a prepackaged bankruptcy in order to conduct plenary hearings on behalf of the minority creditors and perhaps even shareholders. If this occurs, the bargaining of prepackaging becomes an unnecessary expense. [6]

The jury is still out on prepackaged bankruptcies. For Southland, the prepackaging strategy failed in part because Southland was forced to renegotiate the plan once bankruptcy proceedings were commenced. Promoters of prepackaged bankruptcies have to deal with the infirmities the Southland process involved. Does the disclosure satisfy the various (and vague) statutory mandates? (Note that the solicitation of votes on a prepackaged plan constitutes an "offer to sell" the new securities to be issued pursuant to Plan under the 1933 Act, usually registered on Form S-4, unless exempt under § 3(a)(9).) [7] Is the method of soliciting acceptances in accordance with statutory norms? Does the plan comply with the Bankruptcy Code requirements for acceptance?

On the other hand, a plan that involves a formal bankruptcy proceeding (and yet is consensual in nature) entails substantial tax advantages since it is easier to avoid cancellation of indebtedness income, and to preserve net operating loss carry forwards, if the debtor is in bankruptcy.[8]

[1] A secondary use of a prepackaged plan is as a threat. The draft plan accompanies a solicitation of tenders to public bondholders to exchange their securities voluntarily for restructured securities, the idea being to send a clear message: "If you don't tender, then we are headed for Chapter 11." Jones, "Prepackaged Chapter 11 Bankruptcy as a Vehicle for Acquisition and Disposition of Health Care-Related Businesses," in Health Care M&A 1999: How to Structure the Transaction, at 321, 333 (PLI Course Handbook Series No. 111).

[2] See "Prepackaging Plans Can Succeed, Sometimes," National Law Journal, p. 19 (April 15, 1991).

[3] Other examples include West Point Acquisition Corp., Charter Medical, Kendall, and Memorex. See Gross & Maguire, "Prepackaged Chapter 11 Plans," in Chapter 11 Business Reorganizations 1994, at 433, 435 (PLI Course Handbook Series No. 682) [hereinafter Gross & Maguire].

[4] In Southland, the debtor obtained authority to pay pre-petition trade creditors only if they agreed to continue to extend credit. Gross & Maguire, N. 3 supra, at 459.

[5] See "Pre-Packaged Bankruptcies Combine Benefits of Chapter 11, Out-of-Court Restructuring," 6 BNA's Corp. Couns. Wkly. 6 (April 17, 1991). For disputed claims, it may be possible to treat them as unimpaired by "rolling them through to the surviving entity, which can fight it out with overly ambitious claimants. Gross & Maguire, N. 3 supra, at 452.

[6] Citing Southland, a publication of the American Bankruptcy Institute has editorially attacked prepackaged plans, the editor remarking that the hype in connection with such filings can be deliberately designed to give minority creditors the sense that the success of the plan is assured and the bankruptcy proceeding simply amounts to lawyers and judges going through the motions. Tatelbaum, "Prepackaged Bankruptcies," IX ABI Newsletter, pp. 2, 19 (Nov.-Dec. 1990). In the words of the author, a prepackaged bankruptcy accompanied by excessive tub thumping may amount to a "manipulative use of the system," prejudicing the "legitimate rights and concerns" of the minority. Id.

[7] Pohl & Samole, "Out of Court Restructurings and Prepackaged Plans, Dealing with Secured Claims & Structured Financial Products," in Bankruptcy Cases 2004, at 295, 299 (PLI Course Handbook Series No. 867). The exemption from the '33 Act § 5, provided by § 1145(a)(1) of the Bankruptcy Code, obviously doesn't apply until after the proceedings commence. Section 3(a)(9) does not apply to securities exchanged in a bankruptcy proceeding. Note that a solicitation pre-petition may also involve the proxy rules and so-called "going private" rules under Section 13e-3 of the 1934 Act. Pohl & Samole at 303.

[8] See Gross & Maguire, N. 3 supra, at 444.

Joseph W. Bartlett, Special Counsel,

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