Ohio Practical Business Law : Columbus Ohio Business Lawyer & Attorney : Teri Rasmussen : Plunkett Cooney Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

So the latest brilliant (?) idea about what to do about the financial predicament GM finds itself in  - notice nobody is even talking in any meaningful way any more about resuscitating Chrysler - is to do what is known as a "363 sale" (so called because of the section of the Bankruptcy Code allowing it) in a quick two week "surgical" bankruptcy. 

How would that work?  And could it really be done in less than a fortnight?  Perhaps if you still believe in Santa Claus and the Tooth Fairy and think all those stores about Paul Bunyon are true.  But otherwise, it's one tall tale to swallow.  As Jonathon Glater recently wrote in his NYT news analysis "A Quick Bankruptcy for G.M.?  Not So Fast":

Any hope of a high-speed bankruptcy by General Motors faces a serious obstacle:   a judge -- not the Obama administration, not G.M. management and not the company's creditors -- would reign in court.  

Overview of 363 Sale Process

Leaving aside considerations of "how things actually work in the real world", what are the mechanics involved in making a 363 sale happen?  Well, reduced to the bare essentials, the debtor files a motion (or motions) seeking authorization to sell certain, or all, of its assets.  Sometimes there is a written purchase offer from a prospective purchaser (who is known in bankruptcy circles as a "stalking horse" and will often seek payment of a "break-up fee" or topping fee" to protect against other would-be purchasers) that may be described in, or attached to the Motion.  Other times the Motion seeks authorization of some sort of auction procedure or submission of sealed bids.  Depending upon the complexity and size of the case, these procedures can often be -- and most certainly would be in a GM bankruptcy -- incredibly complicated.  Then the Bankruptcy Court may or may not hear testimony and ultimately issues an order approving the sale as proposed or as modified.     

There are of course rules that govern how all of this is supposed to take place.  Section 363(b)(1) states that a debtor "after notice and a hearing, may use, sell or lease, other than in the course of ordinary business, property of the estate..."  For purposes of a 363 sale, "property of the estate" is essentially the debtor's assets, i.e. equipment, real estate, etc. 

After Notice and a Hearing,,, or Not

And it is true that "after notice and a hearing" has a rather elastic meaning and may not really require an actual hearing in all cases.  According to section 102 of the Bankruptcy Code, it

(A)  means after such notice as is appropriate in the particular circumstances, and such opportunity for a hearing as is appropriate in the particular circumstances; but

(B) authorizes an act without an actual hearing if such notice is given properly and if --

(i)  such a hearing is not requested timely by a party in interest; or

(ii)  there is insufficient time for a hearing to be commenced before such act must be done, and the court authorizes such act.

SO, at least theoretically, a 363 sale could be authorized by the Bankruptcy Court in a matter of days in a GM bankruptcy.  

Section 363(f) - When Sale Can Occur

There are, however, some other requirements which might slow things down, even theoretically speaking.  Section 363(f) of the Bankruptcy Code will only permit the sale of the debtor's property "free and clear of any interest ,,," (which is of course the whole reason for doing a 363 sale in the first place) if and only if:

• Applicable non-bankruptcy law permits sale of such property free and clear of such interest;
• The lienholder or other party with an interest in the property consents;
• With respect to lienholders, the price at which such property is to be sold is greater than the aggregate value of all liens on the property being sold;  
• The interest is in bona fide dispute; OR
• The lienholder or other party with an interest in the property could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.

Now it used to be that bankruptcy courts routinely reasoned that state foreclosure law -- and similar laws with respect to personal property going by such names as replevin or "claim and delivery") -- provided all the rationale they needed to approve a 363 sale.  After all, the end result of a foreclosure IS that lienholders get however much money is paid at the sheriff's sale in the order of their priority. If you're the third lienholder and the sale proceeds only pay 10% of your debt after the folks ahead of you get paid, that's just too bad; you can still chase the debtor of course, but the successful purchaser at the sheriff's sale now owns the property free and clear of your lien.  The Uniform Commercial Code provides for a similar result when personal property is sold by the secured creditor in a "commercially reasonable" way.

Section 363(m) - What Appeal?

And, thanks to section 363(m) of the Bankruptcy Code, once the Bankruptcy Court had "done the deed"  of authorizing a 363 sale, the reversal or modification of that Order on appeal "does not affect the validity of the sale... under such authorization to an entity that purchased... such property in good faith, whether or not such entity know of the pendency of the appeal, unless such authorization and such sale... were stayed pending appeal."  Because 363 sales were often consummated moments after the Order authorizing them was signed by the Bankruptcy Judge, disgruntled lienholders and other parties in interest often never had a chance to even seek a stay, let alone obtain one.

You may have noticed that I've been using the past tense in the last couple of paragraphs.  That's because the Ninth Circuit U. S. Circuit Court of Appeals Bankruptcy Appellate  Panel recently raised some questions about the supposed invulnerability of an order authorizing a 363 sale.  In Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25 (B.A.P. 9th Cir. 2008), the Bankruptcy Court had authorized a 383 sale in which the ultimately successful purchaser was the bank which held the first priority lien over the objection of the junior lienholder.  The bank "credit bid" the amount that was owed to it so it did not come out of pocket and no dollars flowed into the bankruptcy estate to pay the junior lienholder which a a $2.5 million claim.  The BAP overuled the bankruptcy court with a rather intricate interpretation of section 363(m).  In addition, the case was remanded to the Bankruptcy Court for a more specific demonstration that the provisions of subsection 363(f) were being met.   

For more detail on this case and what the BAP holding may mean  in general, visit "Clear Channel Raises Troubling Issues in Section 363 Sales But Case Doesn't Spell the End of Free-and-Clear Sales" , an article by Christopher Combest and Faye B. Feinstein in the Turnaround Management Journal.

Also check out "Will Section 363 'free and Clear' Sale Orders Survive an Appeal?  A recent Appellate Decision Raises New Doubts" by Robert Eisenbach III of the In the (Red) blog.

Although technically this only affects bankruptcies in the Ninth Circuit on the West Coast  - one place we can be certain GM will not file -- bankruptcy law has long been a procduct of trends starting in one particular jurisdiction.  Thus it's entirely possible that whatever Bankruptcy Court GM winds up facing would adopt this viewpoint.  So the net result of this is that a purchaser at any 363 sale might need to wait out the 10 day appeal period (and any subsequent appeal) before consummating the sale authorized by the Bankruptcy Court.  And some sort of real record will need to be made demonstrating the satisfaction of section 363(f) - there will need to be at least a modicum of due process allowing some preparation time before the hearing.

Other Important Requirements 363 Sales Must Meet 

There's also other substantive requirements that must be met before a 363 sale can be approved.  In the United States Sixth Circuit  -- which is certainly one place a GM bankruptcy might well unfold given its headquarters in Michigan -- a sale of all of the debtor's assets (and possibly by extension, the most important assets) can only be approved "when a sound business purpose dictates such action."  Stephens Indus., Inc. v. McClung,  789 F.2d 386 (6th Cir. 1986).  To determine whether that standard has been met in a particular case, the Bankruptcy Court must look at the following factors:

• whether the terms of the proposed sale reflect the highest and best offer for the assets
• whether the negotiations were conducted at arm's length
• whether the sale is in the best interest of the estate and its creditors

There must also be a finding that the the purchaser has acted in "good faith" and that the sale itself is in "good faith".  The words of a slightly earlier case in the Sixth Circuit, Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel), 722 F.2d 1063 (6th Cir. 1983) seem particular pertinent today:

In fashioning its findings, a bankruptcy judge must not blindly follow the hue and cry of the most vocal special interest groups; rather he should consider all salient factors pertaining to the proceeding and, accordingly, act to further the diverse interests of the debtor, creditors and equity holders, alike.  he might, for example, look to such relevant factors as the proportionate value of the asset to the estate as a whole, the amount of elapsed time since the filing, the liklihood that a plan of reorganization will be proposed and confirmed in the near future, the effect of the proposed disposition on future plans of reorganization, the proceeds to be obtained from the disposition vis-a-vis any appraisals of the property, which of the alternatives of use, sale or lease the proposal envisions and most importantly perhaps, whether the asset is increasing or decreasing in value.  This list is not exhaustivee, but merely to provide guidance to the bankruptcy judge. 

By now you're probably starting to understand how unlikely -- even in the theoretical vacuum-- it would be for GM or any other debtor to get in and out of a "surgical" aka "prenegotiated" or "prepackaged" or "controlled" (as if any bankruptcy could really be controlled once filed !). bankruptcy in two weeks, even using a 363 sale.

There's one more thing.  Section 363(b)(2) applies in situations in which antitrust law might apply to the proposed sale.  It REQUIRES a FIFTEEN DAY waiting period, which may be extended, but CANNOT be shortened.  While that might not be relevant in many situtions, it surely could become relevant in a GM bankruptcy.

So there you have it.  Whether it's a Chapter 11 case of a small business or a mega case like GM would be, this is what you have to do in order to sell assets once in bankruptcy.  The procedures also apply in a Chapter 7 liquidation bankruptcy with a bankruptcy trustee.  The emphasis is on transparency and what is "fair" and "equitable".  And that is not something that can be achieved in a "shotgun" bankruptcy, even if there really was such a beast outside of legend. 

UPDATE (6/1/09): So now it's official - GM is now in bankruptcy.  Filed in NYC, Case No. 09-50026, Judge Gerber presiding.  Check out my post GM Follows Dealership Affiliate to Obtain NYC Venue for Its Bankruptcy for all the basic filing info and press releases.

Looks like I might be wrong about the speed of approval for a sale, but in my defense (A) GM HAS actually been working pretty hard lately before filing to clean up loose ends and (B) I was naive enough to think we would actually go by real bankruptcy rules as opposed to distoring them beyond all recognition.  Nonetheless since GM doesn't actually have a third party seller like Chrysler did, it may still take longer than GM and the obama Administration are planning... even they gave up on the idea of a TWO WEEK surgical bankruptcy.

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With all the speculation swirling around about whether the automakers (or at least GM or Chrysler) will eventually file bankruptcy, we've all overlooked one pretty important thing.  It's really not that hard to start involuntary bankruptcy proceedings against a company.  And, when it comes to Chrysler or General Motors, NOBODY has.

Section 303 of the Bankruptcy Code requires only the following:

1.  To file an involuntary bankruptcy proceeding under Chapter 7 or Chapter 11 [no, you can't do an involuntary Chapter 13 against an individual], the target company  (or individual) must owe at least $13,475 in unsecured debt - THAT'S ALL!!!  This amount is indexed and will increase from year to year, but for right now, that's the number.

2.  If there are at least 12 unsecured creditors, then at least three (3) must join in the petition.  If there are fewer than twelve creditors, then a siingle creditor is all that is required.

3.  The unsecured creditors joining in the bankruptcy petition must have a claim that is not EITHER (A) "contingent as to liability"; or (B) "the subject of bona fide dispute".    If you've got a judgment, you're definitely in, but if you're a trade creditor and there's been no stink about the quality of what you've delivered, you're probably still "good to go", even if you don't have a judgment yet.

4.  There must be appropriate indicia of fincancial distress as demonstrated by EITHER

A.  A state law custodian or receiver has been appointed in the preceding 120 days;

OR

B.  The target company is not paying bona fide debts as they come due.

That's basically it.  For those wondering why this wouldn't also work for AIG, the answer is that  Section 109 of the Bankruptcy Code (when read in conjunction with section 303) prohibits an involuntary bankruptcy filing against banks and insurance companies, primarily because there are other specialized insolvency proceedings for these entities. 

It is of course possible that the Bankruptcy Court could require the posting of a bond by the petitioning creditors or by the target debtor (if it wants to regain possession of its assets), depending upon its view of whether the filing is frivilous or meritorious.  And the target debtor does have an opportunity to object and dispute the filing or to decide just to convert the whole thing to a voluntary Chapter 11 filing.  But the point is, it would be a start.... and no one seems to be biting.

Now, in real life, I usually try to discourage clients owed money from filing involuntary bankruptcy against another company.  Why share whatever assets and cash flow exist with other creditors according to the bankruptcy priority scheme when you might be able to do better through the "squeaky wheel' theory of interaction?  So maybe that's what's happening here too. 

Or perhaps the automakers are still paying all of their debts in a timely manner?  And so nobody actually has standing yet.

Generally, an involuntary proceeding works best when one is concerned about the activities of the management of the company or the possible dissipation of assets, either through legitimate activities by the target debtor, or as a result of less than honest behavior by those in charge.  Now I'm not suggesting for an instant that anything shady is going on in the corporate suites in Detroit, but i have to think that at least some folks are getting a little worried about where the automaker managment is taking these companies and what may be a deterioration in value of their assets.

So, again I come back to the question: if so many people think GM and Chrysler should be bankruptcy, why hasn't anyone actually done something about it?  And why NOT?

I don't have an answer - I just think it's an interesting question.  

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As a business/commercial attorney whose practice is becoming increasingly weighted towards the Chapter 11 bankruptcy, workout, and general creditors' rights side of the ledger, I freely acknowledge being completely captivated (in the intellectual isn't it cool that something I do work about is being talked about a lot way) by the distressed financial plight of Detroit's Big Three automakers and the various proposals being bandied about  as possible solutions.  The bankruptcy alternative - prepackaged or otherwise - has of course been of particular professional interest to me, mainly because it - properly tweaked - may just be the only way out of this mess.  

One could easily spend entire days just Googling away on this topic without running out of interesting and informative blog posts, news feeds, and websites to read.  Everyone seems to understand and agree that SOMETHING has to be done, but after that, the WHAT and HOW become murky and a source of great disagreement.  And most recently, we're now hearing that a "study" -  to which we all tend naturally to give great weight -- claims that a bankruptcy of at least two U.S. automakers would cost as much as FOUR times more than a "bridge loan" from the federal government.    

So, how to make sense of all this and figure out what it really makes sense to back?  Three detailed discussions of proposed strategies for addressing the crisis have caught my attention  which I think help illustrate the various arguments being made.  I wanted to highlight those, along with some commentary of my own.

• NYU School of Business Professor Edward Altman, who recently testified on Capital Hill presents "My View: Why GM Should File for Bankruptcy" on the Turnaround Management Association website.    
• Weathorford School of Management (Case Western Reserve University) Professor of Economics Susan Helper and Wharton School of Business (University of Pennsylvania) Associate Professor John Paul MacDuffie, self described "scholars who have spent our professional lives studying the auto industry" advocate a "Better Than a Bailout" nonbankruptcy plan in a recent issue of The New Republic magazine.   
• Corporate bankruptcy attorney Richard N. Tilton sets out a very detailed proposal in "GM Death Watch 219: GM Prepackaged Reorganization"  in a guest post on the Truth About Cars blog which I think comes closest to my view that some form of bankruptcy is necessary, but the significant participation of the feds is still a crucial component 

Altman: Bankruptcy IS the Answer.   Altman advocates forcing General Motors (and presumably at least Chrysler, if not Ford, as well) into Chapter  11, although he acknowledges that the U.S. government may have to be the DIP (debtor-in-possession aka post banklruptcy filing company for the uninitiated - see, isn't bankruptcy fun with its terms of art?)  lender.  Altman's conclusion:

Management and boards of Detroit's Big Three "which have been in a state of denial, should face up to the reality of their dismal outlook and request the DIP loan.  The government should be given the choice of supporting this unique rescue,  concluding that it would be better for the country and the economy to 'right-size' the U.S. Auto business now and make it more competititive, rather than to have it deteriorate further and to be sold off at a later date with even  ore lost jobs and cuts in pensionn, /health care benefits. " 

In support of his conclusion, Altman makes the following points:

• "All this talk about a government rescue of General Motors and other automakers is misguided, likely a waste of taxpayers' money, and a potential dimunition in the creditworthiness of the U.S. government."
• Absent bankruptcy, the automakers face not only the prospect of a severe prolonged U.S. recession, but also "the weight of their own inefficiencies, huge pension and health care benefit packages, and their now clear bankrupt profiles," things much more difficult to address outside bankruptcy.
• Chapter 11 provides enormous benefits  and options to companies availing themselves of its protections, including protecting their assets, suspending fixed payments on most liabilities, allowing superpriority lending to occur in the form of DIP lending  which substantially reduces the risk to lenders, and "enhanc[ing] the ability of management to renegotiate existing and legacy pension and health care claims."

Avoid Bankruptcy - It's the Kiss of Death.  In contrast to Altman, Susan Helper and John Paul MacDuffe contend that a nonbankruptcy solution is the preferable choice.  They start, logically enough, with an examination of the companies themselves and their strengths and weaknesses.  Unlike many commentators, their view is that "labor costs are  no longer a big problem," (although they do acknowledge that obligations to retirees remain an issue).  They also point out that labor costs only account for perhaps ten percent of the overall cost of an automobile .  Helper and MacDuffe say that larger challenge for the automakers is relations with parts suppliers and having a better understanding of how to utilize their leverage with suppliers appropriately.  As they see it,

The companies really are too big, although the problem starts with the number of brands, rather than the number of factories.  Each brand has its own set of delaers, each of whom demands vehicles and attention to their product lines.  It's impossible for the companies to fill out each brand's lineup  with innovative, quality products -- let alone to  market each of them appropriately.  In other words, it's hard for GM to push Pontiac, when  it's also pushing Buick, Chevrolet, and Saturn.  (emphasis supplied)

Helper and MacDuffe see several problems with forcing bankruptcy on the Big Three automakers:

• Incentives inherent in Chapter 11 might discourage the automakers from further integrating production techniques in favor of focusing on short-term profits even more relentless.
• Consumers may be concerned about warranties, continued availability of service and parts, and other drawbacks of purchasing a vehicle from a company in bankruptcy.  
• Suppliers would be unsecured creditors and would receive substantially reduced payouts on their debts, something their precarious financial situation may not be able to weather.

Helper's and MacDuffe's solution is similar to what has been recently been discussed on Capital Hill in the sense that it seeks to mimic the effect and benefits of a Chapter 11 proceeding without the "disgrace" of filing.  According to them, this solution

could not only spare GM -- and its counterparts -- much of the messy, wasteful litigation that goes with Chapter 11 filings; it could also encourage the right kind of restructuring.  Instead of simply paying people less for doing the same inappropriate tasks they used to do, the Detroit Three would further change the way they design, build, and sell cars -- yielding a set of smaller more sustainable automakers headquartered in the United States.   (emphasis supplied)

 Their plan:

instead of letting a bankruptcy judge supervise the process, the government would appoint a special advisory committee to oversee the process.  This committee would consist of knowledgeable, independent monitors -- a mixture of former industry executives with experience working for Toyota or Honda' academics who study the industry; and experts in aternative engine technology or labor-management collaboration.  It would, naturally, have a director and full-time staff, plus the ability to work with outside consultants.  Under the scenario we envision, the committtee would set goals and require the companies to report on progress quarterly, as a condition for obtaining additional funds.  If a company missed its goals for, say, two quarters in a row, the committee would then provide only enough funds to prepare for liquidation or nationalization.  (Leftover money could go to retraining workers and softening the blow of downisizing on communities.}

Prepack Bankruptcy - with a Twist - Is the Way to Go.   Finally, Richard Tilton (who is apparently keeping a really low internet profile since I really wanted to add a link to him and couldn't find anything), in a somewhat lengthy (by internet blog posting standards), but useful article, succinctly recognizes the basic problem facing the Big Three:

GM's legal obligations to bondholders and trade creditors cannot be changed or modified without a bankruptcy, or the written consent of ech individual creditor.  That's a near impossible task.  Attempting to reorganize GM outside of a legal proceeding would encourage creditors to holdouts (sic) for special treatment, delaying  any chance at restructuiring.

  His points:

• While a true "prepack" Chapter 11 bankruptcy would by definition involve the agreement of all major stakeholders, that is not absolutely essential so long as the U.S. Treasury as sgined on to be the DIP lender.
• Because Chapter 11 allows DIPs to stop paying interest or principal on unsecured debt, cash available for operations will be increased.
• Although the automakers have significant obligations to retirees, these are unsecured claims under the Bankruptcy Code and therefore would be frozen and entitled to less favorable treatment in a Chapter 11 bankruptcy.
• The assertion of Detroit's Big Three  that "millions of jobs will be 'lost' ignores the simple fact that companies continue to operate their businesses while in chapter 11, albeit under a great deal of scrutiny ....  While it is definitely a lot of paperwork, legal and turnaround professionals do this type pf work every day."
•  "A GM reorganization paln  must be based upon a realistic projection of future profitability.  Future cash flows will determine the enterprise value of the reorganized company, and hence the value of new  common shares which will be distributed under the plan."

His plan:

• U.S. Treasury extends a secured  DIP loan in the amount of perhaps $40 billion.  "Taxpayers should demand that any loan made to GM be made only in connection with GM's Chapter 11 filing, that it be fully secutred, and only disbursed pursuant to detailed written budgets."
• A portion of the U.S. Treasury DIP loan "should be available to support essential suppliers throough loans, letters of credit and pre-payments."
• "Since the government lacks experience in administering secured loans to insolvent companies in Chapter 11 reorganizations, it might be preferable to have the loan guaranteed by the U.S. Treasury.  Funds would be advanced periodically by a consortium of financial institutions experienced in lending to Chapter 11 debtors.  They'd be better able to monitor day-to-day compliance within the terms and covenants of the loan."  
• "potential future liabilities [for payments to the retiree trust for rtiree benefits]... not only would weigh heavily on GM's post reorganization success. but also would depress the market value of ay new common shares issued by GM.  With creditor consent, the retiree trust could receive  subordiated debt, with future maturity dates timed to GM's future profitability."
• Existing shareholders get NOTHING.
• New Board of Directors includes representation from major creditor stakeholders and constituencies..   

Under his hypothetical plan, Tilton forsees: 

• Taxpayers getting a warrant for 10% of GM's post-confirmation stock as security for the repayment of the DIP loan.
• GM's existing secued creditors will stay in place and be treated in accordance with federal bankruptcy law
• Warranty claims assumed under plan
• Unsecured debt, including bondholder, trade payables, legacy/retiree claims, and other unsecured claims get their pro rata share of the stock of the reorganized automaker

I don't pretend to know the answer to the crisis presented by the financial problems of Detroit's Big Three automakers, although I am beginning to form a definite opinion which I'll share in a subsequent post.  I do, however, think it's very important for each of us to think hard about this and about what should be done.  Hopefully, these three proposals can be helpful in ordering and organizing that analysis. 

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If you've been paying any attention at all to the national news of late, you know that Detroit's Big Three automakers are in deep trouble and that a substantial number of folks seem to think that forcing them into a "prepackaged " bankruptcy is the ANSWER.  When I first heard this, I thought this seemed like a pretty good idea ....  until I started really thinking about both what can and can't be accomplished  with this sort of Chapter 11 bankruptcy proceeding. 

So in a two-part post, I want to first explore the nature of the beast  those of us in the "biz" call a "prepack" and then focus more specifically on how it might actually operate in the context of the problems being faced by America's automakers.  While superfically appealing, a prepack is far from the panacea some seem to think it could be.  To understand why, you first have to understand how prepacks work in general.

Prepack Coming of Age.  Chapter 11 (and they always are Chapter 11 reorganizations) prepackaged bankruptcies came to the fore about twenty years ago.  Many say that  Dallas based hospital owner Republic Health Corp. was the first successful prepack with a plan confirmed less than five months later.  Prepacks became somewhat more popular during the 1990's in the context of failed LBO's, to implement mass-tort settlements, or as a vehicle to consummate sales or mergers of companies.   In the August issue of the Turnaround Management Association's Journal of Corporate Renewal, an article by Douglas Foley and James Van Horn entitled "Prepacks on the Rise in Chapter 11 Bankruptcies Prenegotiated Plans Can Accelerate Reorganization", asserts that there has recently been renewed interest in this variation of Chapter 11 with four filed in 2007 and more than a dozen filed in the first half of 2008. 

Companies utilizing the prepackaged option have included Donald Trump's Taj Mahal Casino in Atlantic City, Zenith Electronics, Aurora Foods-Pinnacle Foods merger, and TWA.  More recent participants have included Davis Petroleum (Case No. 06-20152, Bankr. S.D. Tex.) (whose plan was confirmed less than a week after filing), Blue Bird Body Co. (Case No. 06-50026, Bankr. D. Nev.), Bally Total Fitness (Case No.07-12395, Bankr. S.D.N. Y.), and Mrs. Fields' Original Cookies (Case No. 08 - 11953 , Bankr. D. Del.) (plan confirmed in less than sixty days after bankruptcy filed).

To promote organization and judicial economy, some jurisdictions such as the Northern District of California Bankruptcy Court and the Southern District of New York Bankrptcy Court have even adopted local rules governing prepackaged bankruptcies.   

Prepack Advantages.  The hallmark and principal advantage of a successful prepack is a substantial savings in time and disruption as compared with the ordinary Chapter 11 bankruptcy case.  The average Chapter 11 case, even a relatively small one, is rarely likely to be completed in less than a year and it can often take two or three years, or even longer, for a company to emerge from Chapter 11.  By contrast, prepackaged cases typically take less than six months, thus saving both time and money typically spent on case administration.  Conventional wisdom also holds that deterioration of the intrinsic value of a business which is often a consequence of a Chapter 11 filing and the attendant uncertainty is lessened through use of the prepackaged option.  (For a general discussion of the general effect of a Chapter 11 bankruptcy on a public company's shareholders, visit the discusssion of "What Every investor Should Know ... Corporate Bankruptcy" on the SEC's website.)

Technically, a prepackaged bankruptcy differs from a prenegotiated bankruptcy in that votes for a plan of reorganization have already been solicited and agreed upon prior to the filing, thereby leaving nothing to chance when it comes to achieving a successful confirmation of the Plan of Reorganization.  In a prenegotiated bankruptcy, actual votes or agreements to vote have not yet been reached with the critical mass of creditors, although resolution has typically been reached with those creditors deemed most crucial to success. 

The most important characteristic of a prepack  (or a prenegotiated bankruptcy) is that the major players in the bankruptcy have come to an agreement among themselves about the most important issues of subsequent financing, lien priority, and the extent to which the debt owing will be discounted or terms of repayment extended.  This reduces the potential for the debtor to lose control of the proceeding and allows it to proceed directly to its contemplted reorganized operations.  By minimizing the time spent subject to the restrictions and various oversight provisions embodied in the Bankruptcy Code and reaching important agreement before  even filing, the liklihood of full blown creditor second-guessing and need to balance the influence of various interests is thought to be significantly and productively decreased. 

Nuts and Bolts.  Section 1126(b) of the Bankruptcy Code and Bankruptcy Rule 3018(b) explicitly allow prepetiton solicitation of votes for approval of a Plan of Reorganization as long as certain procedures are observed.  The key elements to a successful prepetiton solicitation crtical to making a prepack a "go" are:

• The proposed plan must have been transmitted to substantially all creditors or equity security holders entitled  to vote in a class;
• Sufficient time  must have been allowed for voting (or in the words of the statute, the time allowed must not be "unreasonably short" which is of courae a case by case judgment call)
• Those solicited must have been provided with "adequate information" in connection with the solicitation of their vote.
• The provisions of any applicable nonbankruptcy law  such as federal securities law governing communication with shareholders of public companies must be complied with.

In essence, a prepack allows the debtor to bypass the lengthy time (starting with a 25 day notice period  for a hearing on the Disclosure Statement) involved in getting a disclosure statement approved by the Bankruptcy Court, distributed to creditors, and gathering/tabulating ballots approving or rejecting the proposed Plan of Reorganization.  There is of course the risk that the Court will determine after the fact that the prepetition solicitation process did not meet the requirements set forth above; this can happen either as a result of a motion by a party in interest on the Court can make such a finding on its own initiative.

What a prepack does not do, however, is change the requirements concerning creditor approval of a Plan of Reorganization.  Pursuant to section 1126(c), a class of "impaired" creditors (i.e. those not being paid in full) will be deemed to have accepted the plan if and only if the creditors in that class voting hold two-thirds in amount and at least a majority in number of claims voted do in fact vote to accept the plan.  In addition, pursuant to section 1129(a)(10), the plan cannot be confirmed unless at least one class of impaired creditors vote to accept the plan.  there are also the other usual requirements of feasibility and the like. 

Prepack Risks and Obstacles.  Prepackaged bankruptcies tend to work best where there are a limited number of sophisticated secured creditors involved with whom productive negotiations can actually be had.  They tend to work less well when a debtor has a large number of creditors, especially if unsecured, with a variety of different claims ( e.g. trade creditors, employees, landlords, equipment lessors,etc.) entitled to varying treatment under the Bankruptcy Code and which may fluctuate considerably during the period immediately preceding a filing.  Large numbers of contingent claims can also be an obstacle for the obvious reason that time must be spent determining how to estimate the amount of such claims.

In addition, by immediately proceeding to the plan confirmation phase, a debtor does lose the benefit of the "breathing spell" provided by the automatic stay which arises immediately upon the filing of the petition.  And, of course, it does tip the debtor's hand as to its financial distress (which may often be obvious anyway).

Drawing Conclusions.  While there are certainly some useful rights and remedies available to Detroit's Big Three should they decide to file Chapter 11 - being able to shed burdensome labor and/or dealer contracts springs to mind - there are also substantial risks - will consumers continue to spend thousands of dollars to buy vehicles from a car company in bankruptcy.   Prepackaged bankruptcy seems to be advanced by many of its advocates as a way to maximize the advantages of being a Chapter 11 debtor while eliiminating the "down side" of a bankruptcy filing.  I just don't think it's that simple.

So next time I will focus more specifically on how well suited the prepack option really is for Detroit's Big Three and what it might and might not be able to do for them.,

UPDATE:  In the first quarter of 2009, prepackaged bankruptcies hit an 8 year high with more than in all of 2008.

Also thanks to Scott Jagow of American Public Media's Scratch Pad for putting a practical spin on how this would apply in a Chrysler bankruptcy.

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