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Business Law Today

The Untold Story of the Bankruptcy Courts
A Positive Resource For Business
By Ronald S. Gellert
The inner workings of bankruptcy courts are a mystery to many people. To some, bankruptcy involves a group of unfortunate people who have lost everything, arrive at court with their pockets turned inside out, and are looking for a way to get out from under their debts. Many people also have similarly misinformed views about corporate bankruptcy, believing that such companies have run out of money and are going out of business, leaving little, if any, assets for their creditors.

Perhaps these misimpressions are not that far from the truth on occasion, but there is often little understanding of bankruptcy as a positive tool for business. This article will debunk these misconceptions and highlight how companies can use bankruptcy courts to improve their business and rectify uncertainties in various industries.

The Evolution of Bankruptcy Courts
Bankruptcy courts are essentially deputies of debt. Unlike other federal courts that exist pursuant to the mandate of Article III of the U.S. Constitution, bankruptcy courts were created under Article I, Section 8, of the Constitution, which gives Congress the power to establish uniform laws on the subject of bankruptcy throughout the country. Because bankruptcy courts are not Article III courts, the judges do not have lifetime appointments. Technically, jurisdiction over bankruptcy cases is first granted directly to the federal district courts, which refer bankruptcy cases to the bankruptcy courts for their district. Thus, bankruptcy courts are arms or specialized divisions of the federal district courts.

Bankruptcy courts were established with the adoption of the Bankruptcy Code in 1978, as revised by the 1984 amendments. Prior to this legislation, under the former Bankruptcy Act, bankruptcy "referees" presided over bankruptcy matters. When the Bankruptcy Code was passed, the referees put down their whistles and picked up gavels to become bankruptcy court judges.

The Bankruptcy Code is located in Title 11 of the United States Code and is separated by chapters. The most popular and well-known chapters include Chapter 7, governing liquidation for individuals and businesses; Chapter 11, providing for business reorganizations; and Chapter 13, dealing with reorganization of individual debts.

Benefits of the Chapter 11 Process
When a company enters, or nears a distressed situation, it should consider some form of bankruptcy protection. In many states, including Delaware, it may be among the directors' and officers' fiduciary duties to consider preserving assets of the estate for the benefit of the company's creditors and shareholders. Although liquidation is an option, bankruptcy may also be used to continue a business, albeit in a different form.

The sale of a company through the bankruptcy process offers many benefits. A Chapter 11 proceeding may even be preferred, or required, by a potential purchaser due to the significant advantages associated with the release of successor liability. In other words, a buyer need not be concerned about the liabilities associated with the seller's operations and can take the assets/business segment free and clear of all liens, claims, and encumbrances, with all such claims being funneled back and attaching to the proceeds of the sale held by the debtor-seller. This is a unique feature of the Bankruptcy Code and has led to a number of cases where a company's operations and employees remained intact, less the overwhelming obligations that hampered the debtor-seller's ability to be successful.

Other significant benefits of a Chapter 11 proceeding include the following: the rejection of underperforming contracts and leases; the assumption of advantageous leases and contracts; orderly liquidation and distribution mechanisms; actions to bring money back into the debtor's estate for equal distribution among creditors; and, most importantly, the time and leverage to deal with creditors.

Even where refinancing of existing debt is sought, lenders may prefer the orderly protections associated with a bankruptcy proceeding and make that a requirement of the financing.

Moreover, bankruptcy courts often help achieve efficiency in the marketplace and are otherwise useful tools for the overall economy. For instance, while extensive competition in an industry may appear to be good for consumers, it may actually be harmful for the economy. For instance, when an entity is dropping its price points below that of the break-even point in order to remain competitive, it tends to have a long-term effect on competitors, all of whom are either dropping margins to stay competitive or holding pat and losing customers. Eventually most, if not all, participants in the industry begin to suffer. This was part of the problem driving the fairly recent wave of telecommunications, commercial airlines, and retail bankruptcies, to name a few. Out of these bankruptcy cases arose consolidation and efficiencies that preserved many jobs and improved overall service, without driving consumer prices through the roof.

In sum, considering bankruptcy protection among a company's options is both wise and may even be a required duty. In addition, bankruptcy courts have helped stabilize segments of the economy through certain downturns while maintaining efficiency in the marketplace.

Breadth of Practice Areas and Interests
Another element that makes bankruptcy courts unique is the wide swath of practice areas that come before the court and the court's ability to effectively juggle the interplay of those issues while guiding an entity through the Chapter 11 reorganization process. Consequently, bankruptcy judges must possess a significant amount of business judgment and knowledge to be able to look at issues from both the debtor's and creditors' point of view.

In addition, bankruptcy courts are presented with practically every issue that a business entity may encounter, from toxic tort cases to intellectual property issues, all while being governed by the provisions of the Bankruptcy Code.

Bankruptcy courts are also adept at evaluating a wide variety of positions held by various parties associated with the bankruptcy case. For example, most debtors have secured lenders who are looking to recover the highest value of their collateral while their unsecured creditors (most of the time formed into "committees" by the U.S. Trustee's office) are looking to maximize distributions on unencumbered assets. Further, most cases also affect employees and retirees, shareholders, bondholders, landlords, equipment lessors, insurers, subcontractors, taxing authorities, and personal injury claimants, to name a few. Bankruptcy courts must permit each party to make its position known and then must weigh the respective and oftentimes competing interests, all in the name of allowing the debtor entity to have a chance to reorganize (or make a successful sale of its assets).

Ready, Willing, and Able
Bankruptcy courts have been and are becoming more adept at handling cases from the moment they are filed. Considering that a business seeking Chapter 11 protection often has payroll (and morale) needs to meet, suppliers that are demanding payment, and shipments in transit (to name a few examples), bankruptcy courts must be ready to react within a day or two of the filing of a bankruptcy petition.

These issues become even more important where the size of the entity makes the bankruptcy filing a "mega case," which typically includes companies with more than $100 million in assets and liabilities and potentially thousands of creditors. In the context of mega cases, the first step in the process is usually a "first day" hearing with the attendant consideration of "first day" motions. The hearing is usually scheduled within a day or two of the filing of the bankruptcy petition and is expedited so that parties are given prompt notice of how to continue dealing with the debtor company. These motions cover a number of issues, including, but not limited to, payment of wages and other employee benefits, the maintenance and operation of bank accounts, dealing with essential suppliers, and the use of cash collateral (or interim use of debtor-in-possession financing which allows the debtor to become indebted with court approval). Frequently in such cases, courts schedule "omnibus" hearing dates and times for each bankruptcy matter so that all business before the court on that matter can occur at one given time.

Certain cases known as "prepackaged" cases require even more flexibility by the court to evaluate everything from typical motions to a proposed sale or replacement financing on day one. These cases can be handled quickly because the debtor's bankruptcy plan is negotiated and drafted with the debtor's main constituents prior to the filing of the bankruptcy petition.

Most impressive is the bankruptcy court's ability to handle these first day issues without the participation of many affected creditors. The court, with the help of the U.S. Trustee, must not only evaluate the relief requested as it will impact the debtor entity, but also must evaluate how and whether the relief may impact parties who are not yet aware or up to speed about the bankruptcy matter. As a result, the orders entered with respect to first day motions are typically interim in nature, with a final hearing taking place after the debtor provides potentially affected parties with notice of the bankruptcy and the final hearing date.

Perhaps the most well-known court for handling mega cases is the United States Bankruptcy Court for the District of Delaware. Until recently, the two full-time bankruptcy judges, the Honorable Mary Walrath and Peter Walsh, handled nearly the entire caseload. With help from a number of visiting judges who volunteered to assist, the Delaware bankruptcy court was one of the busiest in the country. Now that four additional judges have been sworn in, the Honorable Kevin Carey, Kevin Gross, Brendan Shannon, and Christopher Sontchi, the Delaware bankruptcy court has grown in consistency and capacity. The recent inflow of cases to Delaware undoubtedly is due to the special abilities of the members of the bench and the court's effectiveness in handling larger bankruptcy matters.

Other notable courts for handling mega cases are New York, Chicago, and Texas. Each of these courts has carefully studied the needs of the debtors filing commercial cases and understands the prompt need for certain critical relief from the onset of the filing.

Recently, other districts have adopted certain of the best attributes of the above-mentioned courts and have streamlined their process to handle large cases efficiently. New Jersey, Virginia, California, Florida, and Pennsylvania are among the growing number of districts adopting local rules and practices making the administration of larger Chapter 11 cases more efficient.

Importantly, these courts are also recognizing the national experience of many bankruptcy practitioners whose client's needs are adjudicated in courts around the country. Many bankruptcy judges are visited by out-of-town counsel on a regular basis. In response, bankruptcy courts have streamlined telephonic hearing procedures and pro hac vice procedures. Indeed, especially in districts such as Delaware where local counsel is required at all hearings, the local practitioners have become efficient at walking their co-counsel and clients through the local bankruptcy process in an effort to minimize and avoid duplicative costs.

Bankruptcy Litigation
Perhaps at one time you or your clients have been confronted by a preference or fraudulent conveyance action arising out of a bankruptcy case in which the debtor sought to recover payments received prior to the bankruptcy filing. These suits are the primary way that bankruptcy courts attempt to balance the varied interests of multiple parties in administering reorganization and liquidation proceedings, by bringing money back into the debtor's bankruptcy estate. Preference actions generally seek to recover any funds paid out to creditors within the 90 days leading up to the bankruptcy filing. In brief, fraudulent conveyance actions seek funds expended without an equivalent benefit being conferred upon the debtor.

What is impressive about this litigation is the fact that the litigation matters are typically filed in large volumes, each with its own separate docket number. For instance, in the Fleming Companies, Inc., bankruptcy case, the post-confirmation trusts filed over a thousand individual preference actions. Other bankruptcy cases such as Loewen Group International, Inc., have spawned thousands of such suits at a time.

The ability to handle this voluminous litigation is due, primarily, to the court's adoption of streamlined case management procedures. First, by instituting uniform pretrial schedules and procedures, bankruptcy courts have placed the cases on a track which balances the parties' discovery needs and motion practice, and which facilitates settlement negotiations. Further, districts such as Delaware have instituted a mandatory mediation program which has become an exceptional tool in prompting settlements, thereby whittling down the massive caseload.

In sum, the ability to efficiently handle large numbers of related litigation matters further demonstrates that bankruptcy courts are effective places to conduct business.

Bankruptcy courts do much more than allow businesses to close their doors. They are specialty courts that deal with issues arising in almost every area of law in order to help businesses reorganize or liquidate in an efficient and organized manner. The cases are often complex, involving multiple parties and millions of dollars, but at the end of the day, bankruptcy courts are able to balance competing interests to achieve a result that benefits all parties involved.
Gellert is a member of Eckert Seamans Cherin & Mellott, LLC, practicing in the Bankruptcy & Restructuring Department at the firm's Philadelphia and Wilmington, Delaware, offices. His e-mail is rgellert@eckertseamans.com.

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