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California Business Reorganization in Receivership May be Preferable to Ch. 11 Bankruptcy in Right Situation By Rense, Kirk* There was a time when business reorganizations were accomplished under state laws rather than under federal statutes, and California’s rules – which parallel those of the Bankruptcy Code to an extent—remain somewhat intact. The interesting question is whether new statutory changes making business reorganization more difficult under Chapter 11 may prompt more distressed entities (and their major secured creditors) to consider reorganizing their debt under state law? First, a brief look at the similarities and dissimilarities of state and bankruptcy law reorganization proceedings. In both settings the assets of the distressed company are under the supervision and/or control of the court. A bankruptcy estate, created upon petition filing (11 USC Section 541), is comprised of all assets of the debtor. These remain under the control (within court-supervised limits) of the debtor’s management while reorganization is attempted. In a receivership the company’s property (the receivership estate) is placed in the control of the receiver, and is “under the control and continuous supervision of the court.” Turner v. Superior Court, 72 Cal. App. 3d 804, 813 (1977). The bankruptcy automatic stay (11 USC Section 362) prevents third parties from interfering with the bankruptcy debtor or its assets—wherever located (reflecting the bankruptcy court’s national jurisdiction)—during the case. Violations are punishable. In a receivership, taking (or bringing) an action against estate assets within the state court’s jurisdiction without prior permission of the court is punishable as a contempt. Strain v. Superior Court, 168 Cal. 216, 220 (1914); Clark, Law of Receivers, 3rd Ed. Vol. IV Section 976 (1959). In both scenarios the prohibition against such actions may be lifted by the court. The state court has less long-term control over such actions than bankruptcy court, however. Preference recovery law (11 USC Section 547) is a major component of many (if not most) Chapter 11 reorganizations —payments the debtor made within specified periods are reviewed for favoritism and may be targets of recovery actions. There are no preference recovery requirements under state law in a reorganizing receivership, however. Cal. Civ. Code Section 3432. A reorganizing company’s fraudulent conveyances (i.e. conveyances made for less than full and fair consideration) are recoverable both in a bankruptcy proceeding (11 USC Section 548) and in a state court reorganizing receivership (California Civil Code Sections 3439 et seq.). Perhaps the most important distinction between attempting reorganization under the different sets of laws is in debt restructuring. In both bankruptcy and in receivership debt may be permanently restructured: by a plan of bankruptcy reorganization under Chapter 11, or by court order in a receivership. But in bankruptcy a creditor’s debt may be restructured over creditors’ objections by a confirmed plan. In a receivership the creditors must agree to their proposed debt reorganization treatment, or a court order binding them will not be issued. As this suggests, reorganization in state court is essentially a cooperative effort and requires that all parties—the troubled company, its principal secured creditor(s) and its unsecured creditors—work together civilly and rationally to structure a reorganization plan in every entity’s best interests. In a bankruptcy setting the court may force creditors (usually unsecured creditors) to accept an unpopular plan if it is otherwise acceptable under the Bankruptcy Code’s complex confirmation procedures. A few other important similarities include strict, enforceable bar dates for the filing of claims and conditional availability of new financing to assist the reorganization process. New financing with a super priority may be obtained in bankruptcy if existing lienholders are assured of adequate protection (even if they don’t agree). In a state court receivership secured creditors must agree to the creation of such new priority debt—unless it is strictly necessary to preserve receivership estate assets. Significant dissimilarities exist with respect to control over the reorganizing company. In bankruptcy existing management guides the activities of the debtor entity (unless replaced for cause with a bankruptcy trustee). The creditor body has little or no input or control over company operations. In a receivership the appointed receiver (often a skilled businessperson) typically has control of the reorganizing entity, and uses existing management only to the extent it is beneficial to the company. The extent of this control in receivership is usually worked out cooperatively in advance of filing by the troubled company and its principal secured creditor(s), then is set out in the order of appointment (which is quite elastic). This removes a friction point—creditors who don’t trust existing management have little recourse in bankruptcy. In a receivership they deal with a new person—the court’s receiver—with credibility and the weight of the court behind her or him. Let’s return to the original question with these points in mind. Do changes in the Bankruptcy Code make state court reorganization more attractive to California businesses? Plan exclusivity isn’t an issue in state court—the reorganizing entity and its principal creditors work together to structure a plan. The process isn’t adversarial, or not nearly so adversarial as in a typical bankruptcy proceeding. Lease assumption also is less of an issue in state court. The fact that the reorganizing entity and its principal creditors—usually including landlords—work together cooperatively usually defuses this issue. The reduction in time for a bankruptcy debtor to decide whether to assume or reject a lease under the new Bankruptcy Reform Act may be, at worst, a minor deterrent to bankruptcy filings. The time during which payments are to be made to creditors (including tax creditors) in a state court reorganization is left to the parties and the discretion of the court. The new limitations on treatment of taxing authority claims in a Chapter 11 proceeding may make a state court reorganization somewhat more attractive, depending upon the degree of cooperation exhibited by the taxing agency. California law currently caps its priority for wage claim at $4,300 earned within 90 days before the filing of the case (Cal. Code Civ. Pro. Section 1204), as compared with a $10,000 cap on wages earned within 180 days of the case commencement in bankruptcy. This may make a substantial difference to smaller cash-poor companies. The same may be said for the new bankruptcy requirement that debtors provide “adequate assurances” to utility companies in the form of bonds, cash payments and the like in order to keep the power on during reorganization. Keeping the lights on without an immediate cash outlay may be negotiated by an entity reorganizing in a state court reorganization. The enhanced reclamation rights of vendors and suppliers of goods under the Bankruptcy Code are more generous than under state law, where a vendor has only ten days after receipt of its goods to demand their return (Cal. Uniform Com.Code Section 2792), as compared with 45 days to make demand after delivering goods (or 20 days after the petition filing). This may be a strategic difference to a troubled company needing inventory to remain operating while reorganizing its debt. A general tightening of timing restrictions and greater reporting and disclosure requirements for “Small Business Debtors” in bankruptcy are undoubtedly designed to weed out unrealistic cases and filings done merely to postpone an inevitable liquidation. The state court’s structurally less-formal regimen, where timetables will be set by the court, may allow a troubled company the greater flexibility it needs to work out its reorganization plan. These are not all the factors and features that may bear on a company’s choice of forum. Certainly a company with multi-state operations and interests must use Chapter 11 because of the federal court’s national jurisdiction (and reach of the automatic stay). And determined creditors can always stifle an attempted state court reorganization by filing an involuntary bankruptcy petition against the company, throwing it into the bankruptcy court. But the usually greater costs (and delay) of a bankruptcy proceeding will seldom enhance dividends to be paid to unsecured creditors when compared with a state court action. And secured creditors enjoy measurably greater influence over a state court reorganization attempt (where there are no cramdowns unless voluntarily entered into) when contrasted with bankruptcy court proceedings. In summary, the changes to the Bankruptcy Code do make state
court reorganizations somewhat more attractive to California businesses.
Time will tell if this results in more reorganizations under California
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