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    Posts Tagged ‘“debtor-in-possession”’

    It’s Different In Hong Kong

    Monday, January 24th, 2011

    Readers of this blog will know that a number of jurisdictions around the world have remodeled their insolvency schemes based on concepts developed originally in the US under Chapter 11 of the Bankruptcy Code.  Relatively recent examples of this trend include the People’s Republic of China as well as Mexico.

    But not all jurisdictions have rushed to follow the US.  For one, Hong Kong – one of the world’s leading financial centers – has struck out on a different path.

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    With origins steeped in colonial history and a long-standing tradition of UK law, Hong Kong still follows the legal contours of most commonwealth jurisdictions, including those applicable to the resolution of insolvencies.  In Hong Kong, a “winding-up” is the traditional means of achieving a moratorium on creditor activity; however, “winding up” has been limited to liquidation.

    Corporate reorganization (or “corporate rescue,” as it’s sometimes called) relies on the implementation of a “scheme of arrangement.”  In Hong Kong, however, schemes are deemed of little practical value where their comparative complexity and expense buy no moratorium from creditors.

    Previously, corporate reorganization in Hong Kong relied upon an ad hoc solution – utilization of the “winding up” procedure to implement what was known colloquially a “provisional liquidation.”  The essence of the “provisional liquidation” concept is that a voluntary winding up is commenced – and the debtor can avail itself of a moratorium against creditor action – while a court administrator is appointed to oversee the debtor until the company and its creditors can reach acceptable reorganization terms (at which time, the winding up is dismissed and the debtor reorganized consensually).  Though initially accepted, such solutions were ultimately sharply limited by the Hong Kong courts.

    In 2009, Hong Kong’s Financial Services and Treasury Bureau (FSTB) published a consultation paper reviewing corporate rescue procedure with the aim of reforming key reorganization issues.  The FSTB paper – and the different concepts it proposes for Hong Kong reorganization vis á vis “US”-style Chapter 11’s – are the subject of recent analysis by Dr John K.S. Ho, Assistant Professor, School of Law, City University of Hong Kong and Dr Raymond S.Y. Chan, Associate Professor, School of Business, Hong Kong Baptist University.

    Specifically, Dr’s Ho and Chan ask “Is Debtor-in-Possession Viable in Hong Kong?”  In providing an answer, they discuss reform efforts in Hong Kong, noting that a “provisional supervision” has been and remains the preferred approach to Chapter 11 rather than a US-style “Debtor-in-Possession” (DIP) approach, where management remains in control of its own destiny.

    So why doesn’t a US-oriented corporate rescue scheme work in Hong Kong?  According to Ho and Chan, “[i]n order to understand the corporate rescue law of a jurisdiction, one must also recognize the economic nature and historical development of that society.”  Some of the differences in economic development which shape differences in US and Hong Kong insolvency laws include:

    Varying Appetites for Risk.  “In the US, it is widely believed that there is a different attitude towards risk and risk-takers . . . .  Debt forgiveness, both personal and business debt, ultimately was seen as critical to a vibrant American economy.  These historical and economic factors explain in large part why the US business bankruptcy system is more forgiving towards the debtor than other jurisdictions are.  However, the same analogy may not apply to the concept of corporate rescue in Hong Kong because the stakeholders which reform proposal in Hong Kong is most concerned with are different from Chapter 11 in the US.”

    Different Stakeholders.  How are Hong Kong stakeholders different?  And why should corporate rescue look different in Hong Kong than in the US?

    [I]n Hong Kong, the objectives for . . . corporate rescue are radically different . . . .  [E]mployees should generally be no worse off than in the case of insolvent liquidation and . . . consideration should be given to allow greater involvement of creditors in the rescue process in exchange for their being bound by the moratorium once the process commences and the rescue plan is agreed . . . .  [P]revious attempt[s] to introduce a corporate rescue law failed in Hong Kong because of the disappointing treatment of workers’ wages, complete exclusion of shareholders from the provisional supervision process, and the difficulty in classification of creditors.  Therefore, if a law is to be successfully promulgated this time, greater consideration would need to be given to these stakeholders.

    Though they explain how the proposed treatment of Hong Kong stakeholders in a corporate reorganization might differ from those in a US Chapter 11, Ho and Chan don’t really explain the why of those differences.  What they do offer is an explanation for the absence of any interference with secured creditors’ rights, noting that this “is understandable given the fact that many major secured creditors [in Hong Kong] are financial institutions such as major banks and their influence both politically and economically cannot be ignored given that the growth of Hong Kong as a financial services hub has been supported largely by the banking sector.”

    These differences are “in line with the legal creditor rights ratings of the two jurisdictions as reported in a financial economics study in which a creditor rights index is developed for 129 countries and jurisdictions. This index ranges from 0 to 4 (with higher scores representing better creditor rights) and measures four powers of secured lenders in bankruptcy.  Hong Kong (and also the UK) has a perfect score of 4, but the US has a score of 1.”

    Different Corporate Ownership and Control Structures.  A more interesting difference arises from the authors’ argument that, unlike in the US, share ownership and corporate control in Hong Kong are closely related:

    According to research conducted at the turn of the millennium, . . . separation of ownership and control, [has] largely become the phenomenon in the US.  This trend was accompanied by a shift in bankruptcy law towards a more flexible, manager-oriented regime, assuming that managers of corporations that have filed Chapter 11 will subsequently make business decisions in the best interests of the corporations as a whole. On the bankruptcy side these developments culminated in 1978 with the enactment of the Bankruptcy Code and its DIP norm.  However, in Hong Kong, [this] type of [dispersed corporate ownership] is not as prevalent. According to research on ownership structures and control in East Asian corporations, about three-quarters of the largest 20 companies in Hong Kong are under family control, while fewer than 60 per cent of the smallest 50 companies are in the same category. As for corporate assets held by the largest 15 families as a percentage of GDP, Hong Kong displays one of the largest concentrations of control, at 76 per cent. For comparison, the wealth of the 15 richest American families stands at about 3 per cent of GDP.

    Because of this reality, the Ho and Chan argue that the DIP concept so common in US reorganizations simply isn’t practical in Hong Kong:

    Given such context, a corporate rescue process based on the DIP concept of the US will not be practical for Hong Kong because wide dispersion of share-ownership and manager-displacing corporate reorganization simply do not exist in reality.  This is consistent with the government’s proposal in rejecting the DIP given concerns that if the existing management was allowed to remain in control, a company could easily avoid or delay its obligations to creditors as the managers of a family business either are family members or are nominated by the family.  They are expected to place the family’s interests in the corporation as the first priority even at the expense of creditors’ interests.

    Though these differences may be true in the case of publicly held and traded US corporations, they are not so clear in the case of closely-held US companies – which many readers will acknowledge comprise the bulk of US business.

    Why No Post-Petition Financing?  As for post-petition financing – a mainstay of US reorganizations – Ho and Chan point out that though the US has developed a vibrant distressed debt market, “the debt market is not as developed and is materially underused in Hong Kong.  The major reason for illiquidity and lack of use is best expressed as Hong Kong’s cultural background.  Hong Kong lacks no resources for deal structuring but has no tradition of traded debt, and corporate governance practice has historically been insufficient to support issue of debts by large companies.”

    Economic Efficiency.  Finally, the authors cite well-recognized and frequently noted flaws in the Chapter 11 process: Its perceived inefficiency arising from its “one-size-fits-all” approach, as well as the arguably high rates of recidivism amongst those debtors who do successfully confirm a Chapter 11 Plan.

    Whatever one’s take on Ho and Chan’s assessment of US-style reorganizations, their work affords an interesting glimpse into alternative methods of corporate rescue currently under consideration in one of the world’s most sophisticated financial jurisdictions.

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    Buying Assets in Bankruptcy – To Be or Not to Be . . . a Stalking Horse?!

    Monday, March 1st, 2010

    With both the global and regional Southern California economies showing early signs of life – but still lacking the broad-based demand for goods and services required for robust growth – opportunities abound for strong industry players to make strategic acquisitions of troubled competitors or their distressed assets.

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    Ray Clark, CFA, ASA and Senior Managing Director of VALCOR Consulting, LLC, is no stranger to middle-market deals.  His advisory firm provides middle market restructuring, transactional and valuation services throughout the Southwestern United States from offices in Orange County, San Francisco, and Phoenix.

    As most readers are likely aware, distressed mergers and acquisitions can be handled through a variety of deal structures.  Last week, Ray dropped by South Bay Law Firm to offer his thoughts on a process commonly known in bankruptcy parlance as a “Section 363 sale.”

    In particular, Ray covers the “pros and cons” of this approach.

    The floor is yours, Ray.

    Today’s economic environment has created an opportunity to acquire assets of financially distressed entities at deeply discounted prices, and one of the most effective ways to make those acquisitions is through a purchase in the context of a bankruptcy under Section 363 of the Bankruptcy Code (the “Code”).  When purchasing the assets of a failed company under Section 363, there are distinct advantages to being first in line.  Depending on the circumstances, however, it may be best to wait and let the process unfold – and then, only after surveying the entire landscape, submit a bid.

    The 363 Sale Process

    A so-called “363 Sale” is a sale of assets of a bankrupt debtor, wherein certain discrete assets such as equipment or real estate – or substantially all the debtor’s business assets – are sold pursuant to Section 363 of the Bankruptcy Code (11 USC §363).  Upon bankruptcy court approval, the assets will be conveyed to the purchaser free and clear of any liens or encumbrances. Those liens or encumbrances will then attach to the net proceeds of the sale and be paid as ordered by the Bankruptcy Court.

    A Section 363 sale looks much like a traditional controlled auction.  Basic Section 363 sale mechanics include an initial bidder, often referred to as the “stalking horse,” who reaches an agreement to purchase assets – typically from the Chapter 11 debtor, or “debtor-in-possession” (DIP).  The buyer and the DIP negotiate an asset purchase agreement (APA), which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to “higher and better” or “over” bids.  The Bankruptcy Court will approve the bidding procedures, including the incentives, i.e., a “bust-up” fee, for the stalking horse bidder, and will pronounce clear rules for the remainder of the sale process.  Notice of the sale will be given, qualified bids will arrive and there will be an auction.  The sale to the highest bidder will commonly close within four to six weeks after the notice and the stalking horse will either acquire the assets or take home its bust-up fee and expense reimbursement as a consolation. 

    Advantages for the Stalking Horse Bidder

    Bidding Protections - During negotiations with the debtor for the purchase of assets, the stalking horse will also typically negotiate certain protections for itself during the bidding process.  These bidding protections, which include a bust-up fee and expense reimbursement, will be set forth in the 363 sale motion and are generally approved by the bankruptcy Court.  As a result, stalking horse bidders seek to insulate themselves against the risk of being out-bid.  To do so, proposed stalking-horse bidders commonly require that any outside bidder will typically have to submit not only a bid that is higher than that of the stalking horse, but will also need to include an amount to cover the stalking horse’s transactional fees and expenses.

    Bidding Procedures – The stalking horse will also negotiate certain bidding procedures with the debtor, which will be set forth in the 363 sale motion that will be evaluated, and most likely approved, by the Court.  The sale procedures generally include the time frame during which other potential bidders must complete their due diligence and the date by which competing bids must be submitted.

    Other delineated procedures typically included in the motion include the amount of any deposit accompanying a bid and the incremental amount by which a competing bid must exceed the stalking horse bid.  In addition, if the sale procedures provide for an abbreviated time frame in which to complete an investigation of the assets, a competing bidder will be at a distinct disadvantage and may be unable, as a result, to even submit a bid.

    Deal Structure – As the first in line, the stalking horse bidder will also negotiate all of the important elements of the transaction, including which assets to acquire, what contracts – if any – to assume, the purchase price and other terms and conditions.  In doing so, it establishes the ground rules by which the sale process will unfold and the framework for the transaction, which will be difficult, if not impossible, for another outside bidder to change. 

    “First Mover” Advantage – The stalking horse bidder will typically be viewed by the Court as the favored asset purchaser in that it will have negotiated all of the relevant terms and procedures, and established its financial ability and intent to acquire the assets.  As a result, short of an overbid by an outside party, which typically involves an additional amount to cover the stalking horse’s bust-up fee and expenses, the stalking horse bidder will prevail.

    Cooperation of Stakeholders – As the lead bidder, the stalking horse also has an opportunity to negotiate with other key stakeholders in the process and establish a close relationship with those parties that may prove advantageous when all offers are evaluated.

    Bust-up Fee and Expense Coverage – Lastly, if an outside party happens to submit the high bid, the stalking horse will typically receive its bust-up fee and expense reimbursement. This generally includes items such as due diligence fees, legal and accounting fees, and similar expenses, but is limited by negotiation. 

    Disadvantages to the Stalking Horse Bidder

    Risk of Being Outbid – As noted, the stalking horse will expend a great deal of time, energy, and resources analyzing and negotiating for the purchase of the assets.  All a competing bidder must do is show up to the sale and submit an over-bid.  If the competing over-bidder prevails, the stalking horse runs the risk of walking away with only its bust-up fee and expense reimbursement.

    Risk of Bidding Too High – After negotiating the APA, the stalking horse then participates in the 363 sale process.  If no other bidders materialize, it may be because the stalking horse effectively over-paid for the assets. 

    Inability to Alter Terms – If some new information comes to light that would otherwise suggest a reduction in the price or alteration of the terms, the stalking horse may have difficulty altering either of these and may be locked in to the negotiated structure.

    Questions?

    Contact rclark@valcoronline.com or mgood@southbaylawfirm.com.

    Meanwhile, happy hunting.

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    The Law of Unintended Consequences

    Monday, September 14th, 2009

    Unintended consequences.

    Unfortunately, life is full of them . . . and so is the 2005 Bankruptcy Code.  Today’s post will discuss just one: The expanded protection afforded trade creditors under Section 503(b)(9).

    What does this section do?  And just how much protection does it provide?  As amended, Section 503(b)(9) was intended by Congress to protect vendors who supplied goods to a debtor within 20 days of a debtor’s bankruptcy filing by extending “administrative” (i.e., 100% payment) status to their claims.  Along with amendments to Section 546(c), the idea was to protect vendors who extended credit to a debtor immediately before the debtor filed a case.  But in fact, Section 503(b)(9)’s application may now be leaving many such vendors at greater risk.

    How so?  A recent Daily Deal piece by Natixis’ Christophe Razaire briefly outlines three general problem areas. 

    Goods?  Or services?  Section 503(b)(9) protects suppliers of goods well enough, and understandably so: Along with Section 546(c), it is designed to preserve and augment the protections extended to the same vendors under the Uniform Commercial Code.  But what about suppliers of services?  Unfortunately, as a number of creative service providers have discovered, the Code offers no such similar protection.  Moreover, where a company relies primarily on services for its activity, it appears doubtful that the Code’s amendment does anything to alleviate the risk of a debtor’s default and eventual bankruptcy.

    Payment?  Or post-petition payables?  Though Section 503(b)(9) provides administrative priority for “20-day” vendor claims and Section 546(c) likewise permits vendors to assert reclamation demands for goods supplied immediately prior to the debtor’s filing, in practice, vendors rarely see any early compensation in the case. 

    Instead, a bankruptcy court is far more likely to simply afford such claims their entitled administrative status, then require the vendors holding them to wait until the conclusion of the case for payment.  Economically, this means that vendors who should be enjoying administrative protection and receiving cash are, in fact, merely exchanging one “IOU” for another – and, in the meantime, suffering as much liquidity distress as any other general unsecured creditor.

    Needless to say, this liquidity distress has to be dealt with in some fashion.  And it is often addressed through a refusal to further supply the debtor-in-possession except on “COD” or similarly restrictive terms.  Alternatively, other customers of a cash-strapped vendor may feel the squeeze through tightened terms as the vendor struggles to compensate for large – but unsatisfied – administrative obligations owed by the debtor.

    Administrative protection?  Or administrative insolvency?  Perhaps the most unintended consequence of Section 503(b)(9)’s amendment is that business reorganizations involving large numbers of “20-day” claims may, in fact, be threatened by its application.

    “20-day vendors” can, if they so choose, accept payments on their administrative claims at a discount – and, in fact, it is not uncommon for debtors to attempt to cut such deals.  But where there are numerous “20-day” claimants, the debtor often faces very slow, arduous negotiations.  Many vendors are reluctant to negotiate with the debtor for fear of “selling out” too low; others may try their hand at brinksmanship, betting that the debtor’s need to satisfy such claims prior to emerging from bankruptcy will reward their willingness to “hold out.”

    Often, the “reward” for such bargaining is something less than creditors may have hoped for.  The debtor concludes it cannot negotiate and must instead incur the [additional] administrative expense of contesting such claims directly in an effort to reduce their aggregate amount.  If these claims disputes do not go the debtor’s way, or if the debtor is already struggling to emerge with sufficient cash, the debtor may be forced to liquidate – thereby leaving all creditors, from secured debt to general unsecured claims, with far less than might otherwise be the case.

    How big can these problems get?  A recent “Dealscape” blog post by Ben Fidler illustrates how the section is playing out in the troubled retail and auto parts sectors, where vendors of goods often play a significant role in a company’s operations.  Fidler points to larger Chapter 11 filings, such as Empire Beef Co., Blackhawk Automotive Plastics, Inc., and Plastech Engineered Products, Inc., which have been left administratively insolvent or have been threatened with such insolvency, as a result of section 503(b)(9)’s amendments.

    Though not every case is as large as the ones cited by Fidler – and not every case results in administrative insolvency – similar dynamics with similar results can just as easily arise in smaller Chapter 11’s.

    In sum, this anecdotal data suggests that Congress’ well-intended efforts to afford some creditors with more options in a debtor’s reorganization may, in fact, have left all creditors with far less options.

    Surely, this cannot have been Congress’ intended consequence.

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