Given the economic crisis and its profound impact on the U.S. auto industry, the phrase “prepackaged bankruptcy” or “prepack” suddenly has become the term du jour. Once an industry term familiar only to bankruptcy practitioners, prepacks suddenly have become the focus of debate among those in Washington, the news media and the blogsphere, primarily in reference to potential bankruptcies of the Big Three automakers. Now that the U.S. Treasury Department has hired bankruptcy attorneys to evaluate the restructuring options of the Big Three, prepacks are receiving even more hype. What does this term really mean? And how would it affect any potential bankruptcy of a U.S. automaker?
Put simply, the goal of any true corporate bankruptcy is to restructure a company’s debts according to a plan formulated by the company, referred to as a plan of reorganization, which must be voted upon by creditors and approved by the bankruptcy court. This process is referred to as plan confirmation and can take months or years to achieve, depending upon the different categories and number of creditors, complexities and circumstances of the company’s bankruptcy case. A typical prepack is a bankruptcy case wherein the debtor proposes, negotiates and solicits confirmation of a plan of reorganization with its major constituencies prior to a bankruptcy filing. Section 1126(b) of the U.S. Bankruptcy Code provides that votes cast before the commencement of a Chapter 11 bankruptcy case may be counted for purposes of confirmation of a debtor’s plan of reorganization. Once the plan is negotiated and approved by creditors, the debtor then files its bankruptcy case with a consensual restructuring plan in place and seeks approval of such plan from the bankruptcy court. This process allows the restructured debtor to emerge much more quickly from the bankruptcy case.
A prepack can be an enticing option for a debtor with a concise and manageable creditor group. It allows the debtor to retain more control over the bankruptcy process by locking in the support of key constituencies before the bankruptcy filing and by giving the debtor control over the length and nature of the bankruptcy proceeding, including the role of management in the restructured company.
Savings on both sides
Prepacks save time and money by avoiding much of the protracted litigation with creditors that nearly always ensues in large Chapter 11 bankruptcy cases and by presenting a confirmable plan of reorganization to the bankruptcy court immediately after the bankruptcy filing, as opposed to many months or years later, as with the typical bankruptcy case. This compacted period saves the debtor, and thus its creditors, costs associated with an ordinary Chapter 11 bankruptcy proceeding — in particular, the cost of professional fees. Each day that the debtor does not have to operate under the scrutiny of the bankruptcy court is one less day that the debtor must pay the fees of its professionals and those hired by any creditor committees in the case, among others. In general, a prepackaged bankruptcy can be invaluable to a debtor whose quick emergence from bankruptcy may be critical to its future operations and business plan.
In light of the many benefits, a prepack can appear to be an attractive alternative to a typical Chapter 11 bankruptcy filing. Yet if prepacks are so much better, why don’t all debtors file them? Perhaps the most obvious answer is that a prepackaged bankruptcy requires significant (and often protracted) prepetition negotiations with the debtor’s major creditor groups. This means that a prepack requires ample time and organization, so that negotiations can be completed sufficiently in advance of any severe financial crisis that would otherwise drive a debtor directly into a Chapter 11 bankruptcy case. This makes a prepack ideal when the debtor has a limited number of creditors or discrete aligned classes of creditors.
A herculean task
Unfortunately, large and complex corporate bankruptcy cases — or megacases — such as any case that would be filed by one of the Big Three automakers, often have varied and divergent creditor groups that have very different views of the path the debtor’s restructuring should take. Secured and unsecured bondholders with different levels of priority and different collateral packages, coupled with varied trade creditor groups, labor unions, suppliers, customers and government agencies — to name only a few — make filing a prepack for a complex megacase a herculean task.
A prepackaged bankruptcy is also not an ideal framework for administering vast numbers of executory contracts and leases. The analysis and administration of, for example, an automaker’s thousands of supply contracts is not a process that generally can be completed within the time constraints of the typical prepackaged bankruptcy. The administration of executory contracts and leases in a large and complex bankruptcy proceeding, such as supply contracts and franchise agreements with various automobile dealerships, can be the source of protracted litigation with the debtor’s contract counterparties and can cause significant delay in the debtor’s reorganization efforts, depending on the value of the executory contracts and leases at issue to the debtor’s estate, and thus could defeat the purpose of filing a “prepack.”
Furthermore, the intricacies of certain industries may make the negotiation and confirmation of a prepackaged bankruptcy more difficult. For example, most manufacturers, like the U.S. automakers, are parties to collective bargaining agreements, making their labor constituencies a significant force in any bankruptcy. The U.S. automakers are also parties to countless franchise agreements with dealers across the United States, making individual dealers and dealers’ associations a constituency with its own, unique concerns in any automaker bankruptcy. Each of these groups will have unique perspectives on the appropriate goals of the debtor’s restructuring, making a prepack easier said than done.
Another unique challenge
The U.S. automakers face another unique challenge — they likely are parties to numerous contracts with auto parts suppliers across the United States and overseas that are in bankruptcy proceedings themselves. During the past year, many auto parts makers and suppliers have filed for bankruptcy. Due to the interconnected nature of the auto parts supply chain in the United States, the bankruptcies of auto parts suppliers add a significant layer of complication to any potential automaker bankruptcy. Such ancillary bankruptcy proceedings can create conflicts between what is in the best interests of each of the debtors’ creditors and bankruptcy estates; i.e., the automaker versus the auto parts supplier. This additional challenge makes a prepackaged bankruptcy even more thorny for any of the large U.S. automakers.
In light of the constraints of a prepack, it is a tool used by only a select group of particularly situated debtors. That does not mean that all other business bankruptcy proceedings are simply unplanned events. To the contrary, most large and complex business bankruptcy cases are the result of considerable preplanning and often are the product of lengthy negotiations with the debtor’s most significant creditors. There are a variety of strategies that debtors can implement so that they enter bankruptcy with some of their creditors already on board.
For example, it is more common for a company to file a prenegotiated or prearranged bankruptcy as opposed to a prepackaged bankruptcy. This is when the company negotiates the consent of certain classes of creditors to a proposed plan of reorganization prior to the bankruptcy filing, but does not engage in a prebankruptcy formal vote solicitation process as with a prepack, and the plan confirmation process takes place subsequent to the bankruptcy filing. Some debtors may obtain agreements by certain creditors to support a plan that fits into a specified framework — referred to as “lock-up agreements.” Still other debtors may reach agreement with particular creditor groups as to certain aspects of the restructuring, including, but not limited to, the marketing and sale of certain business segments of the debtor, the closing of certain of the debtor’s retail locations, manufacturing plants or other operations, or the liquidation of certain of the debtor’s assets.
These various orderly and prearranged Chapter 11 bankruptcy cases provide more benefits to the debtor’s creditors and estate by streamlining the bankruptcy process and allowing the debtor to enter its bankruptcy case with a level of organization. Given that the U.S. automakers have been strategizing about their financial distress for many months now, if any of them were to file for Chapter 11 bankruptcy protection, it is likely that they would implement one or more of these strategies to proceed with an orderly restructuring — as opposed to a prepack — given all the complexities contemplated in any bankruptcy of the Big Three automakers.
The government bailouts being allocated by Congress are worth billions of dollars. Certainly, a way to protect those funds would be to provide the money through a bankruptcy proceeding, as opposed to out-of-court funding, as has been done to date. Thus, while the form of any restructuring of the U.S. automakers is not known at this time, and a prepack may not be viable for the reasons discussed above, the driving force for any automaker bankruptcy filing could be the government seeking to protect its financing of the automaker. A bankruptcy provides special protections to lenders that finance the debtor after the bankruptcy is filed. A debtor in possession (DIP) loan, as this is called, may be protected by granting the DIP lender priority liens on all assets of the debtor in bankruptcy and priority in payment — which means that the DIP lender gets repaid before any other creditors. The ability of the DIP lender to trump all other creditors in terms of repayment often is the only way to obtain funding of an otherwise over-encumbered company and is the incentive for any such funding by the lender.
An enticement for lenders
A DIP loan can be accomplished regardless of whether a prepack occurs, and by its own terms can encourage a more speedy resolution of the bankruptcy case. Usual conditions to a DIP loan include delineated restructuring benchmarks for the debtor to achieve in the bankruptcy, including a deadline for confirmation of the plan of reorganization and a date certain by which the agreed-upon funding (if paid over a period of time) will cease and be repaid. Thus, a DIP loan, under the right circumstances, can be enticing for a lender, as it offers far more lender protections than an out-of-court loan. A DIP loan can also be very expensive to the bankruptcy estate — an expense that, in turn, actually may help foster a more speedy reorganization.
Thus, while prepackaged bankruptcies are of interest, and certainly the topic of the day among the political pundits and news outlets, perhaps the more compelling and relevant discussion as far as the Big Three automakers are concerned is how the government’s multibillion-dollar loans will be protected through any restructuring. Indeed, “DIP loan” may soon become the new term du jour.
Robbin L. Itkin and Katherine C. Piper are members of the business and financial restructuring group in the Century City, Calif., office of Washington-based Steptoe & Johnson LLP. They represent debtors, creditors and other interested parties in corporate restructurings and bankruptcies throughout the United States and internationally. They can be reached, respectively, at firstname.lastname@example.org and email@example.com.