On November 2, 2009, CIT Group, Inc., a leading provider of financing to small businesses and middle market companies, filed for bankruptcy in the United States Bankruptcy Court for the Southern District of New York.  Click here for a copy of the CIT Voluntary Petition

Only two of CIT’s business units filed for bankruptcy, and CIT has stated that none of its operating subsidiaries, including CIT Bank, its business segments or its international business operations, are part of the bankruptcy filing and it expects business as usual will continue throughout the reorganization process.  CIT also states that it has the liquidity to serve its customers. CIT listed $71 billion in assets and $64.9 billion in liabilities.

CIT is over 100 years old, and provides significant capital to small and middle market businesses.  CIT is huge, really huge:  its customers employ more than 90 million employees, it’s the leading provider of financing to the retail sector and to women-, minority- and veteran-owned small businesses.  An outright failure of CIT could have significant adverse effects on the US economy, which is currently in a very fragile state at best. 

So what’s the probable impact of CIT’s bankruptcy filing?  Probably none, assuming the company is able to confirm its prepack plan without any major hitches. Click here for a copy of the CIT Plan (and Disclosure Statement).  As to retailers, many of them likely have already order product for the holiday season and so are not dependant on immediate financing from CIT (nb:  restocking could be an issue).  The markets are becoming more liquid, and other companies could step up to the plate to provide financing to the middle market, like Wells Fargo.

There are those who think businesses will move away from CIT to others, but the likelihood is that businesses will continue to use CIT as long as CIT has is liquid enough to satisfy its customers needs.  However, the real test will be not the next few weeks, but rather the weeks and months after the bankruptcy.  Will CIT’s prepack plan truly put CIT on better footing for the immediate future?  Only time will tell.

The hearing on the adequacy of the disclosure statement and confirmation of the plan is scheduled for December 8, 2009.  Here is a copy of the Scheduling Order, and for other bankruptcy information, click http://www.kccllc.net/citgroup.

In a recent decision by the Delaware Bankruptcy Court, the Court held that a person holding the title of an officer, including vice president, is presumptively what he or she appears to be — an officer and, thus, an insider.  See In re: Foothills Texas, Inc. et al. (Bankr. D. Del. 09-10542)

In Foothills Texas, the Debtors are independent energy companies engaged in the acquisition, exploration, exploitation and devlopment of oil and natural gas properties, and have 10 employees.  Two of the employees have the title of Vice President, and have a prepetition employment agreement (the “Employment Agreements”) that, if the agreements were assumed by the Debtors, would provide a retention payment to each of those employees.

The Debtors sought to assume the Employment Agreements, but the United States Trustee objected on the grounds that (i) the employees are insiders, (ii) the payments to be made under the Employment Agreement, if assumed, would be retention payments, and thus, (iii) the Debtors need to satisfy Section 503(c)(1) of the Code.  Section 503(c)(1) prohibits the payment to an retention payment to an insider unless a debtor proves that (A) the individual has a bona fide job offer from another business at the same or greater compensation; (B) the services of the individual are essential to the survival of the debtor’s business; and (C) either (i) the payment is not greater than 10 times the amount of the mean payment to nonmanagement; or (ii) if no payments made to nonmanagement employees, then no more than 25% of the amount paid to such insider.  In practice, this is a very difficult standard to satisfy, and, Section 503(c)(1)(A) has proven virtually impossible for debtors to meet. 

The Debtors argued, among other things, that the employees, despite their title of vice president, are not officers, and thus, not insiders, and thus, the more liberal standard of Section 503(c)(3) (i.e., payments made outside the ordinary course of business for the benefit of officers, managers and consultants) is applicable.  [NB:  Payment made to insiders that are incentive payments are permitted — see In re Nellson Nutraceutical, 369 B.R. 787 (Bankr. D. Del. 2007).]

The Court analyzed the plain meaning of the word officer and concluded that a vice president is presumptively an officer, and thus, an insider; however, the presumption can be rebutted by evidence sufficient to establish that the “officer” does not, in fact, participate in the management of the debtor.  However, in Foothills Texas, the Court focused on the job responsibilities of the two employees:  both had positions of broad responsibility that focused on the core essence of the Debtors’ existence — that is, compliance with state and federal laws and regulation, oil and gases leases and production, evaluation of reserves, technical reporting and development of capital spending projects.  The Court also noted that both of these employees reported directly to the Debtors’ President.  Based on the evidence, the Court found that the Debtors were unable to rebut the presuption that the two employees were officers, and thus, insiders, and subject to the more difficult standard of 503(c)(1).  

The Court also held that obtaining authority to make retention payments that are prohibited by Section 503(c)(1) is not a responable exercise of the Debtors’ business judgment to assume the agreements (and make the payments).  Accordingly, the Court denied the Debtors’ motion, and consequently, the vice presidents, because they were deemed to be officers, didn’t get the money they would have received had the company not been in bankruptcy.    

Would this case have turned out differently if the employees did not have a title or were merely referred to as managers?  Perhaps, but in all likelihood the Court would still have focused on the specific facts of the case and looked beyond the titles of the employees.  That said, keep in mind that there may be a cost (albeit possibly and, indeed, probably unknown) to having an officer’s title for those working for a company in distress.

Under the GM deal reached with the Obama Administration, the US Government will own 60% of New GM — that is, the “leaner and meaner” GM (of course, only time will tell if that becomes the case).  The problem for the Obama Administration is that the US, between Chrysler and GM, has now ventured into ownership of private companies.  There are numerous interesting questions to ponder:  what will the US do if, in the most unlikely event, another bidder bids on the assets of the GM (I realize this is a virtual improbability)?  In such a case, would the Government enter into competitive bidding?  Would the answer to this question change if such a fantasy bidder is a foreign or sovereign entity compared to a private entity?  Assume the US is the successful bidder, which it will be, what happens if the US sells its 60% share shortly after New GM is formed — the US will likely take a substantial hit leaving the taxpayers out of the money (which will create a difficult political situation for the Obama Administration)?  On the other hand, if the Government does not sell its majority interest in New GM, will it start telling New GM (and Chrysler) what type of cars to make (no doubt they will be told to make small, “green” cars)?  Will it provide tax credits to those buying New GM (and Chrysler) cars?  Will it provide subsidies like China does for Chinese companies so that New GM and Chrysler appear profitable?  If the US Government attempts to alter the market either through subsidies, company specific policy creation/enforcement, or company specific tax policy, it will alter the fundamentals of American economics and capitalism by creating a form of American socialism (a very scary thought!).  The questions go on and on…  Click here to read an interesting NY Times article addressing some of these issues.  One thing is for sure:  the answers to these questions will truly reveal Obamanomics.

GM filed for Chapter 11 bankruptcy protection today in the United States Banrkuptcy Court for the Southern District of New York at 09-50026.  A copy of the petition is here, and a copy of the GM press release describing the bankruptcy proceedings are here.  To read a good discussion about the bankruptcy proceedings, click here.

According to Bloomberg.com, U.S. Treasury and some of GM’s bondholders reached a deal today that will permit GM to file for bankruptcy on Monday, June 1, 2009 (Of course, notwithstanding this “deal”, GM would likely have filed by then anyway, but that’s all speculation now).   The deal will provide the bondholders 10% equity of new GM with warrants to purchase up to 15% more.  The union health trust will get 17.5% of the new equity and the US Government will get up to 72.5%.   The details of the deal and proposed DIP financing are set forth in GM’s 8-K that was filed today.

A few of Chrysler’s secured creditors have found a backbone and decided to fight the Executive Branch’s unconstitutional actions of turning one of the most basic principles of the Bankruptcy Code on its head – the absolute priority rule.  The Indiana State Teachers Retirement Fund, Indiana State Police Pension Trust, and the Indiana Major Moves Construction Fund (collectively, the “Indiana Funds”) have filed a Motion seeking the appointment of a Trustee so that “an independent, disinterested person [can make] business decisions that are in the best interest of [the debtors’] estates…  The basis of the Indiana Funds’ motion is that the Treasury Department is causing Chrysler to ignore “fundamental principles of bankruptcy law by allocating distributions according to the government’s political agenda rather than the creditors’ legal priority.  The motion, among other things, alleges that the government has no authority to take the actions it has in these cases under any statute, including, but not limited to, TARP (i.e., the Troubled Asset Relief Program) or EESA (i.e., the Emergency Economic Stabilization Act).

Back to the beginning:  TARP was suppose to be for financial institutions, but after Congress failed to pass legislation to assist the auto industry, the Treasury Department (Paulson) stated that the auto companies could be considered financial institutions under TARP.  This semantics game provided Chrysler $4B on a junior secured basis – junior to the senior secured creditors (“Senior Secured Creditor”), who are owed a whopping $6.9B (the Indiana Funds are part of the senior secured creditors group – owed roughly $43 million of the outstanding $6.9B).  The Government’s $4B loan was at 5% interest with a December 30, 2011 maturity date, with an option to accelerate the entire amount due if Chrysler failed to put together a restructuring plan acceptable to the Obama Administration by February 17, 2009. 

On February 17, 2009, Chrysler submitted to the Government a restructuring plan  that sought to restructure as a stand-alone US entity by restructuring its debts, raising additional capital and completing an alliance with Fiat.  Upon reviewing the business judgment of Chrysler’s management, the Obama Administration said that Chrysler’s restructuring plan was not viable, and that Chrysler would have 1 month (30 days) to reach an agreement with the Senior Secured Creditors, the Treasury Department, VEBA, the unions, other creditors, and Fiat.  After this point, the President’s Auto Task Force took over certain negotiations for Chrysler with the Senior Secured Creditors and the union. 

President Obama also characterized the Senior Secured Creditors as speculators who were unwilling to make sacrifices; however, as the Indiana Funds’ motion makes clear, the Indiana Fund only invests in first lien secured debt, which, under the UCC, is suppose to be among the safest forms of investment.  Also, the Indiana Funds’ were willing to take a 50% haircut – much more than what the unions were willing to accept. 

Understandably, the Indiana Funds view the Chrysler situation as unfair because they are victims of breaches of fiduciary duty by Chrysler’s management, and abuse of power by the Executive Branch to further its political agenda.  And they are right to do so – and the other Senior Secured Creditors should be just as angry as the Indiana Funds.  The actions of the Government raise too many questions, such as, how can the Treasury Department and unions, which are unsecured, get anything before the Senior Secured Creditors are paid in full?  Indeed, how can the union get more than the Senior Secured Debtors?  How will a plan with these terms be confirmed without the consent of the Senior Secured Creditors (it can and shouldn’t)?  Can the Government change, and should it be able to change, the laws for its own purpose to achieve a political end?  How can capitalism endure if the legal framework can be altered at the whim of the Government?  The questions can go on and on, but it will certainly be interesting to see how either the Court rules on Indiana Funds’ motion – certainly the ruling may help answer some of these questions.

According to an article in Bloomberg.com, Obama Said to Plan for Chrysler Bankruptcy, Alliance , Chrysler may now file for bankruptcy as early as tomorrow.  If anyone thinks that Chrysler will just do a quick 363 sale to Fiat (or some new entity), they have another thing coming.  While the “major” secured creditors may be willing to roll over (and Big Labor gave some concessions), there is no telling what the “minor” secured creditors (e.g., those who have mold liens, etc.) may do.  Also, let’s see how the unsecured creditors are going to be adversely affected in a Chrylser bankruptcy — I say strap yourself in and get ready for a bumpy ride.  The real question is:  what happens at the end of that ride if Chrysler still has high labor cost, adequate quality and uninventive vehicles?  I think we all know.

There was an interesting article in the New York Times on Saturday, April 26, 2009, at Detroit Would Prefer Any Auto Bankruptcy to Be Handled Locally (April 26, 2009) discussing the possible venues for either a GM or Chrsyler bankruptcy filing.  No doubt Detroit would prefer a GM or Chrysler filing to occur there for political reasons, but the reality is that there are only 2 venues that can efficiently handle such large cases:  Delaware or S.D.N.Y.  The reality is that those two venues are probably about the same, excluding some unfavorable case law in the Third Circuit, and both have extensive experience in automotive cases, a sophisticated bench and bar in automotive bankruptcy cases, and have large courtrooms with state of the art audio-visual systems.  Also, while Detroit is considered the home for automotive, both GM and Chrysler are large multinationals that have substantial business connections in numerous locations in the US and abroad, so DE and NY are certainly as good of a place as any to file for bankruptcy.  I’ll be surprised if either of the automakers files for bankrutpcy in Detroit (FYI:  as of tonight it is looking less likely that Chrysler will file for bankruptcy at all, but GM is a different story with the aweful GM Exchange Offer), and, from my vantage point, the venue of choice for the automakers is either DE or NY.

Congressman Nadler (D, NY) and Cohen (D, TN) introduced the Business Reorganization and Job Preservation Act of 2009 , H.R. 1942, which seeks to amend the Bankruptcy Code by repealing to pre-BAPCPA the following sections: 365, 366, 503(b)(9) (repeals altogether), and 546(c). The purpose of the Act is to increase the changes of retailers to reorganize successfully. For an article discussing changes need to the Bankruptcy Code to increase the likelihood of retailers reorganizing see Suggested Amendments to US Bankruptcy Code.  Certainly, this is one of the most encouraging Acts proposed since BAPCPA from the retailers’ perspective, but the real question is:  will it be adopted?  Unfortunately, probably not, at least not without some strong, unified and consistent lobbying from the retail industry.

In the last post, we discussed the basics of claims trading. In this post, we will look at the topic of insider trading of bankruptcy claims and how that issue is addressed by the Bankruptcy Court. We also will look at the implications of bankruptcy claims trading and how distressed investors can protect themselves so that they do not run afoul of applicable laws.

Insider trading of bankruptcy claims occurs when the purchaser of a claim has acted on material, non-public (i.e., confidential) information. While trading securities on insider information is prohibited under federal securities laws, the prevailing view is that the securities laws do not apply to claims trading. Nevertheless, bankruptcy courts have imposed harsh sanctions (including, but not necessarily limited to, disallowance, subordination, and/or other adverse treatment) when trading claims on insider information has been established.

Members of official committees of unsecured creditors in a chapter 11 bankruptcy need to be cognizant of the prohibition of insider bankruptcy claim trading. Committee members should, and likely will, receive commercially sensitive or proprietary information from the debtor and others. Given that a committee member is a fiduciary who owes both the duties of care and loyalty to its constituency body, he or she is required to hold sensitive or proprietary information in confidence. Failure to hold such non-public information confidential would likely not only negatively impact communications between the debtor and committees, but also likely cause harm to the debtor. However, there have been some courts willing to allow committee members to participate in claims trading if appropriate screening walls have been established.

Trading Restriction Orders

In large chapter 11 cases, often the debtor has generated large net operating losses (NOL) in the months and years preceding the initiation of the chapter 11 proceedings. Subject to certain limitations, the Internal Revenue Code (IRC) provides that NOLs can be used as either carry-backs (i.e., a corporation can use the NOLs to offset taxable income for up to two (2) previous taxable years) or carry-forwards (i.e., a corporation can use the NOLs to offset taxable income for up to twenty (20) taxable years into the future).

The positive tax consequence of NOLs can be lost or restricted (i) if there is a change in ownership through a transfer of a debtor’s stock by its holders, and (ii) if there is a change in ownership through the conversion of debt to equity pursuant to a confirmed plan of reorganization. Essentially, if pre-emergence trading in claims and equity results in persons who are not Qualified Creditors or historic stockholders receiving more than 50% of the equity in the reorganized debtor, the IRC’s more stringent restrictions, which are listed in Section 382, on prospective NOL treatment may apply.

Because of the potential positive tax consequences to the debtor, NOLs are property of the estate that must be protected and preserved. However, since the value of NOLs may be quickly and adversely affected by equity and claims trading, bankruptcy courts in recent years have been willing to enter orders that restrict the trading of a debtor’s debt and other securities during the pendency of the debtor’s bankruptcy proceedings so that the debtor’s NOLs are protected and preserved.

The Bond Market Association and the Loan Syndications and Trading Association have developed a Model NOL Order that attempts to protect a debtor’s NOL by permitting trading of claims, as long as it does not substantially change the ownership structure of the debtor. The Model NOL Order restricts the trading of equity, but permits the trading of claims until (i) the debtor files a plan of reorganization that relies on the Section 382(l)(5) exemption, which is the NOL is preserved as long as debtor’s existing shareholders and/or qualified creditors (held claim for 18months or claim arose in ordinary course of debtor’s business) own at least 50% of the value and voting power of stock after plan confirmation, and (ii) a “sell down” order is entered by the bankruptcy court. Assuming a 382(l)(5) Plan is confirmed, and a party required to comply with the “sell down” order fails to do so, such claim holder forfeits his or her right to any distribution on the portion of his or her claim subject to sell down.

Implications

Restrictions on claims trading, while beneficial to the debtor (e.g., to preserve NOLs), is not beneficial to the distressed debt investor (e.g., hedge funds and private equity firms). Many prognosticators have speculated that the next tide of chapter 11 cases will see a substantial increase in activity by and from hedge funds. Whether this is true or not no one now knows for sure; however, between some recent rulings on claim trading restrictions and hedge fund disclosures, hedge funds may very well be less inclined to be active players in bankruptcy proceedings. In fact, these recent trends may persuade hedge funds to assist debtors in reorganizing outside of bankruptcy.

Corporate defaults are at a 2002 level, and likely will rise as the US economy is headed into the most severe recession in perhaps more than 80 years, which likely will cause a substantial increase in the filing of chapter 11 cases. Although the rate of Chapter 11 filings has increased in 2008 from 2007 levels, as the liquidity crisis eases allowing for the next tide of chapter 11 cases, it is of the utmost importance for distressed debt investors to retain sophisticated bankruptcy counsel who understands fully these recent trends in claims trading (and disclosure requirements) so that these investors are in a position to make informed investment and planning decisions.