Readers will no doubt have heard of ‘Chapter 11’ being talked about in the context of changing Australia’s insolvency laws. What is being referred to are the 95 provisions of the US Bankruptcy Code 1978 which are considered the most liberal and debtor-friendly.
They certainly place great emphasis on corporate rescuing but from a different angle to our own experience in Part 5.3A of the Corporations Act which has been our corporate rescue legislation since 1993. Chapter 11 is used as a model for insolvency law reforms in several other countries and more so since governments have needed to respond to COVID-19.
The US law is advantageous in that it provides higher planning reliability and thus avoids short-term thinking in decision making. It provides continued employment and wages for employees and it preserves the skills and experience of those employed and directing the company, its brand and relationships. Those in business appreciate just how these intangible assets are valued and can take years to build so being able to keep such assets can dictate the rescue.
Australia’s prism of Chapter 11
During this century, Australian governments have rejected moving towards a Chapter 11 style insolvency law.
For example, the 2004 Joint Committee on Corporations and Financial Services report into insolvency and the 2015 Productivity Commission inquiry into Business Set-up, Transfer and Closure both concluded such a move inappropriate for Australia due mainly to the objection that an insolvent company’s directors should not be in control of a company once insolvency is declared.
The Senate Economics References Committee in its report on the performance of ASIC in 2014 called for the government to review insolvency laws and “consider features of the Chapter 11 regime,” whilst the Financial System Inquiry in 2014 rejected the idea of a Chapter 11 saying it considered it would be costly, restrict or defer capital, create more uncertainty for creditors and that its poor success rate in the US has “rarely enabled businesses to continue.”
Then during 2020 and the COVID-19 pandemic the Government introduced Part 5.3B of the Corporations Act – considered by some to be moving into Chapter 11 territory.
During 2020 the Treasurer stated that the 2021 reform “draws on key features of the Chapter 11” model suggesting that the reform “will help more small businesses restructure and survive the economic impact of COVID-19” because it is “critical that distressed businesses have the necessary flexibility to either restructure or to wind down their operations in an orderly manner.”
However, the new 2021 small business restructuring process in Part 5.3B has few parallels with the Chapter 11 model apart from allowing the company, and not the Restructuring Practitioner, have control of its business despite the company’s insolvent state.
The Chapter 11 process
Chapter 11 has a broad range of legislative infrastructure that supports it, particularly from other chapters of the Bankruptcy Code. It also has judicial infrastructure as the Chapter 11 proceedings must be filed in a Federal District Court and heard by a specialist bankruptcy judge.
Additionally, there is an office of the US Trustee as part of the Federal Department of Justice. The US Trustee may appear in any case, examine the debtor and apply to take over the Chapter 11 case.
The filing of a Chapter 11 petition requests the Court to allow the commencement of the case which will provide relief for the debtor company. Accompanied to this are what are called ‘first day motions’ seeking Court approval for allowing inter alia, the debtor company to engage professional advisors and the payment of pre-petition claims like employee wages.
There is no requirement that the debtor company is insolvent but it must only file a petition under Chapter 11 in good faith. The commencement of the case is done to have a rescue plan approved by the creditors and the Court.
Upon the commencement of the case, the debtor company becomes what is referred to as ‘debtor in possession’ – the management including the directors of the company usually remain in their roles. However, the ‘debtor in possession’ is a fiduciary and is required to protect and preserve the company’s property for the benefit of the creditors. The debtor in possession has the authority to run the business in the ordinary course but needs to obtain Court approval for asset sales or use of company property as collateral.
The debtor in possession usually has a number of advisors helping to formulate a viable rescue plan. These advisors have their fees approved by the Court. The object of Chapter 11 is to have a reorganisation plan approved by creditors and the Court and this is to be done by filing a plan within 120 days of the initial Court order. This can be extended for up to 18 months.
The plan to be implemented requires a creditors’ vote with 2/3 majority in value and a simple majority in number and then the Court will confirm the plan, inter alia, if it complies with the provisions of Chapter 11 and is proposed in good faith and that the creditors in each class will not receive less than they would under liquidation. The plan can be accepted by the creditors within 180 days of the initial Court relief action.
Courts can cram-down on other classes of creditors so as to achieve agreement but an absolute priority rule applies – meaning lower class of creditors cannot be paid until the higher ranking class is paid in full.
Importantly during a Chapter 11 case there is an extensive stay against claims being enforced by all creditors. Additionally, there is protection against automatic termination (ipso facto) by creditor contracts.
A Chapter 11 case continues until it is dismissed or transferred into liquidation (Chapter 7) by the Court or there is a finalisation of a plan following approval by the creditors and the Court.
The US has tweaked Chapter 11 to differentiate small business recovery and in light of COVID-19. They have streamlined the process and reduced administrative costs. The Small Business Reorganization Act 2019 inserts Subchapter V into Chapter 11. It applied to companies with less than $2.5m in debt. The debt threshold was recently increased to $7.5m.
Some features of the new laws are that there is an initial interview to evaluate business viability and additional financial reporting at commencement of a case. There is increased monitoring and additional oversight by the US Trustee. The absolute priority rule does not apply to this type of rescue process and there is a longer period of 300 days given to file a rescue plan.
Australia is now under the influence of some features of Chapter 11 in Part 5.3B – although it will take some time before leaving control of the company in the hands of those who are often the cause of the company’s financial distress will sit comfortably with the local psyche. In 2021 we are about to see whether parts of it can be realistic and practical for the Australian recovery toolbox.