By: Donald L Swanson
This is reality:
- Small businesses reorganize, all the time, under Subchapter V;
- Farmers reorganize, all the time, under Chapter 12; and
- Large businesses reorganize, all the time, under regular Chapter 11.
That’s because all of those three types of debtors have bankruptcy reorganization processes designed specifically for them.
Middle Market Debtors
But what about a middle-market debtor: the privately-owned business that doesn’t qualify for Subchapter V (e.g., because of too much debt or affiliation with a publicly traded company)?
There is no bankruptcy process specifically for that debtor.
Let’s say owners of a middle market debtor in financial stress want to reorganize the business, need bankruptcy to do so, and want to keep their ownership interests intact.
That’s a problem. Here’s why:
- the only bankruptcy process available is regular Chapter 11; and
- regular Chapter 11 doesn’t work because of the absolute priority rule, which does NOT allow plan confirmation with owners retaining their interests, unless creditors are (i) paid in full, or (ii) agree to something less (which they rarely do).
Neither Subchapter V nor Chapter 12 has an absolute priority rule (it is unique to regular Chapter 11). That’s why those processes work for eligible debtors.
But what are middle market debtors to do?
How can owners reorganize their middle market business, in regular Chapter 11, and keep their ownership interests too?
One bad answer is this: they can’t—the only viable option in regular Chapter 11 is to liquidate.
Another bad answer is this: by promising to pay way-too-much over time to get creditor votes. The problem with this over-pay solution is: the debtor rarely survives—because it simply can’t make the large payments required.
The Nebraska Three-Step Solution
But there is an alternative that can work in many situations for middle market debtors, with owners retaining their interests, despite the absolute priority rule.
I call it the “Nebraska Three-Step,” because I’m in Nebraska, the solution has three steps, and I first used it to confirm a Chapter 11 plan (with debtor’s owners retaining ownership) back in the early 1990s.
—The Three Steps
Here are the tree steps:
- Step 1: propose a plan that would be confirmable, absent the absolute priority rule, with a Nebraska Three-Step provision included;
- Step 2: get the plan confirmed under regular Chapter 11 requirements; and
- Step 3: comply with the Nebraska Three-Step provision.
Here are the three-steps substance of a Nebraska Three-Step provision:
- Step 1: upon confirmstion, pre-petition ownership interests are cancelled;
- Step 2: promptly after plan confirmation, 100% of ownership interests in the reorganized debtor are auctioned to the highest bidder; and
- Step 3: the confirmed plan identifies a stalking horse bid (from an insider) that will be accepted, absent a competing bid.
—Why It Works: A Premium Price
Here is a practical reason why the Nebraska Three-Step works: the insider’s stalking horse bid is at a premium price, whatever it’s amount might be.
This premium price reality exists because the plan, to get confirmed, must pay:
- the value of all assets (usually to secured creditors);
- the combined amount of all priority claims (e.g., taxes); and
- the combined amount of all administrative claims (e.g., legal fees and U.S. Trustee fees).
So upon confirmation, the reorganized debtor is, typically, insolvent ab initio (i.e., from the beginning). That means the insider’s stalking horse bid is paying, whatever it’s amount, a premium price.
—Disincentive For Non-Insiders
Therefore, a non-insider who wants to over-bid for ownership of the reorganized debtor:
- cannot be a bottom feeder looking for a great deal, because there is no such deal to be had; and
- would need to have a bidding incentive sufficient to support a premium price bid.
—What Will Work & What Won’t
In most middle-market circumstances, the Nebraska Three-Step will work—i.e., the risks are acceptable and can be managed. That’s because no one, other than an insider, is willing to pay a premium price for the reorganized debtor.
On the other hand, circumstances with higher (i.e., unacceptable) risks for the Nebraska Three-Step include:
- debtor’s primary asset is a scarce resource for which non-insiders will pay a premium (e.g., unique intellectual property); or
- debtor’s competitor is highly motivated to acquire the debtor (e.g., to eliminate competition or to settle a score).
To be sure, the Nebraska Three-Step takes some audacity to attempt and is NOT for the faint of heart or risk averse.
On the other hand, the Nebraska Three-Step is proven to be effective for middle-market businesses, (i) in getting reorganization plans confirmed, with ownership interests intact, and (ii) as a baseline for negotiating with creditors to avoid filing bankruptcy.
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