“Using State Receivership Statutes to Maximize Insolvent Debtor’s Estate Value”
By Ken Naglewski
From the June 2007 issue of the ABF Journal
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) introduced several noteworthy changes to bankruptcy law. While provisions eliminated some Chapter 11 debtor advantages - including condensed exclusivity periods and stringent, exacting KERP requirements- the new law also increased utility deposits and expanded reclamation claims.
In its aftermath, David Skeel, resident scholar of the American Bankruptcy Institute, predicted an increase in state receiverships as a means of providing the bankruptcy filing benefits without the high cost or lengthy proceedings. More recently, in the April issue of ABF Journal, Deidre Martini, Senior Restructuring Advisor for the CIT Group, expressed concern with the escalating cost of formal restructuring, with more companies looking for less expensive state court or non-bankruptcy remedies. While various insolvency professional forums continue to tout state receivership benefits, the predicted renaissance has yet to occur, with primary use still focused on standard, single-asset or real estate transactions.
To a large degree, this appears to be due to lenders’ comfort level with the well-settled and clearly defined laws of the Federal bankruptcy processes, and the lender’s equal unfamiliarity with state receiverships. Hence, there is a tendency to go down the path you have been before.
Insolvency professionals, lenders and potential buyers of debtor assets are much more familiar with the Bankruptcy Code, with its rules generally uniform nationwide. But in many situations, state receiverships can provide a faster, more cost-effective exit strategy for troubled businesses. While primarily used for real estate asset restructuring, receiverships still provide a viable, if not preferred, option for maximum debt recovery, reorganization, sale or liquidation of troubled businesses. Secured lenders and their legal counsel should objectively evaluate each situation to determine whether a state receivership or other alternative to bankruptcy may be a suitable, or even an optimum, resolution to a distressed scenario.
Receivership Basics
Receiverships, trailing back in history to the 1880s as the forerunner to the current Bankruptcy Code, are frequently applied to single-asset real estate insolvencies. All 50 states have statutes or court procedures and precedent, which allow for receivership. But unlike the Federal Bankruptcy Code, state receivership law can differ and is often antiquated. Similarities do reside across the board, with California and Washington statutes closely mimicking Federal bankruptcy law.
Receiverships are typically initiated by a secured lender, acting as the plaintiff. Unsecured creditors can also request a receiver be appointed in appropriate situations, and can act as the plaintiff. Upon motion by the creditor, the court appoints a receiver who acts as an individual and an officer of the court, to take over the debtor’s business and preserve the assets. The receiver considers all factors appropriate to preserve and maximize the assets for creditors. While acting as an individual, as opposed to a corporation, a receiver may hire other support professionals.
The scope of an original receivership order can be narrow or broad, with most states offering considerable flexibility. The order establishes and defines receiver duties and responsibilities, preferably waiving plaintiff fiduciary obligations.
Once appointed, a receiver acts in the best interest of all parties, with no control given to the plaintiff over the receiver’s actions. Although a receiver is typically proposed by the party bringing the receivership action, the receiver, as an appointed officer of the court, has a fiduciary responsibility to act in the best interest of the estate and all creditors.
Receiverships may be either liquidating or operating in form. A liquidating receivership includes the sale of the business as an ongoing entity, while an operating receivership allows for the normal course of business operations to maximize the business value.
Courts may authorize receivers the right to manage the business in some cases if, in doing so, the receiver can preserve and/or increase its value. This may include the right to operate the business in the role of CRO retained by the company’s board. While most receivers take custody of assets for immediate business liquidation, the receiver’s priorities lie in maximizing value. This is necessary in situations where value maximization is attainable through business sale.
Because receiverships are state-centric and antiquated, there are few state statues controlling receiverships in the same way Bankruptcy Code and rules control bankruptcy. Hence, in most cases, receivership orders can allow for greater customization.
Receivership court orders should be broad enough to suit the circumstances and detailed enough to define the receiver’s exact duties, responsibilities and powers. As a matter of law, the receivership order and receiver appointment places all property subject to the plaintiff’s suit in the court’s custody. Key receivership orders can, and frequently do, mimic major provisions of the U.S. Bankruptcy Code.
A state court receivership order should minimally:
- Explain why the receivership is needed
- Describe how the receiver is compensated
- Give the receiver the ability to retain other support professionals
- Establish asset and records custody, except when doing so violates Fifth Amendment rights
- Define how money shall be raised, if necessary, for receivership certificates
- Define how assets shall be liquidated
- Determine how money owned to the estate shall be collected
- Define when legal action shall be initiated
- Describe all contractual negotiations
- Bar other creditor claims
- Establish receiver reporting responsibilities
- Define asset and claim payment distribution procedures
How Do Receiverships Differ From Chapter 11 Bankruptcy
While receiverships and bankruptcies work toward the same end, receiverships have their own unique advantages and disadvantages.
On the downside, receivership initiation does not impose an automatic stay in most states, although there are exceptions. In addition, receiverships do not necessarily provide for the channeling of all claims into a single proceeding. Creditors often can still file separate lawsuits against the debtor in other courts and jurisdictions. To prevent this, the plaintiff may wish to impose a channeling injunction in the receivership order, which specifically requires that all claims against the debtor be litigated as part of the receivership, much like a bankruptcy. Whether this will work across jurisdictional lines is questionable for state court receiverships. For receiverships initiated in federal court, there is significant precedent for channeling injunctions.
Receiverships also do not provide for preference recovery in most states, although again, there are exceptions, and some states have preferences statutes that allow recovery of recent payments by the receiver or by creditors. Further, distribution priority is less exacting than that for bankruptcy. Nevertheless, these issues are not usually significant barriers, where the debt owed the secured lender is greater than the value of the collateral that secures it, thus leaving little or nothing for other creditors.
Payment processes and professional fees incurred on behalf of the receiver are not as exacting as they are for U.S. bankruptcy. In addition, receivers under most state law generally do not have the power to assume and assign contracts without permission of the third-party to the contract, or to reject contracts outright. Also, unlike with bankruptcy, a debtor’s obligations are not discharged through a receivership, but the assets are collected and used to pay the obligations.
On the upside, a receivership offers a faster, more cost-effective resolution than a bankruptcy, with the initiating creditor having the ability to customize the process to make it look much like a bankruptcy. Receiverships also reduce publicity and grant the ability to include a Key Employee Retention Plan, if the receiver deems this necessary and advantageous. Furthermore, while there are some exceptions, receiverships typically require no schedules or statements of financial affairs to be filed by the debtor, as the receiver is in full control upon entry of the receivership order. A single receivership in federal court can work across state lines on a national basis. Ancillary proceedings in other states where property is located are not usually necessary, as the receiver simply files a certified documents in other federal districts, showing his capacity as receiver, and his powers automatically extend to that district as well.
The Debtor and Potential Asset Buyer’s Perspective
Receiverships typically commence when a secured creditor believes the value of its collateral is impaired or when the controlling equity interest cannot or will not take appropriate action to protect the lender from continued losses. As such, receiverships strip the debtor’s control of the business. Often, the receivership may be the step that forces into filing a voluntary bankruptcy, saving the secured creditor the dilemmas and risks of trying to initiate an involuntary petition.
For the potential buyer of the debtor’s assets, receiverships can provide similar protection granted under U.S. Bankruptcy Court orders, including clear title protection against any successor liability, provided the receivership order is clear on this point. Title insurance companies will also frequently issue title insurance in connection with receivership sale deeds. Nevertheless, this protection is not as well developed as the protection afforded by the Bankruptcy Code, as the body of law on receiverships is more antiquated.
The Lender’s Perspective
From a lender’s perspective, the federal bankruptcy process does, in fact, offer several benefits and features that may or may not be available under state receiverships. These benefits include relatively quick dispute resolution, a somewhat predictable outcome on several matters, unquestionably clear title passage on the sale of the debtor’s assets in a 363 sale, maximum protection on any potential successor’s liability, and the automatic stay.
Nevertheless, the lender loses a significant leverage chip in a bankruptcy, because Chapter 11 of the Bankruptcy Code leaves to the debtor control of the company and the exclusive right to propose exit strategies for the initial stages of the bankruptcy. A receivership, on the other hand, gives the secured lender immediate control over the debtor, with appointed receivers empowered to replace existing management. Properly drafted and executed receivership orders can also prove much more cost-effective.
Primary Lender Receivership Questions
- Do you need a separate receivership in each state where the debtor has assets?
State law differs and, in most cases, the law ages back to the golden era of receiverships, between the 1880s and the 1920s, or before federal bankruptcy law enactment providing receivers the cut and thrust of insolvency proceedings. Where federal jurisdiction is available, a receivership in federal court will reach across state lines, and only one proceeding need be filed to reach assets anywhere in the United States. The process is more complicated for a state-court appointed receiver, who may need to petition the courts of other states where the debtor has assets for appointment as an ancillary receiver or initiate legal action (a task which also may be undertaken by the plaintiff in some instances). Receivers can also establish a separate receivership in a foreign jurisdiction. Obviously, the more states in which the debtor has assets, the more complicated and costly the receivership, unless federal jurisdiction is available.
- What if the receiver needs additional funding? Can I loan the receiver additional funds like a DIP loan?
Yes, like debtor-in-possession financing, a receiver can issue receiver certificates with a super priority status to raise funds. The ability of the receiver to raise funds can also be customized in the receivership order.
- Won’t the debtor or unsecured creditors preempt the receivership with a voluntary or involuntarily bankruptcy filing?
While this is a risk (unless the complaining party initiating the receivership wants the debtor to file bankruptcy), it is not a forgone conclusion that a bankruptcy petition will preempt a receivership. Sections 305 and 543 (d) of the Code provide the bankruptcy court sufficient latitude to maintain the receivership if it is in the best interests of the debtor’s estate. If the receivership or other custodial platform has been in place for 120 days, S543 of the Code requires the Bankruptcy Court maintain the receivership.
- Will the buyer of the receivership assets have the same protection as provided by the bankruptcy filing, such as clear passage of title and successor liability?
Clear title is not generally an issue if the secured lender has an unchallengeable, timely filed and perfected security interest in the assets. Potential buyers need to carefully assess what the risks might be. In many cases, the risks appear to be more in perception than reality. Title insurance is also key in situations where real estate assets are at issue.
When are Receiverships Ideal?
While much of the decision to proceed with Chapter 11 bankruptcy or receivership depends on each company’s individual circumstances, various factors can favor the later.
Receiverships are ideal for companies when:
- The controlling equity interest surrenders to the lender.
- The controlling equity interest agrees to the receivership.
- All the company assets are located in one state, or federal jurisdiction is available to cross state lines.
- There is a well-defined exit strategy (i.e. liquidation or business sale).
- There is perishable business value (i.e., when the timeframe and cost of a Chapter 11 would tend to significantly diminish the value of the debtor’s estate).
- The automatic stay and recovery of preferences are not critical.
- Financial obligations to the secured lenders exceed the realistic asset value.
As with all business decisions, the choice to file for bankruptcy or receivership should not be made lightly. Complications may arise when assets reside across multiple state lines, if the debtor files voluntary Chapter 11, or when trade or other creditor dealings present conflict issues. Because each situation is unique, secured lenders and their legal counsel should carefully contemplate situational nuances to determine the most appropriate exit strategy for their particular circumstances.
Summary
While the enactment of the BAPCPA of 2005 led to predictions of a new golden age for receiverships, these predictions have not yet been fulfilled. This appears to be due to a lack of comfort by many insolvency professionals and secured lenders with the particulars of state receivership statues. Business bankruptcy costs remain high, and stakeholders continue to have at least a fleeting interest in the potential effectiveness of a receivership in lieu of a bankruptcy filing to either wind-down the affairs of a failed business or to sell its assets as a going concern. In certain situations, state receivership law can provide an equally effective result at a much lower cost. The unique features of state receiverships should be understood and parties should have practical experience to produce a successful outcome. In many instances, a well-organized and executed receivership is much more cost-effective and valuable than bankruptcy. abfj
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Ken Naglewski is a Managing Director at Focus Management Group and located in the firm’s Nashville, TN office. Naglewski has over 20 years experience advising distressed businesses in a wide array of economic sectors both in the U.S. and abroad. He has played an active leadership role in Chapter 11 bankruptcies, financial restructurings, operational turnarounds and distressed business sales. Recently he has specialized in providing advisory services and expert testimony on behalf of lenders and debtors in a large number of Chapter 11 cases. Naglewski is a CPA as well as a CTP and Certified Insolvency and Restructuring advisor. He can be reached at k.naglewski@focusmg.com.
ENDNOTES
1.David Skeel, “The New (and Very Old) State Law Technique for Restructuring Troubled Companies” American Bankruptcy Institute Journal, August 2006.
2.“From All Angles:CIT’s Deirdre Martini Discusses the Stage of Bankruptcies & Restructurings,” ABF Journal, March 2007, Vol.5, No. 3, page 319.