Business Credit - December 2020

Financially distressed debtors frequently use Chapter 11 to sell their businesses and assets in one or more transactions, primarily in order to pay down secured debt obligations owed to one or more lenders. In the best case, the debtor will generate sufficient sale proceeds to satisfy all of their secured debt, pay administrative and other priority claims against the bankruptcy estate, and confirm a Chapter 11 plan that provides distributions to unsecured creditors. Unfortunately, in many cases, the debtor is left with insufficient sale proceeds, after paying its secured claims, to pay administrative and priority claims—which must be paid in full as a condition for obtaining court approval of a Chapter 11 plan. Under these circumstances, the Chapter 11 plan process is simply untenable and provides no benefit to many unsecured creditors, such as trade creditors.

Worse yet for unsecured creditors is the risk of conversion of the debtor’s Chapter 11 case to a Chapter 7 case. Conversion exposes trade creditors to the possibility that the Chapter 7 trustee appointed to administer the debtor’s bankruptcy case will seek to reel in value for the debtor’s estate by commencing lawsuits against creditors to recover preference claims.

Trade creditors should find comfort in a recent decision by the United States Bankruptcy Court for the Western District of Michigan (the “Bankruptcy Court”). In In re Goodrich Quality Theaters, Inc., the Bankruptcy Court denied a motion to convert the Chapter 11 case to a Chapter 7 case by the Office of the United States Trustee (“UST”) where the debtor, its Chapter 11 and prepetition secured lenders, and the creditors’ committee opposed conversion and instead sought to dismiss the case. The Bankruptcy Court ultimately granted the debtor’s motion to dismiss, finding that dismissal, rather than conversion, was in the best interests of the debtor’s estate and its creditors. The primary factors that the Bankruptcy Court considered were that all of the key parties to the case (other than the UST) supported dismissal, and the debtor’s motion to dismiss did not seek to ignore the Bankruptcy Code’s priority rules. Trade creditors benefit from the Goodrich decision to the extent that dismissal of a Chapter 11 case eliminates preference risk while conversion of the case creates a risk that a trustee will assert preference claims against the trade. Dismissal in lieu of conversion eliminates the double loss that trade creditors would incur from not receiving any recovery on their unsecured claims and then having to pay in response to a trustee’s assertion of preference claims against them.