Chapter 11 – Three Common Misconceptions
by Dan Demers, MBA and Sidney J. Diamond, JD
Three common misconceptions regarding Chapter 11′s are: (1) the perceived ethical restrictions on accounting professionals; (2) the role of the board of directors of a corporation which has filed for relief; and; (3) reporting a Chapter 11 filing to the Securities and Exchange Commission.
Audits Under Chapter 11
Frequently when a public company files for protection under Chapter 11 of the U.S. Bankruptcy Code (“Code”), its auditors believe they are unable to issue audits or reviews because they are more often than not creditors. This is because the American Institute of Certified Public Accountants (AICPA) dictates that “Independence of the members firm is considered to be impaired, when… billed or unbilled fees, or a note receivable arising from such fees, remain unpaid ….[for] more than one year prior to the date of the [audit] report.” (AICPA Professional Standards, Ethics Rulings on Independence, Integrity, and Objectivity, Ruling #52-at ET Section 191.119).
However this ruling goes on to say: “This ruling does not pply to fees outstanding from a client in bankruptcy.” Thus CPA’s, after approval by the Bankruptcy Court as professionals, can conduct and issue an audit report or review even though they are creditors to the Chapter 11 proceeding. In enacting the Code, Congress took special note of potential accounting problems. When adopting 11 USC Section 1125 Congress defined that “adequate information” should include information which is “…reasonably practicable in light of…the condition of the debtor’s books and records… ” ( 11 USC 1125 (a) (1). “Reporting and audit standards devised for solvent and continuing businesses do not necessarily fit a debtor in reorganization.” (italicized emphasis by authors) (Senate Report , Reform Act of 1978).
Additionally, in an apparent effort to further relieve insolvent businesses from costly accounting fees which do successfully reorganize, Congress adopted Section 1142(a) which states:“Notwithstanding any otherwise applicable nonbankruptcy law, rule, or regulation relating to financial condition, the debtor and any entity organized or to be organized for the purpose of carrying out the plan shall carry out the plan and shall comply with any orders of the court.” (11 USC 1142(a))
Recognizing that a Company which successfully emerges from Chapter 11 has special accounting needs, the AICPA issued its Standard Operating Procedure 907 which states: “Fresh start financial statements prepared by entities emerging from Chapter 11 will not be comparable with those prepared before their plans were confirmed because they are, in effect, those of a new entity. Thus comparative financial statements that straddle a confirmation date should not be presented. (emphasis added by authors).
In February of 1998, the Securities and Exchange Commission took a first step by proposing a rule modification which followed the Congressional and AICPA reasoning. The proposed modification to SEC Rule 15c211 would allow market makers wishing to publish quotations in a non-reporting (i.e.., 1934 Securities Exchange Act reporting requirement) issuers stock would be limited to reviewing only “the court approved disclosure statement for the issuer’s plan of reorganization and the issuers financial information from the date the bankruptcy court confirms the reorganization plan.”
(Publication or Submission of Quotations Without Specified Information, SEC Release
No. 34-39670, 63 Fed. Reg. 9661, 9668 (Feb. 25, 1998). (See Proposed SEC Rule Change to Have Beneficial Effect on Chapter 11 ‘s by Demers, Hudgins and Diamond, Norton Bankruptcy Advisor , William L. Norton, Editor in Chief, West Group,Rochester, NY, Issue No. 6, page 6) (See also Petitioner Seeks 1934 Act Reporting Relief During Bankruptcy Reorganizations by Alison Carpenter, Securities Regulatory Update, Volume 1, Issue 5, Commerce Clearinghouse Washington Service Bureau, September 8, 1998, Washington, D.C.)
Unfortunately this modification was included in a much broader proposal which was never formally adopted by the SEC. Because of listing requirement changes by the national stock exchanges (as approved by the SEC), in today’s securities markets, trading of securities in non-reporting companies can take place only on the Pink Sheet Quotation system. Still to be reconciled is the incongruities between the 1934 Securities Exchange Act auditing and reporting requirements and the reality of a successful Chapter 11 company which, at least according to the nations accountants (and certainly implied by Congress in enacting the Code), has no financial past and should not have to report financial information straddling a confirmation.
The Role of the Board of Directors in a Chapter 11
Another common misconception is that a Board of Director’s must approve a plan of reorganization and disclosure statement prior to its being filed with the Court. In enacting the Code, Congress noted that the contents of a plan of reorganization “…may provide for any action specified Section 1123 in the case of a corporation without a resolution of the board of directors. If the plan is confirmed then any action proposed in the plan may be taken notwithstanding any otherwise applicable nonbankruptcy law in accordance with section 1142(a) of Title 11 ” (124 Cong Rec 2h11103 ( emphasis by authors)) (daily ed. Sept. 28, 1978; 517419 (daily ed Oct. 6, 1978); remarks of Rep. Edwards and Sen. DeConcini). The only real role a board of director’s plays in a Chapter 11 proceeding is the adoption of a resolution authorizing the filing of the Chapter 11 petition pursuant to state corporate governance law (Price v Gurney, 324 U.S. 100 (1945))
It appears logical that a board of directors should not have a voice in the adoption of a plan of reorganization. Under corporate law, a board of directors is elected by shareholders. Since equity holders are the last priority under the absolute priority rule and since they have the right to create a committee to represent themselves (11 USC 1102(a) (2), (b) (2)), a board of directors elected by them would essentially give equity holders two representative bodies which could be in conflict. Too, under the absolute priority rule, other claimants have priority over equity holders who could be wiped out under provisions of the Code. Lastly in would be unfair for one class of claimants (i.e. Equity Holders) to have two representative bodies (i.e. an Equity Holders Committee and a board of directors).
Disclosure to the Securities and Exchange Commission
A third common misconception is that a filing for relief under Chapter 11 by a non-public corporation does not require notification of the Securities and Exchange Commission. The Code, as adopted, in 1978 provided that the Securities and Exchange Commission was not an automatic party in interest but has the right to appear and be heard on any issue in a case under Chapter 11 (11 USC 1109(a)) The Senate version of the Bankruptcy Code had provided for defining a “public company” as a “debtor who, within 12 months prior to the filing of a [Chapter 11] petition…had outstanding liabilities of $5 million or more…and not less than 1,000 security holders.” (Senate Bill 2266; S. Rep. No. 989, 95 th Congress, 2″d Sess. 114 (1978))
However, this provision was removed during the Congressional Conference Committee by House and Senate negotiators. Thus the finalized version of the Code did not differentiate between public and non-public companies. (see: Capitalizing on Security Exemptions in Chapter 11 Reorganizations by Demers, Hudgins, Diamond, Shurley and Wilson; Journal of Bankruptcy Law and Practice, Vol 8, No. 3 (March/April 1999), page 288; West Group, Eagan, MN)
Bankruptcy Rule 2002 (j) specifically requires a copy of certain notices (including the Chapter 11 Notice of Relief) be mailed to the Securities and Exchange Commission. Norton’s Editors’ Comment to this Rule advises the Notice to the SEC involves both public and non-public Chapter 11 “…the security and Exchange Commission (SEC) has been traditionally involved in all pre-Code reorganization cases, especially when the corporate debtor issued securities held by the public and traded either on one of the exchanges or over-the-counter. The SEC also has been involved in cases involving nonmonied corporations such as churches or hospitals when these institutions entered into long-term financing arrangements and, in connection with financing, issued debenture bonds which were sold to the public… This Rule [20020).1 has some general, and some specific provisions. For example, a specific provision requires a notice to be sent to the SEC in a Chapter 11 case.” (italicized emphasis by authors) (Rules and Official Forms;
Norton Bankruptcy Law and Practice, Callaghan & Company, Deerfield, Ill; 1990; page 102). There is no differentiation between public or non-public under the Rule. Thus, the authors conclude that the SEC must be notified of any Chapter 11 filing regardless as to whether or not the entity is public or non-public.
Rule 3017(a) acts as a companion to Rule 2002(j) regarding the Securities and Exchange Commission. This Rule specifically requires that a copy of the Plan of Reorganization and Disclosure Statement be mailed to the Securities and Exchange Commission upon filing and before the adequacy hearing. This Rule should be interpreted, in light of Rule 2002(j)’s all encompassing language, just discussed, to require these documents be mailed the Securities and Exchange Commission whether the Chapter 11 entity is public or non-public. Rule 3017(a) acts as the transmittal mechanism to the Securities and Exchange Commission, allowing that agency to review the proposed plan and disclosure statement and thus activates its ability under 11 USC 1109 to “…appear and be heard on any issue in a case under [Chapter 11]…”