It is reality:
- Small businesses are reorganizing, all the time, under subchapter V;
- Farmers are reorganizing, all the time, under chapter 12; and
- Big companies are reorganizing, all the time, under regular Chapter 11.
This is because these three types of debtors have bankruptcy reorganization processes designed specifically for them.
Middle market debtors
But what about an intermediate debtor: the private company that is not eligible for sub-chapter V (for example., due to excessive debt or affiliation to a listed company)?
There is no bankruptcy process specifically for this debtor.
Let’s say the owners of a financially distressed middle-market debtor want to reorganize the business, need to file for bankruptcy to do so, and want to keep their property rights intact.
It is a problem. Here’s why:
- the only bankruptcy process available is regular Chapter 11; and
- normal chapter 11 does not work because of the absolute priority rule, which does not NOT allow confirmation of the plan 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 precedence rule (it is unique to normal chapter 11). This is why these processes work for eligible debtors.
But what should middle market debtors do? How can owners reorganize their mid-market business, in normal Chapter 11, and also keep their stakes?
A wrong answer is: they can’t, the only viable option in normal Chapter 11 is to liquidate.
Another wrong answer is this: by promising to pay way too much over time to get votes from creditors. The problem with this overpayment solution is that the debtor rarely survives because they simply cannot make the large payments required.
Nebraska’s 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 top priority rule.
I call it “Three Step Nebraska”, because I’m in Nebraska, the solution has three steps, and I used it first to confirm a Chapter 11 plan (with debtor owners retaining ownership ) in the early 1990s.
—The three stages
Here are the steps of the tree structure:
- Step 1: Propose a plan that would be confirmable, absent the overriding priority rule, with Nebraska’s three-step provision included;
- Step 2: have the plan confirmed in accordance with the regular requirements of Chapter 11; and
- Step 3: Comply with Nebraska’s three-step provision.
Here is the three-step substance of a three-step Nebraska layout:
- Step 1: Upon confirmation, ownership rights prior to the request are revoked;
- Step 2: immediately after confirmation of the plan, 100% of the interests in the reorganized debtor are auctioned off to the highest bidder; and
- Step 3: The confirmed plan identifies a stalking horse offer (from an insider) that will be accepted, in the absence of a competing offer.
-Why It works: a premium price
Here’s a practical reason why the Nebraska Three-Step works: the insider’s bid is at a high price, regardless of the amount.
This reality of premium prices exists because the plan, to be confirmed, must pay:
- the value of all assets (usually for secured creditors);
- the combined amount of all priority claims (for example., taxes); and
- the combined amount of all administrative claims (for example., US legal and trustee fees).
Thus, after confirmation, the reorganized debtor is, generally, insolvent ab-initio (that’s to say, From the beginning). This means that the insider’s bid pays, whatever the amount, a higher price.
—Dissuasive for the uninitiated
Therefore, a layperson who wishes to outbid the ownership of the reorganized debtor:
- cannot be a bottom feeder looking for a bargain, because there is no such bargain to be had; and
- would need to have sufficient bidding incentive to support a high priced bid.
—What will work and what won’t
Under most middle-market circumstances, the Nebraska Three-Step will work—that’s to say., the risks are acceptable and can be managed. This is because no one, other than an insider, is willing to pay a higher price for the reorganized debtor.
In contrast, circumstances with more (that’s to say.,unacceptable) risks to Nebraska Three-Step include:
- the debtor’s main asset is a scarce resource for which the uninitiated will pay a premium (for example., unique intellectual property); Where
- the debtor’s competitor is highly motivated to acquire the debtor (for example., eliminate the competition or settle a score).
To be sure, the Nebraska Three Step requires some daring and is NOT for the faint of heart or risk averse.
On the other hand, the Nebraska Three-Step has proven effective for middle market companies, (i) to have reorganization plans confirmed, with ownership interests intact, and (ii) as a basis for negotiation with creditors to avoid filing for bankruptcy.