The informal settlement is an out-of-court agreement that usually consists of an extension of time (stretch-out), a pro rata cash payment for full settlement of claims (composition), an issue of stock for debt, or some combination. Developing an out-of-court settlement may take several forms. For example, the debtor, through counsel or credit association, calls an informal meeting of the creditors for the purpose of discussing its financial problems. In many cases, the credit association makes a significant contribution to the out-of-court settlement by arranging a meeting of creditors, providing advice, and serving as secretary for the creditors' committee.

A credit association is composed of credit managers of various businesses in a given region. Its functions are to provide credit and other business information to member companies concerning their debtors, to help make commercial credit collections, to support legislation favorable to business creditors, and to provide courses in credit management for members of the credit community.

At the creditors' meeting, the debtor describes the causes of failure, discusses the value of assets (especially those unpledged) and unsecured liabilities, and answers any questions the creditors may ask. The main objective of this meeting is to convince the creditors that they would receive more if the business were allowed to operate than if it were forced to liquidate and that all parties would benefit from working out a settlement.

In other situations, the debtor or its representative will not negotiate with the creditors as a group, but rather will work individually with, for example, the secured lenders, and attempt to reach a tentative agreement or at least develop a possible agreement and then move on to the unsecured lenders and talk with them. The debtor may continue the process, meeting with individual creditors or groups of similar creditors until an agreement is reached.

A remedy available under state law to a corporation in serious financial difficulties is an assignment for the benefit of creditors. In this instance, the debtor voluntarily transfers title to its assets to an assignee, who then liquidates them and distributes the proceeds among the creditors. Assignment for the benefit of creditors is an extreme remedy because it results in the cessation of the business. This informal liquidation device (although court-supervised in many states) is like the out-of-court settlement devised to rehabilitate the debtor, in that it requires the consent of all creditors or at least their agreement to refrain from taking action. The appointment of a custodian over the assets of the debtor gives creditors the right to file an involuntary bankruptcy court petition.

Proceedings brought in the federal courts are governed by the Bankruptcy Code. Normally it is necessary to resort to such formality when suits have been filed against the debtor and its property is under garnishment or attachment or is threatened by foreclosure or eviction.

Bankruptcy court proceedings are generally the last resort for the debtor whose financial condition has deteriorated to the point where it is impossible to acquire additional funds. When the debtor finally agrees that bankruptcy court proceedings are necessary, the liquidation value of the assets often represents only a small fraction of the debtor's total liabilities. If the business is liquidated, the creditors get only a small percentage of their claims. The debtor is discharged of its debts and is free to start over; however, the business is lost and so are all the assets. Normally, liquidation proceedings result in large losses to the debtor, the creditors, and the business community in general. Chapter 7 of the Bankruptcy Code covers the proceedings related to liquidation. Another alternative under the Bankruptcy Code is to seek some type of relief so that the debtor, with the help of the bankruptcy court, can work out agreements with creditors and be able to continue operations. Chapters 11, 12, and 13 of the Bankruptcy Code provide for this type of operation.

One of the first decisions that must be made at an early meeting of the debtor with bankruptcy counsel and accountants is whether it is best to liquidate (under provisions of state law or Bankruptcy Code), to attempt an out-of-court settlement, to seek an outside buyer, or to file a Chapter 11 petition. To decide which course of action to take, it is also important to ascertain what caused the debtor's current problems, whether the company will be able to overcome its difficulties, and, if so, what measures will be necessary. Accountants may be asked to explain how the losses occurred and what can be done to avoid them in the future. To help with this determination, it may be necessary to project the operations after a 30-day period over at least the next three to six months, and to indicate the areas where steps will be necessary in order to earn a profit.

For existing clients, the information needed to make a decision about the course of action to make may be obtained with limited additional work; however, for a new client, it is necessary to perform a review of the client's operations to determine the condition of the business. Once the review has been completed, the client must normally decide to liquidate the business, attempt an informal settlement with creditors, or file a Chapter 11 petition, unless additional funds can be obtained or a buyer for the business is located. For example, where the product is inferior, the demand for the product is declining, the distribution channels are inadequate, or other similar problems exist that cannot be corrected, either because of the economic environment or management's lack of ability, it is normally best to liquidate the company immediately.

The decision whether a business should immediately file a Chapter 11 petition or attempt an out-of-court settlement depends on several factors. Among them are the following eight:

A voluntary case is commanded by the debtor's filing of a bankruptcy petition under the appropriate chapter.

An involuntary petition can be filed by three or more creditors (if 11 or fewer creditors, only one creditor is necessary) with unsecured claims of at least $10,000 and can be initiated only under Chapter 7 or 11. An indenture trustee may be one of the petitioning creditors. The Court allows a case to proceed only if (1) the debtor generally fails to pay its debts as they become due, provided such debts are not the subject of a bona fide dispute; or (2) within 120 days prior to the petition a custodian was appointed or took possession. The latter excludes the taking of possession of less than substantially all property to enforce a lien.

The timing for filing the petition is important. For example, if the debtor delays filing the petition until the creditors are about to force the debtor into bankruptcy, the debtor may not be in a position to effectively control its destiny. On the other hand, if the petition is filed when the problems first develop and while the creditors are reasonably cooperative, the debtor is in a much better position to control the proceeding. If possible, it is best to file the petition near the end of the month or, even better, near the end of the quarter, to avoid a separate closing of the books.

Tax factors should also be considered in deciding when to file the petition. For example, if a debtor corporation that has attempted an unsuccessful out-of-court settlement decides to file a petition, the tax impact of the out-of-court action should be considered. If, in the out-of-court agreement, the debtor transferred property that resulted in a gain and a substantial tax liability, it would be best for the debtor to file the petition after the end of the current taxable year. By taking this action, the tax claim is a prepetition tax claim and not an administrative expense. If the tax claim is a prepetition claim, interest and penalties stop accruing on the day the petition is filed and the debtor may provide in the plan for the deferral of the tax liability up to six years. If the tax claim is an administrative expense, penalties and interest on any unpaid balance will continue to accrue and the provision for deferred payment of up to six years does not apply.

The accountant must supply the attorney with certain information necessary for filing a Chapter 11 petition. This would normally include the following:

The debtor must also file any additional reports or documents that may be required by local rules or by the U.S. trustee.

A petition filed under the Bankruptcy Code results in an automatic stay of the actions of creditors. The automatic stay is one of the fundamental protections provided the debtor by the Bankruptcy Code. In a Chapter 7 case, it provides for an orderly liquidation that treats all creditors equitably. For business reorganizations under Chapter 11, 12, or 13, it provides time for the debtor to examine the problems that forced it into bankruptcy court and to develop a plan for reorganization. As a result of the stay, no party, with minor exceptions, having a security or adverse interest in the debtor's property can take an action that will interfere with the debtor or his property, regardless of where the property is located, until the stay is modified or removed. Section 362(a) provides a list of eight kinds of acts and conduct subject to the automatic stay.

Under Section 362 of the Bankruptcy Code, a tax audit, a demand for a tax return, or the issuance of a notice and demand for payment for such assessment are not considered a violation of the automatic stay.

The stay of an act against the property of the estate continues, unless modified, until the property is no longer the property of the estate. The stay of any other act continues until the case is closed or dismissed, or the debtor is either granted or denied a discharge. The earliest occurrence of one of these events terminates the stay.

Section 365(a) provides that the debtor or trustee, subject to court approval, may assume, assign, or reject any executory contract or unexpired lease of the debtor. For nonresidential real property leases the debtor must make a decision to assume, assign, or reject the lease within 120 days after the petition is field. Only a 90-day extension will be granted, unless the landlord agrees to a larger extension. If a lease is not assumed by the end of the time period, it is presumed that the lease is rejected. A decision regarding all other leases must be made prior to confirmation of a plan in Chapter 11. In the case of a Chapter 7 petition, the decisions must be made regarding the assumption or rejection of all leases within 60 days, unless an extension is granted.

Executory contracts are contracts that are "so far unperformed that the failure of either [the bankrupt or nonbankrupt] to complete performance would constitute a material breach excusing the performance of the other."^[69] Countryman's definition seems to have been adopted by Congress in the statement that "executory contracts include contracts under which performance remains due to some extent on both sides."^[70] However, before a contract can be assumed, Section 361 indicates that the debtor or trustee must:

The Bankruptcy Code grants to the trustee or debtor in possession (DIP) the right to avoid certain transfers and obligations incurred. For example, Section 544 allows the trustee to avoid unperfected security interest and other interests in the debtor's property. Thus if the creditor fails to perfect a real estate mortgage, the trustee may be able to avoid that security interest and force the claim to be classified as unsecured rather than secured.

The trustee needs these powers and rights to ensure that actions by the debtor or by creditors in the prepetition period do not interfere with the objective of the bankruptcy laws, to provide for a fair and equal distribution of the debtor's assets through liquidation—or rehabilitation, if this would be better for other creditors involved.

In addition the trustee has the power to avoid preferences, fraudulent transfers, and postpetition transfers.

A preferential payment as defined in Section 547 of the Bankruptcy Code is a transfer of any of the property of a debtor to or for the benefit of a creditor, for or on account of an antecedent debt made or suffered by the debtor while insolvent and within 90 days before the filing of a petition initiating bankruptcy proceedings, when such transfer enables the creditor to receive a greater percentage of payment than it would receive if the debtor were liquidated under Chapter 7. Insolvency is presumed during the 90-day period. A transfer of property to an insider between 90 days and one year before the filing of the petition is also considered a preferential payment. An officer, director, or person in control of the corporation would be considered an insider. Action to recover a preferential payment received by a third party that benefited an officer or other insider may only be taken against the officer or other insider and not against the third party. For example, if a president paid off a loan that he personally guaranteed six months before the petition was filed, the payment would be recoverable as a preference from the president, but not from the bank. Preferences include the payment of money, a transfer of property, assignment of receivables, or the giving of a mortgage on real or personal property.

A preferential payment is not a fraud but rather a legitimate and proper payment of a valid antecedent debt. The voidability of preferences is created by law to effect equality of distribution among all the creditors. The 90-day period (one year for transactions with insiders) prior to filing the bankruptcy petition has been arbitrarily selected by Congress as the time period during which distributions to the debtor's creditors may be redistributed to all the creditors ratably. During this period, a creditor who accepts a payment is said to have been preferred and may be required to return the amount received and later participate in the enlarged estate to the pro rata extent of its unreduced claim.

Fraudulent transfers and obligations are defined in Section 548 and include transfers that are presumed fraudulent regardless of whether the debtor's actual intent was to defraud creditors. A transfer may be avoided as fraudulent when made within one year (two years for petitions filed on or after April 20, 2006) prior to the filing of the bankruptcy petition, if the debtor made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud existing or real or imagined future creditors. Also avoidable are constructively fraudulent transfers where the debtor received less than a reasonably equivalent value in exchange for such transfer or obligation and (1) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation; (2) was engaged in business, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; or (3) intended to incur, or believed that the debtor would incur, debts that would burden the debtor's ability to pay as such debts matured.

Under Section 544 of the Bankruptcy Code, fraudulent transfers may also be recovered under state law for payments made between one and six years. Section 546 provides that any action to recover a preference or a fraudulent transfer under Section 548 through the Bankruptcy Code or under Section 544 through state law must commence the action within two years after the order for relief or if a trustee is appointed during the second year after the petition is filed within one year after the trustee is appointed.

In the determination of fraudulent transfers, insolvency is defined by Section 101(32) as occurring when the present fair salable value of the debtor's property is less than the amount required to pay its debts. The fair value of the debtor's property is also reduced by any fraudulently transferred property, and for an individual, by the exempt property under Section 522.

Section 549 allows the trustee to avoid certain transfers made after the petition is filed. To be avoidable, transfers must not be authorized either by the court or by an explicit provision of the Bankruptcy Code.

Setoff is that right existing between two parties to net their respective debts where each party, as a result of unrelated transactions, owes the other an ascertained amount. The right to setoff is an accepted practice in the business community today. When one of the two parties is insolvent and files a bankruptcy court petition, the right to setoff has special meaning. Once the petition is filed, the debtor may compel the creditor to pay the debt owed and the creditor may in turn receive only a small percentage of the claim—unless the Bankruptcy Code permits the setoff.

The Bankruptcy Code gives the creditor the right to offset a mutual debt, providing both the debt and the credit arose before the commencement of the case. Major restriction on the use of setoff prevents the creditor from unilaterally making the setoff after a petition is filed. The right to setoff is subject to the automatic stay provisions of Section 362 and the use of property under Section 363. Thus, a debtor must obtain relief from the automatic stay before proceeding with the setoff. This automatic stay and the right to use the amount subject to setoff is possible only when the trustee or DIP provides the creditor with adequate protection. If adequate protection—normally in the form of periodic cash payments, additional or replacement collateral, or other methods that will provide the creditor with the indubitable equivalent of its interest—is not provided, then the creditor may proceed with the offset as provided in Section 553.

One area where the avoiding power of the trustee is limited is in a request for reclamation. Section 546(c) provides that under certain conditions, the creditor has the right to reclaim goods if the debtor received the goods while insolvent during the 45 days prior to the filing of the petition. To reclaim these goods, the seller must demand in writing, within 20 days after the petition was filed. If the seller does not make a timely demand for reclamation, the seller has to right to an administrative expense claim for goods delivered within 20 days prior to bankruptcy.

Chapter 30 of Title 28, U.S. Code, provides for the establishment of the U.S. trustee program. The Attorney General is responsible for appointing one U.S. trustee in each of the 21 regions, and one or more assistant U.S. trustees perform the supervisory and appointing functions formerly handled by bankruptcy judges. They are the principal administrative officers of the bankruptcy system. The judicial districts of Alabama and North Carolina were not to be a part of the expansion of the U.S. Trustee program until 1992. The Judicial Improvements Act of 1990 (P.L. 101–650) extended the time period in which the six districts must be a part of the system to October 1, 2002. In these districts, some of the functions performed by the U.S. trustee in other districts are assigned to an administrator in the bankruptcy court.

The U.S. trustee establishes, maintains, and supervises a panel of private trustees that are eligible and available to serve as trustee in cases under Chapter 7 or 11. Also, the U.S. trustee supervises the administration of the estate and the trustees in cases under Chapters 7, 11, 12, or 13. The intent is not for the U.S. trustee system to replace private trustees in Chapters 7 and 11. Rather, the system should relieve the bankruptcy judges of certain administrative and supervisory tasks and thus help to eliminate any institutional bias or the appearance of any such bias that may have existed in the prior bankruptcy system.

The U.S. trustees are responsible for the administration of cases. They appoint the committees of creditors with unsecured claims and also appoint any other committees of creditors or stockholders authorized by the court. If the court deems it necessary to appoint a trustee or examiner, a U.S. trustee makes this appointment (subject to court approval) and also petitions the court to authorize such an appointment.

U.S. trustees monitor applications for compensation and reimbursement for officers and accountants and other professionals retained in the case, raising objections when deemed appropriate. Other responsibilities include monitoring plans and disclosure statements, creditors' committees, and the progress of the case.

A proof of claim or interest is deemed filed in a Chapter 11 case provided the claim or interest is listed in the schedules filed by the debtor, unless the claim or interest is listed as disputed, contingent, or unliquidated. A creditor is thus not required to file a proof of claim if it agrees with the debt listed in the schedules. It is, however, advisable for creditors to file a proof of claim in most situations. Creditors who for any reason disagree with the amount admitted on the debtor's schedules, such as allowable prepetition interest on their claims, or creditors desiring to give a power of attorney to a trade association or lawyer, should always prepare and file a complete proof of claim. Special attention must also be devoted to secured claims that are undersecured.

Section 506 provides that if a creditor is undersecured, the claim will be divided into two parts. The first part is secured to the extent of the value of the collateral or to the extent of the amount of funds subject to setoff. The balance of the claim is considered unsecured. The value to be used to determine the amount of the secured claim is, according to Section 506(a), to "be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditors' interest." Bankruptcy Rule 3012 provides that any party in interest may petition the court to determine the value of a secured claim.

Thus, the approach used to value property subject to a lien for a Chapter 7 may be different from that for a Chapter 11 proceeding. Even within a Chapter 11 case, property may be valued differently. For example, fixed assets that are going to be sold because of the discontinuance of operations may be assigned liquidation values, whereas assets that will continue to be used by the debtor may be assigned going concern values. Although courts have to determine value on a case-by-case basis, it is clear that the value is to be determined in light of the purpose of the valuation and the proposed disposition or use of the property.

Section 1111(b) allows a secured claim to be treated as a claim with recourse against the debtor in Chapter 11 proceedings (i.e., where the debtor is liable for any deficiency between the value of the collateral and the balance due on the debt) whether the claim is nonrecourse by agreement or by applicable law. This preferred status terminates if the property securing the loan is sold under Section 363 or is to be sold under the terms of the plan, or if the class of which the secured claim is a part elects application of Section 1111(b)(2).

Another available section under Section 1111(b) is that a class of undersecured creditors can elect to have its entire claim considered secured. A class of creditors will normally be only one creditor. For example, in Chapter 11 cases where most of the assets are pledged, very little may be available for unsecured creditors after paying administrative expenses. Thus, the creditor might find it advisable to make the Section 1111(b)(2) election. On the other hand, if there will be a payment to unsecured creditors of approximately 75 cents per dollar of debt, the creditor may not want to make this election.

The purpose of the election is to provide adequate protection to holders of secured claims where the holder is of the opinion that the collateral is undervalued. Also, if the treatment of the part of the debt that is accorded unsecured status is so unattractive, the holder may be willing to waive his unsecured deficiency claims. The class of creditors making this election has the right to receive full payment for its claims over time. If the members of the class do not approve the plan, the court may confirm the plan as long as the plan provides that each member of the class receives deferred cash payments totaling at least the allowed amount of the claim. However, the present value of these payments as of the effective date of the plan must be at least equal to the value of the creditors' interest in the collateral. Thus, a creditor who makes the election under Section 1111(b)(2) has the right to receive full payment over time, but the value of that payment is only required to equal the value of the creditor's interest in the collateral.

The actual, necessary costs of preserving the estate, including wages, salaries, and commissions for services rendered after the commencement of the case, are considered administrative expense. Any tax including fines or penalties is allowed unless it relates to a tax-granted preference under Section 507(a)(8). Compensation awarded a professional person, including accountants, for postpetition services is an expense of administration. Expenses incurred in an involuntary case subsequent to the filing of the petition but prior to the appointment of a trustee or the order for relief are not considered administrative expenses. They are, however, granted second priority under Section 507. Administrative expenses of a Chapter 11 case that is converted to Chapter 7 are paid only after payment of Chapter 7 administrative expenses.

Section 507 provides for the following priorities:

Priority claims in a Chapter 11 case must be provided for in the plan.

Several accounting firms and other businesses have developed models to handle the processing of claims of both small and large debtors. Some of their features include these six:

One system uses a multifield data base to help debtors deal with the complexities of a bankruptcy. Creditors' files can be sorted in terms of classes of creditors, priorities of claims, and so on, and then alphabetically within these categories. Notices sent to creditors include all the necessary information, such as the amount of a claim and its current status. Ongoing information that changes over time is constantly updated. This could include the extent to which proofs of claim differ from the recorded debt, the assessment of market values of collateral pledged as security, other assets that are not pledged as security, distributions made during the course of a Chapter 11 case, and changes to or withdrawals of claims. Automatically prepared and mailed notices keep creditors current on the proceedings of a case. The system, through automatic mailings, answers telephone inquiries as they are entered.

The debtor or trustee must be able to use a secured party's collateral, or in most situations there would be no alternative but to liquidate the business. Section 363(c) gives the trustee or debtor the right to use, sell, or lease property of the estate in the ordinary course of business without a notice and a hearing. As a result of this provision, the debtor may continue to sell inventory and receivables and use raw materials in production without notice to secured creditors and without court approval. The use, sale, or lease of the estate's property other than in the ordinary course of business is allowed only after notice and an opportunity for a hearing. Under Section 363 of the Bankruptcy Code, companies, with court approval, may sell all of a large percent of the assets of the company. As noted below, the sale of all or a large percentage of the debtor's assets is viewed as a very viable option to the development of a plan.

In most Chapter 11 proceedings, the debtor must obtain additional financing in order to continue the business. Although the debtor was allowed to obtain credit under prior law, the power granted to the debtor under the Bankruptcy Code is broader. Section 364(a) allows the debtor to obtain unsecured debt and to incur unsecured obligations in the ordinary course while operating the business. This right is automatic unless the court orders otherwise. Also the holder of these claims is entitled to first priority as administrative expenses.

If the debtor is unable to obtain the necessary unsecured debt under Section 364(a), the court may authorize the obtaining of credit and the incurring of debt by granting special priority for claims. These priorities may include the following:

DIP financing may be obtained from the existing lender or from a new lender. Most all major banks are involved in DIP financing as well as several other financial entities, including funds that are established to make loans to companies in Chapter 11 and on emergence from Chapter 11. At times existing creditors will lend to the Chapter 11 debtor in order to prevent other lenders from obtaining a position that may be superior to that of the existing lender. The bankruptcy court may allow the debtor to prime the position of the existing lender. However, for the court to authorize the obtaining of credit with a lien on encumbered property that is senior or equal to the existing lien, the debtor must not be able to obtain credit by other means and the existing lien holder must be adequately protected.

Credit obtained other than in the ordinary course of business must be authorized by the court after notice and a hearing. Where there is some question whether the credit is related to the ordinary course of business, the lender should require court approval.

The number of 363 sales has recently increased compared to the number of plans approved. Banks and other financial institutions are less willing to lend funds for the time period necessary for businesses to reorganize, but may be willing to provide funds for a shorter period while the debtor implements a 363 sale. Additionally, creditors appear to be less patient today than they were in the 1980s and early 1990s, asking debtors to sell the business or in some cases filing a motion asking the court to provide for a 363 sale.

Asset sales are not restricted to the middle market or smaller cases. For example, companies like Polaroid (received $56.5 million cash for assets of its Identification Systems Business Division), Fruit of the Loom (business operations purchased by Berkshire Hathaway, Inc.), and LTV Corporation (sold its integrated steel assets to WL Ross & Co.) completed significant asset sales as a part of their Chapter 11 filing.

The Bankruptcy Code provides that a trustee can be appointed in certain situations based on facts in the case and not related to the size of the company or the amount of unsecured debt outstanding. The trustee is appointed only at the request of a party in interest after a notice and hearing. A party in interest includes the debtor, the trustee (in other contexts), creditors' or stockholders' committees, creditors, stockholders, or indenture trustees. Also, a U.S. trustee, while not a party in interest, may petition the court for an appointment of a trustee.

Section 1104(a) states that a trustee be appointed:

The U.S. trustee is responsible for the appointment of the trustee from a panel of qualified trustees, once the appointment has been authorized by the court. It also appears that the U.S. trustee would have the right to replace trustees who fail to perform their functions properly.

The Bankruptcy Code, as originally enacted, provided that in a Chapter 7 case, the interim trustee appointed by the U.S. trustee would serve as the trustee unless a trustee is elected by a majority of at least 20 percent of the unsecured creditors voting in an election at a meeting of creditors under Section 341 of the Bankruptcy Code. In most Chapter 7 cases, the interim trustee serves as the trustee. The Bankruptcy Reform Act of 1994 modified Section 1104 of the Bankruptcy Code to provide that on request of a party in interest (made within 30 days after the court authorized the appointment of a trustee), the U.S. trustee must call a meeting of unsecured creditors for the purpose of electing a Chapter 11 trustee. This change might encourage more creditors to petition the court for the appointment of a trustee in a Chapter 11 case because the creditors now have some impact as to who is appointed.

Under the Bankruptcy Code, the trustee's major functions are to (1) operate the business and (2) conduct an investigation of the debtor's affairs. Under certain conditions, it may be best to leave the current management in charge of the business, without resolving the need for the investigation of the debtor. The Code provides for the appointment of an examiner to perform this function. Section 1104(b) states that if a trustee is not appointed:

Several different types of reports are required while the debtor is operating the business in a Chapter 11 reorganization proceeding. The nature of the reports and the time period in which they are issued depend to some extent on local rules and on the type of internal controls of the debtor and the extent to which large losses are anticipated.

Districts establish local bankruptcy rules that generally apply to all cases filed in that particular district. These rules cover some of the procedural matters that relate to the handling of a bankruptcy case, including appearance before the court, forms of papers filed with the court, assignment of case, administration of case, employment of professionals, and operating statements. The rules for the filing of operating statements have become primarily the responsibility of the U.S. trustee and, as a result, the specific procedures for these statements are those of the U.S. trustee.

One statement required by all regions is an operating statement—profit and loss statement. This statement may include, in addition to the revenue and expense accounts needed to determine net income on the accrual basis, an aging of accounts payable (excluding prepetition debts) and accounts receivable, status of payments to secured creditors, analysis of tax payments, analysis of insurance payments and coverage, and summary of bankruptcy fees that have been paid or are due.

The U.S. trustee also requires cash receipts and disbursement statements. In some cases, it may be necessary to prepare this statement for each bank account of the debtor. For example, the U.S. trustee for the central district of California requires that the debtor, in addition to the regular account, establish separate accounts for payroll and taxes. Separate cash receipts and disbursement statements are also required for each account.

An independent accountant may assist the debtor in the preparation of these monthly operating reports. See Section 45.7(c) of this chapter.

In November 1990, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 90–7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code, which represents the first major pronouncement to be issued on financial reporting by companies in bankruptcy. The SOP applies to any company that files a Chapter 11 petition after December 31, 1990. In addition, the provisions regarding fresh start reporting apply to any entity that has its plan confirmed after June 30, 1991.

The SOP was designed to eliminate some of the significant divergences in accounting for bankruptcies and to increase the relevance of financial information provided to debtors, creditors, stockholders, and other interested parties who make decisions regarding the reorganization, especially the reorganization plan, of the debtor. The SOP applies to financial reporting by companies that have filed Chapter 11 petitions and expect to reorganize as going concerns, and to companies that emerge from Chapter 11 under confirmed plans. It does not apply to companies that are restructuring their debt outside of Chapter 11 or to those that adopt Chapter 11 plans of liquidation. It deals with how to report the activities of the Chapter 11 company during the reorganization proceeding and how to report the emergence of the company from Chapter 11.

A major objective of financial statements issued by the debtor in Chapter 11 should be to reflect the financial evolution of the debtor during the proceeding. Thus, for financial statements issued in the year the petition is filed and in subsequent years, a distinction should be made between transactions and events directly associated with the reorganization, as opposed to those related to the ongoing operations of the business. This principle is reflected in several significant areas of the financial statements.

(ii) Statement of Operations.

The objective of reporting during the Chapter 11 case is to present the results of operations of the reporting entity and to clearly separate those activities related to the normal operations of the business from those related to the reorganization. Thus, revenues, expenses (including professional fees), realized gains and losses, and provisions for losses resulting from the Chapter 11 reorganization and restructuring of the business should be separately reported. According to paragraph 27 of SOP 90–7, items related to the reorganization (except for the reporting of discontinued operations which are already reported separately) should be reported in a separate category within the income (loss) from operations section of the statement of operations. Appendix A in SOP 90–7 contains an example of the form to use for operating statements issued during a Chapter 11 case. The part of the operating statement that relates to the reporting of reorganization items is as follows:

Note that the reader of the statement of operations is able to determine the amount of income generated from continuing operations without the impact of the reorganization being reflected in these totals. While it will involve some judgment on the part of management to determine the part of income that relates to ongoing operations, a reasonable estimate of the segregation will be much more beneficial to the reader than including all items in the same category as is current practice.

A summary of the provisions relating to the operating statements includes these five:

1. Gains or losses as a result of restructuring or disposal of assets directly related to the reorganization are reported as a reorganization item (unless the disposal meets the requirement for discontinued operations). The gains or losses include the gain or loss on disposal of the assets, related employee costs, and other charges related to the disposal of assets or restructuring of operations. Note that the reporting of a reduction in business activity does not result in reclassification of revenues or expenses identified with the assets sold or abandoned, unless the transaction is classified as a disposal of a discounted business under Statement No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets.

2. Professional fees are expensed as incurred and reported as a reorganization item.

3. Interest income that was earned in Chapter 11 that would not have been earned but for the proceeding is reported as a reorganization item.

4. Interest expense should be reported only to the extent that it will be paid during the proceeding or to the extent that it may be allowed as a priority, secured, or unsecured claim. The extent to which the reported interest expense differs from the contractual rate should be reflected in the notes to the operating statement or shown parenthetically on the face of the operating statement (the SEC prefers the latter). Under current practice, some debtors have accrued interest even though this procedure has been somewhat questionable. This practice should cease under the new SOP.

5. Income from debt discharge (forgiveness) in a Chapter 11 case where fresh start reporting is required should be shown as an reorganization item unless it meets the conditions for an extraordinary item under Accounting Principles Board (APB) Opinion No. 30, paragraph 26 dealing with unusual items and infrequently occurring items. Paragraph 41 (as revised) of the SOP indicates that this should also be the case for debtors not qualified for fresh start reporting.

(iii) Statement of Cash Flows.

Paragraph 31 of the SOP indicates that reorganization items should be disclosed separately within the operating, investing, and financing categories of the statement of cash flows. The SOP also indicates that reorganization items related to operating cash flows are better reflected if the direct method is used to prepare the statement of cash flows. An example of the statement of cash flows issued during a Chapter 11 case using the direct approach is found in Appendix A of the SOP.

The SOP indicates that if the indirect method is used, the details of the operating cash receipts and payments resulting from the reorganization should be disclosed in a supplementary schedule or in the notes to the financial statement. The footnote or supplementary schedule should include the information from the reorganization section of the statement of cash flows that is presented above.

It would also be acceptable to reflect this information in the cash flow statement as shown next:

Any reorganization items included in financing and investing activities should also be disclosed separately.

Section 1122 provides that claims or interests can be divided into classes provided each claim or interest is substantially similar to the others of such class. In addition, a separate class of unsecured claims may be established consisting of claims that are below or reduced to an amount the court approves as reasonable and necessary for administrative convenience. For example, claims of less than $1,000, or those creditors who will accept $1,000 as payment in full of their claim, may be placed in one class, and the claimants will receive the lesser of $1,000 or the amount of their claim. All creditors or equity holders in the same class are treated the same, but separate classes may be treated differently.

Generally, all unsecured claims, including claims arising from rejection of executory contracts or unexpired leases, are placed in the same class except for administrative expenses. They may, however, be divided into different classes if separate classification is justified. The Bankruptcy Code does not require placing all claims that are substantially the same in the same class.

Courts have stated that Section 1122(a) "does not require that similar claims must be grouped together, but merely that any group created must be homogeneous."

The items that may be included in the plan are listed in Section 1123. Certain items are listed as mandatory and others are discretionary. The seven mandatory provisions are:

In addition to these requirements, the plan may also include these five:

In determining the classes of creditors' claims or stockholders' interests that must approve the plan, it is first necessary to determine if the class is impaired. Section 1124 states that a class of claims or interest is impaired under the plan, unless the plan leaves unaltered the legal, equitable, and contractual rights of a class, cures defaults that led to acceleration of debts, or pays in cash the full amount of their claims.

A party cannot solicit the acceptance or rejection of a plan from creditors and stockholders affected by the plan unless they receive a written disclosure statement containing adequate information as approved by the court. Section 1125(b) requires that the court must approve this disclosure statement, after notice and a hearing, as containing adequate information.

Prior to the confirmation hearing on the proposed plan, the proponents of the plan will seek its acceptance. Once the results of the vote are known, the debtor or other proponent of the plan will request confirmation of the plan.

The holder of a claim or interest, as defined under Section 502, is permitted to vote on the proposed plan. Voting is based on the classification of claims and interests. A major change from prior law is that the acceptance requirements are based on those actually voting and not on the total value or number of claims or interests allowed in a particular class. The Secretary of the Treasury is authorized to vote on behalf of the United States when the United States is a creditor or equity security holder.

A class of claim holders has accepted a plan if at least two-thirds in amount and more than one-half in number of the allowed claims for that class that are voted are cast in favor of the plan. For equity interests, it is only necessary that votes totaling at least two-thirds in amount of the outstanding securities in a particular class that voted be cast for the plan. The majority in number requirement is not applicable to equity interests.

Section 1129(a), which contains the requirements that must be satisfied before a plan can be confirmed, is one of the most important sections of the Bankruptcy Code. The provisions follow:

Accountants can provide considerable services to their client relating to the formulation of the plan, some of which are described in the following subsections.

The following subsections describe several of the services that the accountant can render for the creditors' committee or for a committee of equity holders.

SOP 90–7 explains how the debtor emerging from Chapter 11 should account for the reorganization both when fresh start reporting should be adopted and when it is not allowed. Fresh start reporting requires the debtor to use current values (going concern or reorganization values) in its balance sheet for both assets and liabilities and to eliminate all prior earnings or deficits.

Companies that qualify for fresh start reporting will value all of the assets at their fair value. If a company does not qualify for fresh start reporting, the provisions of FASB Statement No. 144, Accounting for the Impairment or disposal of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, must be followed. FASB Statement No. 142, as described above, provides guidance for the reporting of the impairment of goodwill.

The accounting for impairment of assets follows a three-step approach for financial statement recognition and valuation:

The loss from impairment of the assets will be the difference between the carrying amount and the fair value of the assets. For example, assume that a manufacturing facility is potentially impaired by use of the plant to manufacture a product different from the original design for plant use. This change in the nature of the product was caused by technological advancements in the industry. The company reviews for impairment by estimating the expected future net cash flows for the asset undiscounted and without interest. For example, if the carrying value of the plant is $3 million and the further cash flows are less than $3 million, then the asset is impaired. The plant is written down to its fair value based on the concept of a "willing buyer and willing seller" as used in FASB Statement No. 15. For example, if the future cash flows were expected to be $2.5 million and the fair value of the plant was determined to be $1.7 million, a loss of $1.3 million would be reflected even though the difference between the cash flows and the carrying value of the plant is only $.5 million. This process is viewed as one only of cost allocation; as a result, subsequent increases in the value of the asset may not be reflected in the accounts.

The rules described here also apply to assets that will be disposed of. Prior practice allowed the entity to reflect these assets to be disposed of at their net realizable value; if there was an increase in their value, a gain was reflected in the accounts to the extent of a previous write-down. This practice will no longer be allowed, except in a case in which FASB Statement No. 144. In the case of disposition of assets associated with discontinued operations, under Statement No. 144 the assets will continue to be measured at their realizable value. At the time a bankruptcy petition is filed, it may appear that assets are impaired and carrying value should be materially reduced. However, with the filing of the petition, there will be a complete analysis of the viability of the business and of the various segments of the business. Until the assessment is complete, the company should avoid the impulse to materially reduce the carrying value of assets.

When the accountant begins an engagement involving bankruptcy or insolvency issues, a decision needs to be made as to application of the attestation standards. Section 9100.48 of Attestation Engagements Interpretation, "Applicability of Attestation Standards to Litigation Services," excludes litigation services that "involve pending or potential formal legal or regulatory proceedings before a trier of fact in connection with the resolution of a dispute between two or more parties ...." Guidance in this area is provided by the AICPA's Management Consulting Division, in Consulting Services Special Report 903–1, "Litigation Services and Applicable Professional Standards" (CSSR03–1). This report concludes in paragraph 76/105.03 that "[b]ankruptcy, forensic accounting, reorganization, or insolvency services, as practiced by certified public accountants ((CPA's), generally are acceptable as forms of litigation services."

CSSR 03–1 notes that the role of the accountant in a litigation engagement is different from the role in an attestation services engagement. When involved in an attestation engagement, the CPA firm expresses "a conclusion about the reliability of a written assertion of another party." In the performance of litigation services, the accountant helps to "gather and interpret facts and must support or defend the conclusions reached against challenges in cross-examination or regulatory examination and in the work product of others."

Appendix G of CSSR 03–1 describes the delivery of reorganization services to include items such as the following:

CSSR 03–1 then concludes that bankruptcy services similar to those listed above that are provided by CPA's generally are accepted as a form of litigation services. Appendix G of CSSR 03–1 provides that:

The above guidelines according to CSSR 03–1 should also apply to services rendered in an out-of-court workout, as described in the following paragraph from Appendix G:

For services to be exempted, they must be rendered in connection with the litigation, and the parties to the proceeding must have an opportunity to analyze and challenge the work of the accountant. For example, when the CPA expresses a written conclusion about the reliability of a written assertion by another party, and the conclusions and assertions are for the use of others who will not have the opportunity to analyze and challenge the work, the professional standards would apply. Also, when the CPA is specifically engaged to perform a service in accordance with the attestation standards or accounting services standards (SAARS), professional standards are applicable.

If it is determined that the analysis or report that will be issued comes under the guidelines as a form of litigation services, it is advisable to explain both the association and the responsibility, if any, through a transmittal letter or a statement affixed to documents distributed to third parties. Appendix 71/B of CSSR 93–1 suggests the following format for a statement that would explain the association of the CPAs and their responsibility, if any:

If it is determined that the service does not qualify as litigation service, any financial statements that might be issued from the services rendered should be accompanied with an accountant's report based on the compilation of the financial statements. Prior to the issuance of a compilation report, the format and nature of the report must be cleared with the firm administrator.

Another area where there is considerable uncertainty is in the issuance of operating reports. All regions of the U.S. trustee require monthly operating reports be submitted to the court as well as annual operating reports. Among those items that were listed in CSSR 03–1 that might fall under litigation services was the preparation or review of the monthly operating reports required by the bankruptcy court. These reports, especially for larger public companies, are often prepared in accordance with generally accepted accounting principles, including SOP 90–7. For example, in the region of New York, Connecticut, and Vermont, the U.S. trustee has issued guidelines that require the statements to conform to SOP 90–7. Other U.S. trustees have on request by the accountant allowed the statements to be prepared in the format that conforms to the manner in which the accountant normally prepares monthly financial statements. Additionally, the accountant is asked to prepare supplemental data not generally presented in monthly financial statements such as an aging schedule of postpetition payables and a schedule of postpetition taxes paid and accrued.

As noted above in CSSR 03–1, the professional standards would apply under two conditions:

In most situations, the second requirement—specifically engaged to perform attestation or compilation services—is not satisfied. Thus, based on this condition, the professional standards would not apply. Certified public accountants are generally engaged to prepare the operating reports that the U.S. trustee and the bankruptcy court require and not specifically to perform an audit or review of the financial records or even compile the financial statements in accordance with the professional standards.

It is the first requirement—expressing a written conclusion about the reliability of a written assertion by another party who will not have the opportunity to analyze and challenge the work—that needs further consideration by the profession. While no specific hearing is scheduled to review the reports, creditors or other parties in interest might raise objections to the content of the reports. Objections to the operating reports have been raised, but rarely. The preparation or the review of monthly operating reports that are required by the court is one of the items listed in the services that are rendered by accountants in the performance of reorganization services. CSSR 03–1 notes that "[b]ankruptcy services provided by CPAs generally are accepted as a form of litigation services."

Since operating reports are considered a form of litigation services, a compilation report should not be issued on the reports. Rather, the following statement should be included in a transmittal letter or affixed to the operating reports:

If, on the other hand, it is determined in a particular engagement that professional standards are applicable and the CPA is associated with the financial statements, then a compilation report should be issued based on the prescribed form as set forth in SAARS No. 3. As noted above, prior to the issuance of a compilation report the format and nature of the report must be reviewed for conformity to applicable standards.

Preference analysis or other special investigative services performed in a bankruptcy proceeding, receivership, or out-of-court settlement are considered a litigation service. As a result, the accountant is not required to issue an agreed-upon procedures report. This would not preclude the professional from issuing a report that described the procedures performed and the results ascertained from the performance of the stated procedures. For example, using the above format, a report issued to a trustee based on an analysis of preferences might be worded:

Section 200.03 of the AICPA, "Statements on Standards for Attestation Engagements," states that the standards for prospective financial statements do not apply for engagements involving prospective financial statements used solely in connection with litigation support services. CSSR 03–1 clearly indicates that prospective financial information qualifies as a litigation service. CSSR 03–1 states that parties-in-interest can challenge prospective financial information during negotiations or during bankruptcy court hearings often dealing with the plan's feasibility and adequacy of disclosure. Projections that are included in a disclosure statement would not be subject to the attestation standards since there is a hearing on the disclosure statement and the court must approve the disclosure statement before votes for the plan can be solicited. Parties-in-interest have an opportunity to challenge the prospective information included. Any projections provided for the debtor or for the creditors' committee that is used in the negotiations of the plan would also not fall under the attestation standards.

CSSR 03–1 does, however, indicate that in situations where the users of the prospective financial information cannot challenge the CPA's work, the attestation standards apply. CSSR 03–1 suggests that the attestation standard might apply in situations where exchange offers are made to creditors and stockholders with whom the company has not negotiated or who are not members of a creditor group represented by a committee. Section 200.03 of the AICPA, "Statements on Standards for Attestation Engagements," indicates that if the prospective financial statements are used by third parties that do not have the opportunity to analyze and challenge the statements, the litigation exception does not apply.

Section 200.02 of the AICPA, "Statements on Standards for Attestation Engagements," indicates that when an accountant submits, to his client or others, prospective financial statements that he has assembled (or assisted in assembling) or reports on prospective financial statements that might be expected to be used by third parties, a compilation, examination, or agreed-upon procedures engagement should be performed. Thus, for prospective financial statements that do not qualify for the litigation exception, the engagement must be in the form of a compilation, examination, or agreed-upon procedures if the accountant is associated with the financial statements.

The determination of the reorganization or liquidation values to be included in the disclosure statement or to be used by the debtor or creditors' committee in the negotiations of the terms of a plan, as well as other services that involve financial projections, would fall under the litigation exception. If it is determined that the report regarding the issuance of financial projections would not fall under litigation services, the format and nature of the report must be reviewed for conformity to applicable standards.

The following wording might be in the transmittal letter or in a statement affixed to the documents: