When the phrase "Chapter 11" is used, it refers to a certain part of the U.S. Bankruptcy Code as passed by Congress and updated occasionally. It should be noted that bankruptcy can only be handled by federal courts because Article 1 section 8 of the U.S. Constitution gives Congress the exclusive power to establish bankruptcy laws.

The U.S. Bankruptcy Code actually consists of nine chapters, with some numbers "saved" for another day. The first three (Chapters 1, 3, and 5) deal with general provisions, bankruptcy case administration, and the relationships between creditors, debtors, and the estate, respectively. These three chapters apply to both individual and corporate bankruptcies. Chapter 7 deals with liquidations, which can occur both for companies deciding to dissolve and for individuals selling off most or all of their possessions to satisfy creditors. Chapter 9 covers the adjustment of the debts of a municipality, while Chapter 12 is tailored to the unique economic situations faced by family farmers or family fishermen. Chapter 13 covers most personal bankruptcies for those individuals who have regular income to pay off some debts. Chapter 15 is the newest chapter, and represents the United States' adoption of the United Nations' Model Law on Cross-Border Insolvency. This newest chapter was considered necessary given the increasingly global implications of corporate bankruptcies with supply chain partners, creditors, customers, shareholders, and employees spread across many different international jurisdictions. That leaves only the focus of this chapter, to highlight Chapter 11, which deals with corporate reorganizations.^[102]

The goal of Chapter 11 is to maximize the value of the distressed firm's assets, either through a reorganization plan approved by the bankruptcy court, through a sale of all or part of the company, or through a liquidation; that is, sometimes a company files for Chapter 11 protection with the assumption that it will reorganize or sell itself as a going concern, but finds such alternatives unfeasible and converts to a Chapter 7 liquidation. This goal of maximizing asset value is required as a way to be fair to creditors, then following the Bankruptcy Code's strict delineation of how those assets are to be distributed during the resolution of the case. Known as the Absolute Priority Rule, it explains in exactly what order stakeholders are to be paid. Essentially, it is a food chain that determines which classes of stakeholders get to eat, and in what amounts. Sometimes a company will find itself insolvent under state law without filing a federal bankruptcy petition; every state has a version of this food chain as well, some of which differ slightly but for the most part mimic the priority of claims established in the Code. (See Box 5 regarding the state law approach to insolvency.) Every country has their own version of this food chain as well, as I explain in the next chapter; many have increasingly come to emulate the U.S. Code.

The power of the Absolute Priority Rule stems from the fact that it lays out a specific order of each class of claimants, and stipulates that until the first (highest-ranked) class of claimants is paid in full, the second-highest class cannot receive anything; until the second-highest class is paid in full, the third-highest class cannot receive anything; and so on. In practice, it does not always work out precisely that way, for a variety of reasons we examine in more detail later, but most notably because the parties negotiate and reach a consensus how best to split the prize.

In the United States, the Absolute Priority Rule establishes the priority of claimants as follows, with the top of the food chain listed first:

The key is that, unless the first class of claims is paid in full, the classes below it are not entitled to anything. Each class in turn must be paid before those below it can receive anything. Each of those claimants has numerous subcategories as well, but I only highlight the key factors of each one:

Secured claims are those debts where the creditor—generally a bank or other lender—has an enforceable lien on a particular piece of property (the collateral) owned by the debtor. It is highly desirable to have such a lien, because secured claims are paid first, and under the Absolute Priority Rule, must be paid in full before any other claims can be paid at all. In order for the creditor's lien to be enforceable (and therefore to be considered a secured claim), the creditor must "perfect" the lien by providing both attachment and notice. Attachment creates the enforceable security interest through the contractual exchange of consideration (e.g., a loan from a bank) in exchange for a security interest in a specific piece of collateral to which the debtor has ownership rights; a company cannot grant a bank a lien on the Brooklyn Bridge, for example. So-called "revolving" liens are permissible, such as a lien that attaches to all of a debtor's inventory, both at the time of the contract's signing and that inventory acquired thereafter. A creditor then perfects the lien by providing notice to the rest of the world that she holds a lien on the specific collateral, thereby preventing other parties from thinking that the collateral was unencumbered. People often think that such notice must require sprawling documents cloaked in legalese, but in fact, there is simply a one-page Uniform Commercial Code (UCC) document that must be filled out and filed with the state's Secretary of State Office, which today can be done via the Internet. The trick is to get legal advice as to which state. Real estate liens are only slightly trickier, as they require the filing of a mortgage in the county where the piece of real estate sits.^[103]

Secured creditors should note two other concerns regarding their claims. First, failure to perfect the lien will prevent it from being honored as a secured claim, thus dropping the creditor's claim down into the much lower-ranked class of unsecured claimants. Timing is also important; if two creditors hold liens on the same piece of collateral, the first to perfect is the first in right to that collateral. Second, a creditor's claim is only secured to the extent that the value of the collateral is greater than or equal to the amount of a claim; any deficit will be converted to a general unsecured claim. For example, if a bank lends $10 million to a company and perfects its lien on the collateral, but then the value of the collateral falls to $7 million, the bank's claim will be bifurcated into a secured claim in the amount of $7 million and an unsecured claim in the amount of $3 million. As a result, asset-backed lenders must diligently monitor the value of the collateral underlying their claims to ensure that they do not find themselves undersecured.

Super-priority claims consist of any loans the company takes out while in bankruptcy, which are known as debtor-in-possession (DIP) loans. Debtor-in-possession is a term used when the company is still operating, with some form of management still running it. Because suppliers will generally put companies in bankruptcy on Cash in Advance or Cash on Delivery, debtors often face a significant cash crunch on a bankruptcy filing, requiring the raising of DIP financing to fund its operations during the reorganization process. (See Box 6 for more information on DIP financing.)

Administrative claims consist of any professional fees paid to attorneys, accountants, investment bankers, valuation experts, or other service providers, as well as any amounts owed to suppliers who provide goods or services after the filing. Again, this elevation of post-petition claims encourages suppliers to do business with a bankrupt company by ironically making it less risky to supply a company in bankruptcy than one that may appear healthy from the outside but is within months of filing. The payment of professional fees can prove exorbitantly expensive, particularly if the court decides to recognize more than one official committee, for the debtor must pay all of the professional fees of each official committee. For example, Kmart paid out $150 million in professional fees. (See Box 7 for more information on the formation of committees.) United Airlines paid out $335 million in fees to lawyers (some of whom billed more than $1,000 per hour) and to consultants. The Lehman Brothers case will go over $1 billion in fees.

Unsecured claims with priority include certain taxes owed, consumer deposits for goods yet to be delivered, and up to $14,000 per employee in owed salary, benefits, and bonus. Occasionally this will come up with an employee that is owed a performance or retirement bonus by a company that files for bankruptcy; the amount given priority is capped at $14,000, and any excess is bifurcated into the next lower class, general unsecured claims without priority. In individual bankruptcies, this used to include spousal and child support, but the 2005 changes to the Code made it impossible to discharge such debts.

Unsecured claims without priority come, for all intents and purposes, last; although there are lower classes of claimants, very rarely do they see any significant recovery. These so-called "great unwashed" include all pre-petition debts owed to trade creditors and suppliers as well as any portion of an undercollateralized secured claim that has been bifurcated. On average, these claimants receive just pennies on the dollar, so there are always contentious battles fought in the name of climbing up the food chain, or alternatively, kicking someone else down it. In a rare case, Flying J, the truck stop company, had an unusual outcome; the unsecured creditors were paid in full because of a successful turnaround of the company by a new CEO and several subsidiaries were sold off in bankruptcy, so the original shareholders wound up with ownership of a midsized company with far less debt. By contrast, a more frequent outcome occurred for Breed Technologies, the primary manufacturer of automobile airbags and seat belts. The senior secured lenders received all of the stock of the reorganized company, with nothing left over for anyone else; over $1 billion owed to creditors was just wiped off the books.

Subordinated claims follow the general unsecured claims. Subordination can arise contractually when a lender agrees to be placed lower in the hierarchy than general unsecured claims in exchange for a higher interest rate or other favorable terms, or a bankruptcy judge might subordinate them to punish a lender with unclean hands, such as one who has committed fraud, breached a fiduciary duty, or meddled too much in the running of the company. This is known as "equitable subordination." Finally, any claims arising from a successful derivative shareholder suit (as mentioned in Chapter Three) would constitute a subordinated claim.

Preferred equity and common equity are the last two classes of claimants, respectively, and very rarely do they participate in any recovery in a Chapter 11 proceeding.

For larger companies each of these food chain categories has multiple subgroups, as the actual food chain of any group of creditors usually represents that company's capital structure. For example, there may be different bonds that were sold over the years and one would look to the bonds' legal documents to determine the priority among them.

The Absolute Priority Rule affects all negotiations in a turnaround situation, particularly once a covenant is breached, such as the covenants listed in Box 1 at the end of the Introduction. This causes the breached party to negotiate the next steps the company must take to be in compliance again. When it becomes clear that not everyone on the list can be paid, that's when the fulcrum security begins to drive the process and perhaps push for bankruptcy to force the company to maximize its return. If for example there are sufficient funds to pay the secured lenders and holders of Bond A, but not pay Bond B in full, Bond B becomes the "fulcrum security." Whether the fulcrum security is a second-lien secured creditor, bondholders, or the general unsecured class, it is the center of most of the negotiations in any turnarounds. The power brokers at any phase of a crisis are usually the secured lenders. They are the ones who have to be kept satisfied in any outcome.

Negotiations can take place at any level. For example, common equity holders are always last in line, and therefore cannot receive a penny until every other class of creditors (and preferred shareholders, if there are any) are made whole. This rarely occurs; if there are sufficient assets to make all the creditors whole, there is typically little incentive to file for bankruptcy protection. However, despite the fact that equity shareholders are usually "wiped out"—that is, they receive nothing—in a Chapter 11 reorganization, the shares of publicly traded companies who have filed for bankruptcy still trade, albeit at a very depressed price. Often, the speculators purchasing those potentially worthless shares are hoping that in order to get a plan of reorganization confirmed, creditors will throw some sops to those out-of-the-money parties below them, including shareholders. Although equity holders may not have a right to any such consideration (often provided in the form of some small share of the reorganized company's future equity value), they can threaten to "melt the ice cube" : delay the process by filing appeal after appeal, which prolongs the bankruptcy and keeps the meter running on expensive attorneys, accountants, and advisors for all parties involved, slowly eroding the value of the estate that can be distributed to all stakeholders. That same type of threat is also used to extort additional value from senior lenders for second-lien holders or bondholders who hold no collateral. The main way to arrive at a plan that provides some value to classes that otherwise might receive nothing is through a "consensual plan," where the classes of creditors agree to a split that differs from the Absolute Priority Rule for business reasons.

The food chain guides all of the negotiations before and during a bankruptcy filing, for it determines who gets what in any recovery analysis. With that in mind, we now examine the pros and cons that affect any decision whether or not a company goes into bankruptcy. (Note that it can happen voluntarily or the company can be put in bankruptcy involuntarily, as described under The Bankruptcy Process, below).

Companies can enter bankruptcy either voluntarily by filing a petition with the Bankruptcy Court, or involuntarily if at least three unsecured creditors with a total of at least $10,000 in undisputed claims file their own petition. (If a company has fewer than twelve creditors, any single creditor can file an involuntary petition.) While by no means unheard of, involuntary petitions occur less frequently than do voluntary petitions. The petition to file is a surprisingly simple form requiring only a brief description of the business, checked boxes indicating the approximate value of the company's assets and liabilities, and a list of its twenty largest creditors, which the court then notifies about the filing. Only companies that have a place of business or property located in the United States may be debtors in a U.S. bankruptcy case. The court test to determine insolvency is similar to the test for the zone of insolvency: an inability to pay debts as they come due, or an upside-down balance sheet where the market value of the company's assets is less than the market or book value of its liabilities.

For debtors, entering bankruptcy offers a number of immediate advantages, the first of which is time. Because the automatic stay provision of the U.S. Bankruptcy Code—explained in greater detail below—prevents creditors from seizing assets or demanding immediate payment, bankruptcy protection stops the bleeding, buying debtors time to reexamine their strategy, stabilize their operations, value the business, examine options for divestiture, and raise capital: essentially, to execute all three legs of the turnaround tripod. It also provides them with a singular platform from which they can address the varying interests of their diverse stakeholder base. In particular, this can be helpful because it puts all creditors of similar classes on equal footing, rather than making the debtor feel compelled to pay first those who push the hardest. The Code's numerous protections, summarized above, allow for the opportunity to reorganize the business more drastically and with fewer punitive measures than would be possible outside of the bankruptcy process. Finally, a bankruptcy filing forces dissenting creditors to the table. Whereas a reorganization negotiated out-of-court can frequently suffer from one dissenting creditor threatening to block a plan from receiving consensus, the Code provides for a variety of ways to prevent such holdouts from enriching themselves unfairly with threats of rejecting any agreement.

Though the automatic stay provision prevents creditors from demanding immediate payment or seizing any collateral upon which they have a lien, creditors also benefit from the bankruptcy process by gaining significant control over the company's management team. The filing of a bankruptcy petition frequently acts as a wakeup call to previously obstinate management teams, and if it does not, the Code provides creditors with the opportunity to question management under oath and even demand their replacement. Those frustrated with the actions of other creditors— whether of the same class of claims or otherwise—will also value the Code's ability to force a settlement among dissenting creditors. Finally, creditors will enjoy the benefits of the Code's protective measures, which provide them with various protections to ensure that they are treated fairly and the value of their collateral is not jeopardized unnecessarily.

The first thing that happens when a bankruptcy court approves a petition for bankruptcy is that the court imposes an automatic stay on creditors that prevents them from demanding payment or seizing their collateral. This prevents a run on the debtor's assets, thus giving the company time to formulate a coherent plan of reorganization. It also halts any lawsuits or judgments against the company, which explains why so many manufacturers of asbestos-related products filed for bankruptcy protection to escape the massive liabilities they incurred in losing toxic tort litigation. Over thirty companies, including Owens Corning and Armstrong, filed for bankruptcy protection from hundreds of thousands of lawsuits for alleged asbestos exposure.

To compensate secured lenders for their loss of the ability to seize their collateral, the court often grants such complaining creditors some form of adequate protection, which could come in the form of additional liens or cash payments from the debtor. The value of such adequate protection will depend on the creditors' negotiating power, which is highly correlated with how critical their collateral is to the company's ongoing operations. Certain creditors may be eligible for relief from this automatic stay— allowing them to seize their collateral—if the court finds that the debtor has no equity in the collateral and that the collateral is not necessary for an effective reorganization. Alternatively, a court could find that there is cause for relief from the automatic stay, such as a lack of adequate protection.

Landlords or secured creditors collateralized by buildings frequently object that they lack adequate protection when a company has declared bankruptcy and wants to continue using the collateral facility but due to cash constraints have stopped paying for maintenance on the building. Such creditors will argue that without necessary maintenance, the value of the collateral will erode, requiring a formal adequate protection hearing before the court to determine what is necessary—cash payments, for example—to provide adequate protection rather than allow the creditor to seize the building. Real estate presents a reasonably simple challenge for the court, as it generally holds its value, but a more difficult challenge arises in the case of a leased fleet of trucks, heavy equipment, or aircraft, which require constant, costly maintenance. The adequate protection hearing will invariably involve a battle of the experts, so managers should always consult with legal counsel if they find themselves on either side of such a hearing.

The day after a company files, creditors can no longer pick up the phone and harass management in hopes of receiving payment, as that would violate the automatic stay and result in grave consequences, determined at the discretion of the presiding bankruptcy judge. Courts have held violating creditors in contempt of court, awarded debtors compensatory or even punitive damages, and forced creditors to reimburse the debtor's costs and expenses, such as legal fees. Once again, any creditor should be very careful about potential violations of the automatic stay, and should consult with legal counsel before taking any action that might constitute such a violation.

While the automatic stay is just that—automatic—many of the other protections of the bankruptcy code require that the debtor's attorneys file a flurry of so-called "first day motions" immediately upon commencement of the case. One of the most important such motions is a request for the use of cash collateral. Cash collateral consists of any cash, securities, deposit accounts, or other cash equivalents in the debtor's possession. Upon filing for bankruptcy, the debtor is prohibited from using any such cash collateral in the ordinary course of business without either the court's approval of that usage or the consent of every entity that has an interest in those assets. Frequently, asset-backed lenders will lend against a company's receivables, with the company's receivables base serving as the collateral for the secured loan. The moment a receivable gets converted to cash, however, the lender still has rights to the cash as part of its collateral, and will often object to the use (i.e., the spending) of that cash collateral. Without approval from that lender, the company must petition the court for permission to use cash collateral, which requires a cash collateral hearing that once again boils down into a battle of the experts arguing over what the collateral is actually worth. This happened in the case of J.A. Jones Construction, which went into bankruptcy with multibillion dollar embassies, dams, and other large construction projects unfinished. The company needed the progress payments from the government to pay the subcontractors to continue to work. The lenders said that was their cash collateral. In the end, the insurance companies wound up footing the bill. Savvy lenders should be careful to ensure that in such situations, every customer buying on credit is informed in no uncertain terms that they are to pay to a bank account under the lender's control. This avoids a situation where an unscrupulous management team could—at the risk of significant civil and criminal penalties—attempt to disguise the sources and uses of cash collateral from its creditors.

After the frequently nasty contentiousness of the adequate protection and cash collateral hearings, there is a slight lull in the action as various groups prepare for battle: unsecured creditors vs. secured creditors, secured creditors vs. other secured creditors, shareholders vs. the board of directors, and all of the creditors vs. the debtor. The debtor must file its statement of affairs and various schedules that detail the company's assets almost down to the number of light bulbs in storage closets, and committees begin to form. The debtor begins its monthly reporting to the court regarding its financial performance, with potentially drastic repercussions—such as the determination that its creditors no longer have adequate protection—if it fails to meet the projections of its 13-Week Cash Flow Model.

Creditors are often horrified to learn that interest stops accruing on any unsecured debt immediately upon the filing of a bankruptcy petition. In addition, any undercollateralized portion of a secured claim also stops accruing interest during the bankruptcy proceedings, so in our previous example where a claim in the amount of $10 million was secured by only $7 million, interest at the claim's contractually agreed-upon rate only accrues on the balance of $7 million. The $3 million becomes an unsecured claim. As an undersecured claim it does not accrue interest. This is especially painful during extended bankruptcy filings, some of which used to drag on for more than five years! Then-recent revisions Congress made to the Code make it difficult for a company to stay in past eighteen months.

Courts will be asked to examine a company's transaction history to determine whether it made any preference actions. In an effort to discourage the kind of aggressive debt collection activities that can force a company into bankruptcy, the Code allows the court to avoid and revoke any payments made within the ninety-day period prior to the bankruptcy filing. The theory behind this rule is that the company did not suddenly become insolvent on the day they filed for bankruptcy protection, but rather that it was a gradual process that took some time. The Code sets an (admittedly arbitrary) look back of ninety days prior to filing. A court revoking preference actions can infuriate suppliers, who suddenly find themselves asked to return a check to the bankrupt estate of a company that probably still owes them money! However, there are seven defenses to preference actions that can help creditors avoid having to return payments from the debtor; the most popular are the following.

The one used most often is to demonstrate that the payment happened in the "ordinary course of business," made on the same terms and conditions and within the same time frame as prior payments from the debtor. In bankruptcy, no good deed goes unpunished, and it may not pay to be nice. If a customer calls, explains that it is experiencing a slight cash crunch, and asks to pay within forty-five days rather than the usual thirty, if there is the slightest suspicion of impending bankruptcy one should refuse and make up some excuse along the lines of times being tough all over. It doesn't pay to be nice here, because allowing the customer an extra fifteen days—or even five days—eliminates the option of using the ordinary course of business defense to a preference action should they file within ninety days of the receipt of the payment. Of course, the customer might still fail to pay you within the normal thirty-day period with the same result, but the point is that one should never willingly grant permission to an act that would prohibit the use of the ordinary course of business defense.

One could grant the customer their extension and instead use the "new value defense" against preference actions, which requires that they prove that they supplied new goods or services to the debtor after the preference payment in question. If the value of these new goods or services provided exceeds the amount of the payment, there is no preference action; if not, they can be offset dollar-for-dollar to reduce the amount of the preference action. Furthermore, any payment made on the date specified per a certain contract may be exempt from avoidance as a preference payment. As usual, this is a simplification of the legal issues surrounding bankruptcies, and companies should consult legal counsel in the event that it receives notice from a court that it may have received a preference action.

This does not, however, mean that a company should not accept a payment simply because it expects that the supplier may be filing bankruptcy soon. Always accept the payment; it is far easier to negotiate from a position of strength (having cashed the check of a company that later files for bankruptcy) and make the debtor—or more accurately, its creditors—jump through the legal hoops necessary to prove a preference action and reclaim the payment. In almost every single situation I have seen, even if there are no defenses available to the company, its creditors will settle for a percentage of that preference action; it may be 80 percent or it may be 50 percent, depending on the parties' leverage and negotiation skill, but it is rarely 100 percent returned by creditors.

This ninety-day "look back" window for preference actions pertains only to company outsiders, however. On any payments to the insolvent company's insiders—including officers, directors, subsidiaries, or parent companies of the debtor—the court will look back a full year to determine preference actions. This can include retirement bonuses or retention bonuses, which have come under increased scrutiny in recent years. A preference can include granting a lien on assets of the company if not done when the goods first changed hands.

The court will also look back two years—and even more in the case of a violation of similar state law—to determine whether the debtor has committed a fraudulent conveyance. Such fraudulent conveyances can occur in a nonbankruptcy context as well, and involve the company in question engaging in any transaction (such as an asset sale or incurrence of debt) for "less than a reasonably equivalent value." Such actions can be avoided and reversed under the Code, although the lengthy look-back period— which can reach as much as ten years in the case of monies sent to certain trusts—makes actual reversal difficult and compels some reasonable settlement. The general test for a fraudulent conveyance is whether the price paid was equal to the fair market value of what was received by the debtor. This prevents an insolvent individual from selling a valuable asset such as a home, automobile, or even a whole company for a nominal sum to a relative or friend in order to shield it from creditors, with the expectation of buying it back once the creditor has settled for some greatly reduced repayment plan.

The best defense comes from proof that a professional advisor such as an investment banker signed off on the price received for the asset, provided a fairness opinion, or ran an efficient auction to determine the transaction's fair market value. Companies in distress that plan to sell assets to remain liquid must therefore be very careful to ensure that the price they receive will pass muster to bankruptcy court observers. In one noted case, the families controlling Cole Taylor Bank merged with Reliance Acceptance Group, Inc., a company focused on financing subprime car purchases. Years later, Reliance collapsed amid allegations of improper accounting standards, and filed for bankruptcy exactly one day before the fraudulent conveyance statute of limitations would expire on the sale of Cole Taylor Bank back to certain board members. The public shareholders filed a bevy of lawsuits against the Cole and Taylor families, ultimately forcing an expensive settlement on their fraudulent conveyance claim based on the fact that the bank had not received a formal fairness opinion on the sale of the bank.^[107] The deal may have been at arm's length but it's tough to prove using hindsight.

While the court conducts these tests for any alleged preference actions or fraudulent conveyances, the company can begin operational changes by reexamining every executory contract to which it is a party, which in bankruptcy means any contract where both sides still have ongoing obligations to fulfill. The most common examples of such contracts are unexpired leases of equipment or real estate, long-term purchase agreements, service contracts, or insurance contracts. One of the Code's greatest powers offered to debtors is the ability to reject these contracts while under bankruptcy protection, allowing companies to escape from painfully unprofitable leases or supply contracts, almost without penalty. As we will see later in this chapter, supermarket chain Winn-Dixie used this aspect of the Code to escape from more than $100 million in annual payments on so-called "dark store" leases: leases on properties where the company had already closed the stores but from which they could not escape outside of bankruptcy. The penalty for such rejection is minimal; in the case of a rejected lease, the landlord receives a general unsecured claim for damages limited to the greater of one year's rent or 15 percent of the total rent remaining for the duration of the lease up to a maximum of three years. As general unsecured claims typically receive pennies on the dollar, this is a powerful way for the debtor to cut costs, one that is unavailable except while under bankruptcy protection. Fanny May Candy management made a major error when they went into Chapter 11, then failed to get out of about half of their store leases, which were losing significant cash. The CEO believed he could now turn them profitable. He failed and only nine months later went into bankruptcy again. Only this time the company was liquidated and its name was sold.

The ability to reject executory contracts should serve as notice to companies doing business with a troubled enterprise. In another example of no good deed going unpunished, landlords who agree to reduce the rent for a troubled tenant can find themselves doubly punished if the tenant then files for bankruptcy soon thereafter. If the tenant subsequently rejects the lease, the claim for damages that the landlord receives will be based upon the reduced rental rate, even if that rate was in effect for a short time.

The power of this clause was weakened significantly by the 2005 changes to the Code, termed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). Previously, companies could wait until the final day of their bankruptcy proceedings to declare whether they would assume or reject each contract. This provided companies—particularly those with many leases, such as retail chains—extraordinary negotiating leverage over landlords, as the threat of a rejection could compel stubborn landlords to negotiate more favorable lease terms; remember that all of the rent accruing during these sometimes lengthy bankruptcy proceedings would simply be converted to an unsecured claim, which might receive pennies on the dollar. After the passage of the BAPCPA, companies have only 120 days—which they may extend only once by 90 days with the court's approval—to identify which executory contracts they intend to reject. Seven months may seem like a long time, but in practice, companies with hundreds of leases signed over the course of a full commercial real estate cycle, on hundreds or even thousands of stores in dozens of states, with widely varying levels of profitability, face an incredibly complex data analysis task. Keep in mind that during those first 210 days, the company is trying to determine its refocused strategy, which may involve closing unprofitable stores, exiting unprofitable product lines, examining its entire supply chain, reengineering its operations, or abandoning unprofitable regions. Naturally, one might be inclined to hang on to any profitable stores, but management would have to conduct a sophisticated optimization analysis to determine whether that store would still be profitable if all the nearby stores were shut down, ostensibly reducing the return on local marketing dollars and increasing the cost of shipping if the regional distribution center was similarly closed. Or a store losing money could turn profitable under a new strategy. The point is, it often takes 120 days simply to gather the data necessary to embark upon these kinds of sophisticated analyses, leaving scant time to draw the appropriate conclusions and then hastily negotiate contracts with landlords before the window closes.

Companies in bankruptcy may also assume such executory contracts, and assign them. For example, a debtor may have a long-term agreement with a supplier dictating that the supplier sell the debtor a specified amount of raw sugar at a fixed cost. Since the signing of that contract, the debtor has filed for bankruptcy and determined that it plans to sell the division that requires raw sugar because that division no longer fits its revamped strategic vision. However, because the price of sugar has risen since the signing of the contract, that contract represents an asset of the debtor-estate; even though the debtor cannot benefit from the below-market price in the contract, someone can. As such, the debtor would choose to assume the contract, and then assign it to the highest bidder: presumably some other third party all too happy to buy sugar at an unusually low price. Another example is a retail chain with one or more long-term leases signed when rents were low; they often assume and assign them to another company and collect a fee. Landlords don't like this, because they'd like that additional rent.

Many companies hear that any contract can be rejected or assumed in bankruptcy and attempt to circumvent this by including a clause in any lease or long-term purchase agreement claiming that the contract is "void in the event of a declaration of bankruptcy by either party." This does not work, as the Code stipulates very clearly that parties cannot contract around bankruptcy law.

Other recent changes to the Code involve retention plans for employees. When Kmart filed for bankruptcy in 2002, management attempted to claim that the company's 280 highest-ranking executives all required retention bonuses because every one of them was needed to turn the company around; now companies must demonstrate that such executives have higher-paying job offers elsewhere in order to justify such payments. (Naturally, if the option is staying at a lower-paying job with an insolvent company or a more lucrative job at a healthy one, it's difficult to convince someone to stay without a retention bonus.)

Another important topic that every supplier should be aware of is that of "reclamation." Under another recent Code change, if you send goods to a company that declares bankruptcy within forty-five days of receipt, you can reclaim those goods in writing within twenty days. The customer has a few defenses, especially if they sold the goods or a bank lien attached, but you have a shot at getting them back or at least a higher priority claim.

For the first 120 days of a Chapter 11 case, the company—which means its management—has the exclusive right to present a plan of reorganization, which they may extend with the court's approval by another ninety days. If they fail to present a plan during that time, or present one that fails to win approval, then other stakeholders have the right to present their own plans. When presenting a plan, they must also produce a thick disclosure statement, not dissimilar to a "red herring" prospectus produced for an initial public offering or any other public securities offering. The plan must state how each class and subclass of creditors is to be paid, by what (cash, debt, stock, etc.), and the percentage recovery they can expect. (See Box 8 on the basics of plan confirmation.) The disclosure statement will discuss how the company got into trouble, how they plan to get out, how they will find the money necessary to pay back creditors, and the strategic, operational, and financial changes necessary to make the company viable once again. Its most important determinations, however, revolve around the post-emergence company's valuation and debt capacity, which in turn determine its post-bankruptcy capital structure; this process is where major battles often take place. It determines which creditors take what slices of the final pie.

In a highly simplified example with only three classes of claimants—secured, unsecured, and equity—an unprofitable company with $300 million in secured debt and $500 million in unsecured debt that files for bankruptcy might enact a three-pronged turnaround that convinces the judge that it will swing it from a money-losing proposition to one that produces $100 million in EBITDA, and that all it has to give to creditors is the equity in the company because there's no cash to pay the accelerated debt. Valuation experts might then convince the judge that such a company would be worth five times leading EBITDA for a total valuation of $500 million, and that such a company could support a 3:2 debt/equity ratio, resulting in a post-emergence company with $300 million of debt and $200 million of equity. In this example, the secured creditors (being owed $300 million) would receive all $300 million in debt, while the unsecured creditors (being owed $500 million) would receive 100 percent of the equity in the reorganized company for a total consideration of $200 million, leaving them with a 40 percent recovery, while the equity holders would receive nothing.

This admittedly simplified example of the recovery "waterfall" demonstrates the negotiation incentives each class of creditors faces in arguing how the emerging company should be valued. Regardless of the company's actual value, the secured creditors will be incented to argue for a very low valuation, probably one just below the amount of their outstanding claims. In the example above, if the secured creditors successfully convinced the bankruptcy judge that the company was only worth $300 million, they would receive 100 percent ownership of the company, irrespective of its capital structure upon emergence. (In this case, they would own $180 million in debt and $120 million in equity.) Unsecured creditors, by comparison, would be incentivized to argue for a more aggressive valuation, but still one that was right at or below the amount of their claims plus the secured claims. If they convinced the judge of an $800 million valuation with the same 3:2 debt/equity ratio, the unsecured creditors would hold 37.5 percent ($180 million) of the company's $480 million in debt (with the secured creditors holding the other 62.5 percent, or $300 million) and 100 percent of the company's $320 million in equity. Obviously, this is a significantly more lucrative recovery than the one that results from a $300 million valuation. However, the unsecured creditors would not want the valuation to creep much higher than the value of their outstanding claims plus those of the secured creditors, because at any higher amount, they must begin sharing with equity holders, who will naturally be incented to argue for the highest possible valuation they can suggest while keeping a straight face. The reason is simple: the higher the valuation (over the sum of the unsecured and secured creditors' claims), the higher the equity holders' share in the reorganized company. With a $1 billion valuation, equity holders would own 50 percent of the reorganized company's equity; with a $1.2 billion valuation, they would own 83.3 percent, and so on. Table 6.1 demonstrates how this waterfall works across varying valuations, and how the classes of claimants who sit lower on the food chain only begin to eat at higher valuations. Note that any increase in valuation between $300 million and $800 million goes entirely to the unsecured creditors, while any increase over $800 million goes entirely to equity holders.

In the example, the unsecured class of claimants is an impaired class at any valuation below $800 million, because they enjoy a less than 100 percent recovery. (By comparison, the secured class is impaired only at valuations below $300 million.) Note that these issues are the same for any size company. Just subtract zeros from these examples and the concepts are the same.

In order for a bankruptcy court to approve any plan of reorganization, allowing the debtor to emerge from bankruptcy, an impaired class of creditors needs to support the plan. Each class's approval is determined by a vote; in order to approve the plan, there is a two-pronged test for each class (and subclass): at least 50 percent of a class's constituents totaling at least two-thirds of the class's total dollar amount outstanding must vote to approve. Sometimes, an impaired class will object to the plan of reorganization, but courts have the power to overcome those objections with what is called a "cram down" if a number of tests are met, most notably a test determining that the proposed plan would still provide the objecting creditors with a greater recovery than they would receive in a liquidation. As such, some of the last things a judge examines in detail before approving a reorganization plan are the varying versions of liquidation analyses prepared by the various liquidation experts retained by the debtor and each class of creditor to ensure that the plan provides a greater recovery than a liquidation might.

In the meantime, there are frequently intercreditor battles brewing on the sidelines. If the plan is confirmed through a complex plan confirmation hearing that can take several days in court, the bankruptcy court can then allow the other intercreditor claims to be litigated. Many creditors will try to knock out other claims by arguing that another creditor has overstated its claim, presented an invalid claim, or failed to perfect a lien, thus making its claim unsecured rather than secured. In one turnaround where I acted as CEO, I recall my bewilderment at the fact that after months of acrimonious fighting with the company's creditors, I had finally brought everyone to agreement, only to find that they were now fighting among themselves to get larger shares of the reorganized company, while the company continued to pay their expensive legal bills! The way it works in bankruptcy court, they don't sue each other, they sue the bankruptcy estate; so I likened it to Creditor A trying to seek revenge on Creditor B by punching me in the face! Perhaps not surprising, my suggestion that everyone send their largest employee to a conference room—into which I would simply empty huge duffel bags of cash, and let them fight it out—fell on deaf ears. With the help of the company's CFO and our attorneys, we finally sorted out the intercreditor disputes and got the company back on the right track.

By the turn of this millennium, publicly traded supermarket chain Winn-Dixie operated almost 1,200 stores across fourteen southeastern and midwestern U.S. states, and twelve in the Bahamas. The company's expansion through the 1990s mirrored a trend nationwide, as chains attempted to gain economies of scale and increase negotiating power with suppliers to counteract the industry's low margins.^[108] During this time frame, Winn-Dixie faced increasing competitive pressure from Wal-Mart (now Walmart), whose scale and resultant buyer power allowed it to gain market share among cost-conscious, low-income customers, a problem exacerbated by the 20 percent wage advantage Wal-Mart enjoyed in a labor-intensive industry.^[109] Winn-Dixie also faced increasing pressure on the high end of the market in the form of Publix, which differentiated itself not on price but on convenience and service quality, consistently receiving the highest customer satisfaction ratings of any American supermarket chain.

These competitive pressures led to declining profits and market share, prompting the Winn-Dixie board to appoint Al Rowland president and CEO in 1999. Rowland attempted to "right size" the company by consolidating and updating the company's stores, restructuring management, and eliminating under-performing products. Under Rowland's leadership, the company planned to exit its stores in Texas and Oklahoma, where competition with Wal-Mart was fiercest, and centralize its procurement. At the time, 90 percent of the company's procurement functions took place at the local or regional levels. This local focus had created strong relationships with local vendors and allowed stores to tailor their offerings to local clientele, but often put purchasing power in the hands of untrained, unsophisticated local managers who failed to coordinate their efforts with Winn-Dixie's marketing department.

The anticipated savings from Rowland's centralization efforts never materialized. Executive management failed to maintain its focus on restoring profitability in stores hurt most by competitive entry, instead diverting its attention to superfluous projects such as the launch of the Save-Rite warehouse stores division. Moreover, while centralization might have been a move in the right direction, management failed to execute it properly. For example, the Central Procurement Department (CPD) listed preselected products from which store managers must choose, but they had no power to control the dictated price or volume of those products. The disconnect led to stores having products with low demand forced upon them by headquarters, with margins declining due to the resultant spike in the wrong products in the wrong stores and manufacturing plants.^[110] Rowland's tenure failed to bring about the desired turnaround, as morale began to plummet along with sales, so in early 2003, the board of directors ousted Rowland and promoted Frank Lazaran to CEO, previously the president of Safeway and Randall's Food Markets.

Lazaran immediately set about addressing Winn-Dixie's out-of-control cost structure by closing 135 stores, three of the company's fourteen distribution centers, and three of its fifteen manufacturing facilities. Even these cost-saving efforts did not come without a price, as the long-term leases remaining on the unprofitable stores resulted in a lease liability of $160.2 million being paid on closed stores per year. The complexity of the company's multi-tiered supply network, with multiple commodities and transportation modes, placed an even greater financial burden on the grocer. Finally, the closing of part of the manufacturing plants appeared insufficient, as Winn-Dixie continued to produce lower-quality products at a higher cost than what was available from outsourced vendors.

Though Lazaran managed to make some progress in slowing Winn-Dixie's cash burn and raised much-needed cash through the sale of noncore assets, Winn-Dixie still held significant financial obligations related to store, distribution center, and plant closings. Meanwhile, the company had done nothing to address its increasingly undesirable positioning between Wal-Mart on the low end of the market and Publix on the high end. Lazaran did begin to address the company's aging stores, many of which had received no capital investment for more than a decade. Although the effort was unquestionably appropriate given the increasingly dingy appearance of Winn-Dixie stores, the company lacked the liquidity to carry it out on the grand scale necessary. By the end of fiscal year 2004, the program had only launched in a third of the company's stores.^[111] Even then, it proved a costly endeavor, costing some $75 million just as the company began struggling to remain liquid. Ultimately, Lazaran's brief, eighteen-month tenure as CEO brought about only a smaller, still struggling Winn-Dixie. Now on their third attempt to find an executive who could effect a successful turnaround, the board asked Lazaran to step down and named Albertson's COO Peter Lynch as his successor.^[112]

Upon taking control of Winn-Dixie in December of 2004, Lynch found an organization in shambles. Weakened relationships with suppliers at the end of fiscal year 2004 exacerbated the company's growing cash crunch. Having witnessed Winn-Dixie's eroding financial position (the company's shares had lost 85 percent of their value of the preceding six years and its credit ratings were downgraded by both S&P and Moody), trade creditors began demanding shorter payment terms.^[113] This reduction in vendor and other credit by more than $130 million placed the company in real danger of insolvency, with a correspondingly negative perception of the company by consumers. As vendor relationships turned sour, large vendors like Kraft, Proctor & Gamble, and PepsiCo shifted payments for consumer promotions at Winn-Dixie to better-performing retailers. To make matters worse, vendors became unwilling to invest in test markets at Winn-Dixie stores, thus limiting the introduction of new products and further depressing consumer perceptions of the company. Finally, the company's disastrously inaccurate forecasts of sales during the 2004 holiday season resulted in cash frozen in excess inventory, forcing Winn-Dixie to increase its borrowings under its credit agreement and further reducing liquidity.^[114] In June 2004, Winn-Dixie entered into an agreement with its lenders to increase its existing senior secured revolving credit facility from $300 million to $600 million so as to mitigate the company's immediate liquidity needs. Trapped by noncancellable leases on dozens of under-performing stores, however, Winn-Dixie remained burdened by its high cost structure and had done little to improve its competitive position in the market.

During Lynch's first quarter as CEO, the company announced year-to-date losses of over $550 million. In the fall, Winn-Dixie violated the minimum fixed charge coverage covenant under the terms of its senior credit facility, preventing it from incurring additional indebtedness or issuing dividends until it climbed safely above the 2.25× minimum. The company found itself caught in a quandary; its stores had deteriorated to the point where customers were fleeing in droves to Wal-Mart or Publix, but it lacked the liquidity necessary to revamp them. The closure of unprofitable stores stemmed the bleeding slightly, but the company remained plagued by the $160 million ongoing "dark store" lease liabilities. A devastating piece by a local Jacksonville news station showed a customer returning goods purchased well after their stamped expiration dates. As the cameras continued to roll, Winn-Dixie employees were seen restocking the expired goods on the shelves.

Equity research analysts hammered the stock after a disastrous Q3 earnings call on Thursday, February 10, 2005, and vendors began refusing to extend credit to the embattled grocer. Fortunately, just days before the call, Lynch had hired restructuring consultants XRoads LLC to help the struggling grocer reexamine its operations and launch a successful turnaround effort. As the crisis reached a fever pitch over the weekend with vendors insisting on cash on delivery, turnaround leader Holly Etlin cut short a trip to Boston and flew immediately to Jacksonville to negotiate with merchants and assure that daily deliveries of perishables such as milk and eggs would continue. "I went with my winter clothes to Jacksonville, where it was 80 (degrees). I spent close to 100 percent of my time during those first days closeted with the merchants, talking to the major vendors . . . We were only going to pay them COD, and we wanted them to keep shipping. That's how those first few days looked: classic complete hair on fire crisis management. It was truly amazing. I think I landed with three guys to begin with and by Saturday we had grown to ten."^[115]

With Etlin's help, Winn-Dixie hastily prepared a Chapter 11 bankruptcy filing. Under bankruptcy protection, the company could continue to pay its merchants and keep the stores stocked during a critical holiday weekend while buying some time with its long-term creditors. Etlin's team immediately set about evaluating the performances and leases of every store in its portfolio. Bankruptcy protection allowed the company to reject executory contracts in the form of leases on any of its current stores, as well as all of the 150 stores that had already closed, thus ending the $3 million per week cash bleed on "dark store" leases. Winn-Dixie also received an automatic stay from recovery efforts of creditors, who were owed approximately $410 million in trade credit,^[116] and halted various lawsuits pending at the time of filing.

Perhaps most important, the Blackstone Restructuring Group team led by Flip Huffard helped Winn-Dixie raise $800 million in the form of DIP financing through a bank group lead by Wachovia Bank, the agent of the pre-petition credit facility. The DIP allowed Winn-Dixie to refinance its existing credit facility and provided much-needed liquidity during the company's sudden cash crunch. With this cash in hand, Winn-Dixie finally gained sufficient breathing room to conduct a more thorough examination of its long-term capital requirements and strategic positioning in the highly competitive grocery industry.

This examination revealed problems that had long gone unnoticed under prior CEOs. Etlin's analysts determined that the vast majority of its profitable stores succeeded because they enjoyed either the #1 or #2 share in their markets, thus giving them pricing power and access to vendor promotions. Though Winn-Dixie still held such market shares in a number of attractive, high-growth markets in Florida and the Gulf states, its ill-advised expansion northward had led to the acquisition of stores as low as fifth or sixth share in markets such as Ohio. Almost without exception, such stores lacked the scale to maintain profitability, as advertising ceased to be cost-effective and negotiating power with suppliers dwindled. Etlin's team analyzed each of the company's more than 900 stores and determined the appropriate footprint for Winn-Dixie's operations. Moving quickly so as to "right-size" the company within ninety days, the team settled on a group of 326 non-core stores to close or sell. These stores did not fit the new, refocused strategy of only operating stores where Winn-Dixie could hold a #1 or #2 market share.

Huffard's team enacted nine simultaneous M&A transactions selling approximately 130 such stores to other retailers, while Hilco Trading and Gordon Brothers liquidated the remaining 200 stores at much less lucrative prices. "When you sell it as a going concern you preserve the jobs of the employees at the store, as well as getting rid of the retail, the inventory, and the lease all in one package," Etlin said. "It's much messier to go through the other side of the process, but we did have to do it for more than 200 stores." Together, the efforts of Blackstone and the liquidators resulted in Winn-Dixie's complete exit from Ohio, North Carolina, South Carolina, Georgia, and northern Mississippi and Alabama. The company's refocused strategic footprint now focused entirely on Florida, the southern Gulf States, and Louisiana.

Those stores that remained had deteriorated to the point consumers shunned them for cleaner, better-lit competitors. Many stores hadn't seen any capital investment for over a decade, and it wasn't an appealing place to buy groceries. For example, the installation of lower-wattage light bulbs in an effort to decrease electricity costs had contributed to a cave-like atmosphere. In effect, Winn-Dixie had unconsciously ceded its competitive position to Publix on the high end, while Sam Walton had applied everything he learned from his tenure on the Winn-Dixie board to capture the value end of the market. With its renewed liquidity from the DIP financing, Winn-Dixie could finally make the necessary capital expenditures to bring its stores up to date.

Winn-Dixie also exited all of its manufacturing operations except for two dairies and the Chek Beverage operation. Given the plethora of lower-cost, higher-quality outsourced options, the company sold all twelve of the remaining manufacturing and processing plants to third parties. Most of the value of such assets came in the form of including the long-term contracts with Winn-Dixie, but until the Chapter 11 filing, those contracts bore a significant default risk, depressing their value. With a strong management team in place and under bankruptcy protection, Winn-Dixie could at last realize some value from the sale of the manufacturing plants.

Lynch also began a herculean effort to change the company's ingrained culture, which had become complacent and lethargic. This dovetailed well with a 40 percent headcount reduction at headquarters, as they reduced the number of stores, which both slashed SG&A expenses and allowed management to select and retain those employees most capable of building a more urgent, customer-centric culture. The company also sought to retain its best store managers, offering court-approved retention and relocation packages to top performers at the defunct North Carolina stores. Meanwhile, Winn-Dixie's CIO began to address the company's technological approach, which lagged some twenty years behind the industry norm.

Throughout the company, Etlin's team found examples of low-hanging fruit that could reduce the company's cash burn, boost sales, and restore public confidence in the grocer's image. One example: Winn-Dixie stores lacked a kosher foods section in a state where certain counties' Jewish populations approach 15 percent.^[117] By addressing local ethnicities and other seemingly obvious problems, Lynch and the streamlined Winn-Dixie management began to turn the company around.

By spring 2006, the strategic, operational, and financial changes made by management began to bear fruit. Winn-Dixie reported a 25 percent reduction in SG&A as a result of headcount reductions at headquarters to match stores closed and sold, with a 4.3 percent growth in same-store sales as a result of improved average sales per customer visit, due in part to improved customer service, the introduction of pricing and promotional programs, and new branding initiatives. Gross margin climbed by 30 basis points as a result of improved inventory shrink management. The company further managed to get its receivables and inventory turnover ratios under control by resuming the collection of receivables from vendors and liquidating approximately $300 million in inventory as part of the store and distribution center closures. With trade vendors reassured about the long-term viability of the grocer, Winn-Dixie ceased COD payment terms and stretched out its payables to a more normal level, thus allowing it to decrease its withdrawals on the DIP facility.

In the meantime, events had transpired in favor of the reorganizing company. Credit markets had loosened considerably during the first twelve months of the bankruptcy process; this allowed the company access to an additional $200 million in liquidity. The sales of stores, store leases, and the liquidation of inventory had also injected more than $300 million in cash into the company, thereby allowing it to pay down its DIP facility almost entirely, invest in store remodeling efforts, and satisfy many of its highest priority claims in cash.

With Winn-Dixie apparently on the right track at last, Huffard began the critical valuation analysis that would determine each of the creditors' recovery. In order to silence the bickering among creditors from its twenty-three separate Winn-Dixie-related entities in bankruptcy, the company reached a Substantive Consolidation compromise. This concept consolidated each Chapter 11 filing from all the various Winn-Dixie entities into one case, with all the property of Winn-Dixie effectively deemed the property of the consolidated estates, eliminating inter-company claims, distributions, and guarantees. This unusual tactic resulted from Winn-Dixie's unusually complex operating structure, and greatly simplified the process of identifying and sorting claimants into various classes based on order of recovery.^[118]

Huffard briefly considered the liquidation analysis prepared by the team. Everyone but the noteholders did better under the consolidation of all the claims. (See Table 6.2.)

Although some creditor groups stood to gain from the consolidation as others lost, even an optimistic liquidation value left all of them far from a 100 percent recovery, thus decreasing the likelihood that they would approve a plan for liquidation. Such an asset-based valuation model ignored the company's value as a going concern. If the company left bankruptcy as an operating entity, the stock in the "new" company (referred to by the nickname Newco) would have real value that could exceed the liquidation values. This would yield more return for the creditors if they received stock in Newco.

This then started another process, that of valuing the stock of Winn-Dixie as a new entity outside of Chapter 11. The company's depressed profitability made using comparable EBITDA multiples problematic, while a traditional capital asset pricing model (CAPM) significantly underestimated the true cost of equity for a company in a turnaround situation, even for one contemplating a balance sheet of 100 percent equity.^[119]

Ultimately, Huffard relied primarily on a discounted cash flow (DCF) analysis, which relied on the financial projections, arriving at a valuation range of the reorganized Winn-Dixie entities of $625 to $890 million based upon an emergence from bankruptcy in the fall of 2006. Those projections included funded debt of only $10 million, resulting in an estimated midpoint equity value of approximately $750 million. The liquidity raised by the company's store divestitures and liquidations allowed it to pay down nearly all of its DIP facility and satisfy more than $400 million in claims through cash payment or assumption of the claims' contractual terms. Note holders, holders of landlord claims, and vendors received the lion's share of the $750 million in Newco common equity, with note holders receiving a 25 percent premium (95.6 percent recovery versus 70.6 percent for landlords and vendors) as compensation for the joint-and-several claims^[120] they forfeited as part of the Substantive Consolidation Agreement. (See Table 6.3.^[121])

Although Winn-Dixie had a very complex set of claims against it, and its subsidiaries, in the end the key to getting agreement was the value of the new stock and how to divide it up. With the emergence from Chapter 11, the officers and management and corporate structure changed. The plan established a new, nine-member board of directors, consisting of CEO Peter Lynch and an independent member deemed acceptable to the creditors, with the creditors' committee selecting the remaining seven members of the board. The reorganization plan also called for the new board to establish and implement a new equity incentive plan for management not to exceed 10 percent of the total outstanding shares of the new common stock.

With the U.S. Bankruptcy Court's approval of Winn-Dixie's final reorganization plan on August 4, 2006, and the $725 million in exit financing, the company emerged from Chapter 11 on November 21, 2006.^[122] The total of 637 days spent in bankruptcy significantly exceeded the average restructuring process for a food retailer, reflecting management's determination to get it right the first time after several failed turnarounds outside of the bankruptcy process.^[123] The reorganized company operated just 553 stores in only five states of the southeastern United States along with seven distribution centers and the three manufacturing facilities. Strategically, Winn-Dixie moved up-market to compete directly with Publix on service, convenience, and quality, abandoning the value end of the market to Wal-Mart and other bulk discount retailers. This drove the operational improvements, improving people, improving locations, improving the way they think about the business, the way they execute out in the stores.^[124]

By January of 2008, Lynch and the Winn-Dixie management team had delivered four consecutive quarters at or above the Plan of Reorganization's projections. Same-store sales continued to grow, with margin expansion of more than 100 basis points due to reduced shrink. So successful was the turnaround that it received recognition from the Turnaround Management Association in the form of its 2007 Turnaround of the Year Award in the "Mega Company" category. As Huffard later recollected, "The thing that made it as successful as it was is the management team, especially in the form of Peter Lynch. He was an incredible force pushing that company in the right [strategic] direction."^[125]

Winn-Dixie had good fortune in filing bankruptcy when it did. Less than a year later, Congress approved the BAPCPA's sweeping changes to the federal bankruptcy code, which made it significantly more challenging for a company in Chapter 11 to reorganize quickly and effectively. As a result of pressure from various lobbying groups, it became far more difficult to take the time to analyze the appropriate contracts and leases to reject, to retain and incentivize effective management teams, and to remain liquid at the outset of the bankruptcy process. Moreover, the credit markets softened greatly in 2007, which would have restricted Winn-Dixie's ability to raise the DIP financing necessary to execute its plan.

In addition to the company's timed bankruptcy filing, Winn Dixie reacted well to a natural disaster as it prepared its plan of reorganization. In late August 2005, Hurricane Katrina devastated whole swaths of Mississippi and Louisiana, including New Orleans, one of Winn-Dixie's remaining core markets. Fortunately, the company had learned from the four hurricanes that had crisscrossed Florida the previous year and had developed rapid response protocols that enabled it to get its 110 Katrina-affected stores up and running faster than its competitors did. With employees and their families safely hunkered down in its Hammond, Louisiana, distribution center, Winn-Dixie was the first grocer to re-open in the heavily damaged areas of the state, going so far as to open mobile pharmacies to maintain the flow of prescription drugs to its customers. The crisis presented a powerful opportunity to revise customer perceptions of the company during a time of need, leading to sustained 20 percent comparable store growth in this core market.

The success of the Winn-Dixie reorganization demonstrates the overarching theme to bankruptcy: though it can wipe out shareholders and undermine customer and supplier confidence, it offers a company powers it would otherwise lack to enact sweeping changes in pursuit of a three-legged turnaround. The ability to reject executory leases represents an opportunity to discard a failed strategy (in Winn-Dixie's case, of northern expansion) in favor of a new one by escaping from leases on unprofitable or closed stores. The automatic stay grants the management team sufficient breathing room to undergo a genuine reengineering process and make the necessary operational improvements, such as Winn-Dixie's headcount reductions and improved information systems. The ability to raise DIP financing and sell assets free and clear out of bankruptcy represents an opportunity to make the financial changes needed to rationalize the company's balance sheet.

One last item about bankruptcy: Companies can declare bankruptcy more than once. That has given rise to nicknames, such as declaring Chapter 22 or 33. There are no such things; they simply refer to a company going into Chapter 11 for the second or third time, respectively.

A good example of multiple bankruptcies is Trump Entertainment Resorts, which filed for bankruptcy three times so far. "The Donald" claimed the recent filing in 2009 was again caused by creditors, owed almost $2 billion, and a general decline in Atlantic City's gambling revenue. One could claim there were even more Trump-related bankruptcies as some of the individual properties filed for bankruptcies along the way. Because of heavy debt always used by Trump it took substantial operating income just to cover debt payments. The Trump Taj Mahal in Atlantic City was financed mostly with $1 billion high-yield "junk bonds" and kept a lean staff to cover operations. This caused problems such as cleaning rooms only every other day as there were only 45 vacuum cleaners to service 904 rooms. They failed to capture high rollers because poor technology systems didn't track their preferences for food, nightlife, and so forth and didn't allow them to create a single loyalty card covering all three Atlantic City casinos owned by Trump. There was no clear strategy to differentiate the casinos, poor operations, and heavy debt load that caused the multiple filings. Each time, Trump himself managed to keep a substantial portion of the equity even when creditors received less than 100 percent of their bargains because he convinced everyone they needed him.

Pillowtex's board of directors similarly failed to observe clear warning signs, thus leading to its own multiple filings, with a less attractive outcome than Trump. The company became the leading U.S. pillow manufacturer, reaching $500 million in sales after twenty acquisitions. They then decided to buy Fieldcrest Cannon, a $1.1 billion towel and home furnishings manufacturer. The acquisition spree distracted management from the warning signs of the decline of the U.S. textile market. They also laid off the most critical Fieldcrest Cannon staff and mismanaged inventories while piling up debt. The abrasive, egotistical style of the CEO didn't help in negotiations with stakeholders when the company was bleeding cash. After the stock declined to less than $1, the CEO resigned and the company filed for Chapter 11 in November 2000. Pillowtex emerged from bankruptcy in May 2002, with only $200 million instead of $1.1 billion in debt. A new CEO was named to replace an interim one, who promptly decided to change the strategy laid out in the bankruptcy plan. That, coupled with increased competition, caused Pillowtex to default on its new, lower debt within four months of getting out of bankruptcy. At the same time, the company discovered that its pension plans were severely underfunded, just when losses instead of forecasted gains were reported. The company filed another bankruptcy petition. After unsuccessfully trying to sell the company and its retailers finding new suppliers, Pillowtex was liquidated in the new bankruptcy filing less than fourteen months after emerging from its first bankruptcy.

In summary, bankruptcy offers many advantages and disadvantages, which dictate whether a company on the brink should embrace it willingly or strive to avoid it at all costs. The Bankruptcy Code lays out how to deal with these advantages and disadvantages and many rules and regulations in one not too convenient package for U.S. companies. In the next chapter, we examine the regulations of other jurisdictions around the world, including the complex interaction of laws governing companies attempting to reorganize with operations in many different countries.