One thing that Toys “R” Us, Sears and Forever 21 have in common is that all three cases are administratively insolvent. Vendors who extended credit to the debtor after the petition date in reliance on the debtor’s assurances that it had adequate “DIP” financing to justify new credit terms got stuck a second time when there were inadequate funds to pay the administrative claims of vendors that had supplied the debtor post-petition. I emphasize “of vendors” because, fortunately, apparently there was enough money to treat post-petition professional fees much more generously.

There is a simple rule in chapter 11: The debtor is supposed to at least fully pay claims that arise after the petition date. Some post-petition losses are OK; businesses rarely turn around on a dime. But chapter 11s are not supposed to get to the point where vendors who supported the debtor in chapter 11 and showed their faith with new credit got materially hurt a second time.

Bankruptcy judges by their nature are compassionate. They want to preserve jobs and facilitate a successful reorganization in order to preserve a customer so that pre-petition creditors can make back their losses. But a bankruptcy judge cannot be expected to conduct extensive financial diligence. For that, the court must rely on the committee and other interested parties to bring matters to the court’s determination.

Management is accountable to its board. Management wants to preserve the debtor’s business — including their own jobs. But management and its advisors also recognize that secured creditors have great control. Debtors have relatively little leverage in this situation. It is good for a secured creditor for the debtor to obtain as much goods as possible on unsecured post-petition credit. It is important to pacify the bank, so, the incentive is to push the pedal hard for post-petition trade credit. Additional collateral comes at the expense of unsecured creditors who might not have knowledge of the debtor’s true finances. Many creditors hear about a huge new “DIP” facility as a reason to extend post-petition credit without realizing that, after roll-ups and carve-outs, there might not be very much additional liquidity for the debtor, or that the DIP-financing headline number really never can be reached because the debtor does not have sufficient collateral on a borrowing base formula to draw down as many dollars as in the headline number. But the debtor might be able to get there if it can induce (seduce?) vendors to ship on open terms post-petition.

In most large cases, and increasingly so in middle-market cases, the debtor engages a chief restructuring officer. CROs understand the bankruptcy process. The idea is that management should be able to focus on fixing and running the business rather than dealing with chapter 11 issues. One such issue is preparation of and compliance with the budget. Post-petition spending is supposed to be within budget parameters, but typically, financial reporting does not enable the court or creditors outside of the case’s inner circle to ascertain how far out on a limb the debtor is. It is the job of the CRO to keep interested parties fully informed as to whether the debtor is reaching a point of no return. The CRO’s job is not simply to monitor; the CRO must speak up and cause management to stop ordering or accepting goods and services for which the CRO has reasonable belief the debtor will not be able to pay. The CRO should be held accountable if they fail to do so, and if the CRO is overruled by the board, then the board must be held accountable.

What is missing is an appropriate level of financial transparency in the chapter 11 process. A publicly available report filed not less than monthly should contain:

  1. the aggregate dollar amount of open post-petition purchase orders issued by the debtor for goods not yet received by the debtor. This should be broken down between:
    • stock goods (salable to another customer in the ordinary course if not taken by the debtor); and
    • goods specifically manufactured for the debtor. Goods with the debtor’s label on the item or name on the packaging would be included here;
  2. goods in transit (including goods in a warehouse or on the dock ready for delivery to the debtor);
    • stock goods that the debtor:
      • currently has the ability to pay for upon delivery; and
      • currently does not have the ability to pay for upon delivery; and
    • custom goods that the debtor:
      • currently has the ability to pay for upon delivery; and
      • currently does not have the ability to pay for upon delivery;
  3. unpaid post-petition liabilities for goods and services received, including estimated professional fees and expenses;
  4. cash on hand; and
  5. liquidity (borrowing availability under current credit lines).

This information should be filed with the court not less than monthly and be part of the public record, prominently placed on the website maintained by the debtor’s noticing agent and prominently placed on the debtor’s website. Among other things, the court should have this information when allowing professional fees.

Unless the U.S. Trustee modifies its reporting requirements, or unless there is a local rule requiring this reporting, the court enters its own order, and the CRO or CFO (if there is no CRO) should prepare (or oversee the preparation of) this reporting and make the reports available as suggested above. The CFO or CRO also should certify that the reports are accurate.

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Reprinted with permission from the American Bankruptcy Institute. © 2020 American Bankruptcy Institute. All Rights Reserved.