A bankruptcy primer

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I am likely breaking some sort of gaming taboo discussing the topic of bankruptcy, however, with the current state of the economy, struggling to recover from the collapse of the financial markets, the bankruptcy filings of the Trump, Tropicana, Fontainebleau casinos, and the recent bankruptcy filing of gaming powerhouse Station Casinos, a discussion of bankruptcy law seems timely.

The gaming industry, once thought of as “recession proof,” is showing cracks in its armor, as gaming revenues have fallen in local hubs, like Las Vegas and New Jersey, and in distant places like Macau. Indian gaming has not been unscathed; gaming revenues for Indian casinos, while presently stable, have experienced a reduction over the past couple of years, causing significant belt tightening in Indian country.



Causes of Casino Bankruptcies

The causes are as abundant as bad business decisions. Typically, a bankruptcy filing occurs when business expenses and other liabilities exceed cash flow or assets, and creditors come banging at the doors to demand collateral. In the gaming industry, it’s easy to exceed available cash flow. This can occur prior to a casino’s opening if construction or development costs unexpectedly escalate.

Similarly, it may arise after opening if an expansion project suddenly goes sideways. As most casinos are heavily leveraged at the outset, for obvious reasons, a number of causes, whether it be an economic downturn or poor marketing and management, can result in lower revenues and a redlined EBITDA.

Additionally, missing a single debt payment can trigger a loan agreement’s immediate repayment clause or, in certain cases, gaming license suitability issues. Either of these can result in a parade of financial repercussions. Finally, casino operators and management groups may also over-extend themselves by purchasing competitors or expanding gaming holdings in untapped domestic or foreign markets.



Bankruptcy History

In the U.S., bankruptcy actions are authorized by Article 1, Section 8, Clause 4 of the United States Constitution. Congress has exercised its congressional authority to enact “uniform laws on the subject of bankruptcies” in several instances, with the most recent being the enactment of the Bankruptcy Reform Act of 1978, codified as Title 11.

Like most other federal legislation, the BRA has been subjected to several congressional amendments, including the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Under Title 11, bankruptcies are either voluntary or involuntary, with voluntary petitions making up the majority of filings.



The Bankruptcy Petition and Immediate Stay of Creditor Action

To initiate bankruptcy proceedings, the party seeking protection must file a petition with the court. Pursuant to Bankruptcy Code Section 362, once the petition is filed, the court orders an immediate “stay” of all creditor actions seeking recovery of assets. This prohibition covers lawsuits, liens and any other form of recovery that is not court approved. The petitioner is required to list all known creditors on the petition, which serves as notice to interested parties of the filing. Once a Chapter 7 (Liquidation) or 11 (Reorganization) claim is filed, the court may appoint a bankruptcy trustee or allow the petitioner to retain possession of the bankruptcy estate as a “debtor-in-possession.” After receiving notice, creditors are provided with a date by which they must file “claims” against the bankruptcy estate.

Bankruptcy estate assets are defined broadly under Bankruptcy Code Section 11, U.S.C. §541(c), and include “all legal and equitable interests of the debtor in property.” This statutory text covers anything of tangible value, including legal claims, agreements, licenses (including gaming licenses), and monetary entitlements, such as tribal per capita payments. See In Re Nicholas Kedrawsky, 284 B.R. 439 (W.D. Wis. 2002).

Subsequent to a court supervised asset valuation and sale, the court pays business creditors according to their creditor “class,” with secured creditors (debt secured by collateral with recovery rights), and the court (for bankruptcy administration fees and expenses) having a superior right to the estate’s assets than unsecured creditors (debt without collateral and recovery rights). Unsecured creditors are divisible into several subclasses, such as priority unsecured and general unsecured creditors. However, this distinction is of little import if the estate doesn’t have enough assets to satisfy the claims of creditors in higher classes.

While the bankruptcy estate includes the lion’s share of the debtors assets, the Bankruptcy Code does provide the debtor with a bit of relief, as Section 522 permits a debtor to exclude some essential property, such as medical devices, motor vehicles and retirement funds. The code for the debtor’s state of domicile may provide a list of state approved exemptions as well.



Bankruptcy Options-Nuclear or Rebirth

Ch. 7 - Liquidation

A Chapter 7 filing is the bankruptcy equivalent of the “nuclear option” in the world of military warfare. Chapter 7 bankruptcies most often have no happy ending, as all business assets are turned over to a court-appointed trustee tasked with valuating the “bankruptcy estate” and liquidating all business assets. The court must also approve all asset sales to ensure that value is maximized and ensure the debtor doesn’t repurchase assets at a discount. Subsequent to the asset distribution, a bankruptcy petitioner’s case is “discharged,” usually with the petitioner moving forward with his life, and creditors left with pennies on the dollar, or in the case of unsecured creditors, nothing.

Ch. 11 - Reorganization

Chapter 11 is the alternative to the “nuclear option.” This provides the petitioners with a wide variety of reorganization options, from a partial sale of the estate, to the assumption of debt by new lenders, to equity exchanges or infusions, to a combination of these options. Debtors may also receive court approved Debtor in Possession financing from existing creditors for various purposes, including the completion of construction projects and the funding of casino operations.

There are a number of drawbacks to filing Chapter 11. It is extremely expensive due to the involvement of numerous professionals necessary for effectuating the reorganization, including specialized legal counsel, interim asset or gaming managers, investment bankers, and one or more financial consultants.

Chapter 11 also provides for court appointment of various committees to permit creditors to participate in the bankruptcy proceedings to protect their rights. Additionally, to emerge from Chapter 11, a company must submit an acceptable reorganization plan to the court, subject to creditor confirmation, prior to the discharge of the petitioner’s case. However, the distribution scheme is the same as Chapter 7, with claimants grouped according to their class, and secured creditors having preference over unsecured creditors.

In contrast to a Chapter 7 filing, there can be quite a bit of gamesmanship between the debtor and creditors in a Chapter 11 reorganization. It is not atypical for either the debtor or creditor, with the assistance of their bankruptcy professionals, to attempt to play fast and loose with the valuation of the bankruptcy estate since it is the single most important issue for the debtor to establish, as it controls the estate sale price, and, consequently, whether and at what percentage creditors will realize value. This is especially important when a property is simultaneously in bankruptcy and also a going concern.

Creditors themselves frequently partake in bankruptcy gamesmanship. For instance, a debtor may try and pit creditor against creditor by offering to pay a larger percentage of the estate to the creditor with the largest percentage of outstanding debt to incentivize it to confirm a reorganization plan – a plan that is almost always detrimental to smaller creditors.



Tribal Creditors – Protecting Your Assets

As the development of Indian gaming has progressed, tribal governments have included tribal or non-tribal projects as part of investment portfolios. As previously noted about bankruptcy proceedings, once assets are liquidated or new financing arrives, secured creditors have a higher payment priority than unsecured creditors. Thus, it is highly recommended that all outstanding loans be appropriately securitized just in case the financed business files for bankruptcy protection.



Special Issues with Tribal Bankruptcies

Filing a bankruptcy petition on behalf of a tribally-owned casino is interesting and potentially problematic; it’s unclear whether the Bankruptcy Code even applies to Indian tribes. Although tribes appear not to be specifically excluded from it under Section 109, there is no statutory text expressly including tribes within its scheme either. Even if the code is applicable, federal and state laws could be implicated.

The applicability of state rules and regulations, and possibly state gaming suitability regulations, may be harmonious, but could also significantly complicate matters. For example, if state gaming licensure requirements are applicable, a finding of non-suitability for a potential investor may complicate the transfer of a gaming license to a new management or investment group. As the Indian Gaming Regulatory Act requires gaming to take place on “Indian lands,” any attempt to transfer gaming assets may require various federal governmental approvals.

Finally, the law is unsettled concerning whether the Bankruptcy Code permits creditors to force a tribe or tribal corporation (Section 17 or otherwise) into bankruptcy. At least one court, Navajo Nation v. Krystal Energy Corporation, 357 F.3d 1055 (9th Cir. 2004), found Bankruptcy Code Section 106 permits the waiver of tribal sovereign immunity because a tribe falls within the statute’s definition of “governmental unit” for purposes of abrogating sovereign immunity. However, several cases dispute this holding. See National Cattle Congress, 247 B.R. 259 (N.D. Iowa 2000), Confederated Tribes of Colville Reservation Tribal Credit v. White, 1996 WL 33407856, and In Re Mays, 294 B.R. 145, 148 n.10 (10th Cir. 2003).

Seeking bankruptcy protection is not for the squeamish. If you have ever owned something precious and had to turn it over to be controlled, dissected and perhaps liquidated by total strangers, then you are on the right track to understanding what the bankruptcy process entails. However, despite the financial costs and the negative societal connotations associated with a bankruptcy filing, under the right circumstances companies have benefited from its protections and emerged from the arduous process poised for future success.

Jack Duran is a gaming attorney with Rosette & Associates, PC, in the firm’s Folsom, Calif. office. You may contact him at (916) 353-1084 or via e-mail at jduran@rosettelaw.com.