Once you’ve already missed a loan payment or violated a covenant — which puts you on the precipice of a default or even foreclosure — you should focus not on whether to restructure, but on how to restructure. When a business can’t pay its creditors, it has two broad options. First, an “out-of-court” restructuring, where the company negotiates with its creditors. Second, an “in-court” restructuring (typically Chapter 11), which is run under the supervision of a bankruptcy judge. In both cases the goal is to continue the business as a going concern, and the company has, for the moment, avoided a Chapter 7 liquidation. Both of these restructuring scenarios assume that the business can be successfully turned around if the right choices are made and its debt is reduced to a level the business can actually sustain.
The Appeal of a Workout
The appeal of a workout is easy to see. Negotiating with your lenders directly is far cheaper than a Chapter 11 case, which is why most troubled companies try it first. It’s faster, since no court has to sign off on everything. And it’s completely private (no public filings) so it causes less embarrassment and less disruption to operations. If creditors buy it, it also sends a signal that they trust management and that the problem is temporary.
But it isn’t always possible. Liquidity is basically “do we have enough time to play?” If the answer is no, you’ve got no choice but to move straight into bankruptcy. But even if you do have time to play, the number of creditors and the complexity of the debt structure makes an out-of-court workout less and less probable. Every additional creditor increases the likelihood that at least one of them will be the type who just says no. If you try to rewrite the debt outside of court, you need every creditor who’s affected to agree. Just one small creditor can say no and derail the whole process, pushing the company straight into bankruptcy. We call that a “holdout problem.” Even a senior bank lender can sit on its hands if it’s owed money after a covenant breach, because it expects to get full payback in Chapter 11.
When you avoid court, you miss out on the protections a court order would provide. Creditors can keep coming after you for payments. They can also sue the company for breaching the loan agreement. Suppliers might stop doing business with you, or demand payment up front at above-market rates, with no protection if you fail to pay. And there’s no finality in an out-of-court deal; it doesn’t trump a creditor who disagrees.
You need to convince the creditor to work with you outside the courtroom, and to do that, you have to make the story sound like: “We blew it. It was all our fault, but we messed up due to circumstances we controlled, because of timing or because we made a dumb decision, which means we can fix it.” Demonstrate that you and your management team can get through the tough times and solve the problem if the creditors back you up. Be upfront and transparent, so that you’re an easy person to work with. Don’t just beg for a second chance if you don’t have a reason or a plan. If you can’t reach an agreement with your creditors, you haven’t wasted your time. At least now you know what your creditors want, and those failed negotiations can form the foundation for a plan of reorganization in Chapter 11.
The Big Gun in Chapter 11
The automatic stay is the big gun in Chapter 11. It springs into effect the second you file the petition, and from that moment creditors are legally prevented from collecting, filing lawsuits, or even bothering you. That gives management breathing room to focus on a plan of reorganization instead of trying to talk people out of threatening to shut the doors.
Chapter 11 also helps with cash. First, you can use debtor-in-possession (DIP) financing. DIP financing lets you continue operating. To get lenders to do that, the Bankruptcy Code will let them get “super priority” status (they can be paid first) or liens on assets. Another way is to file a “critical vendor” motion, which asks the court to let you pay old bills to someone whose goods or services are crucial to staying in business. They’re motivated to keep supplying you in exchange. Meanwhile interest on unsecured debt and under-secured debt stops accruing, which helps with cash.
Court approval brings a quieter benefit as well. When the court OKs the DIP loan, and then the vendor payments, and finally the plan, it implies that the court thinks the company has a chance of turning itself around. There are no guarantees, but that support can give suppliers, customers and other stakeholders comfort to keep doing business with the company while it’s protected by bankruptcy.
When a business files Chapter 11, it also gets to grab the leases and contracts it wants and toss the ones it doesn’t like. Of course, it has to pay any defaults on the contracts it keeps, but it can’t cherry pick and pick only parts of a contract. And the other side gets an unsecured claim for damages. There’s also the cramdown provision: even if a class of creditors votes no on the reorganization plan, the plan can still be confirmed as long as the Bankruptcy Code’s conditions (like voting requirements and fairness tests) are satisfied. And if assets are sold under Section 363, they’re sold free and clear of claims. Which means buyers pay a higher price.
The Main Drawback of Chapter 11
The main drawback of Chapter 11 is the fees, and everyone who gets involved gets a cut. Restructuring advisors. Turnaround consultants. Lawyers. The court fees (which include a fee called the U.S. Trustee’s fee). If a case drags on or gets complicated, those costs keep mounting on top of a company that was already struggling. Prepacks helped shorten the average Chapter 11, which is good.
When you go into Chapter 11, you have to get the court’s okay for just about everything you do, and you can’t pay old (prepetition) debts without getting court approval. Also, it’s not a process you can speed up. You have to file financial reports every month, a business plan, and all sorts of financial projections, and spend a lot of time at the courthouse and negotiating with creditor committees. You don’t get to keep the bankruptcy quiet, either. Customers, suppliers, competitors, and even employees all find out about it, and the publicity often makes the business worse. And when the court makes its ruling, it’s final, so both the company and the creditors lose leverage in any negotiations.
Whatever you choose, tax implications are lurking. Modifying or cancelling debt can create cancellation of debt income, or CODI. If you are solvent, CODI is taxable, but if you are insolvent, CODI is not taxable, inside or outside of bankruptcy.
So what do you do? Opt for a cheap, quicker restructuring out of court? Or suffer through the more expensive, time-consuming process of Chapter 11? Financially, you always want an out-of-court restructuring. It’s cheapest and leaves you the most freedom to run the business. But it only works if you have enough cash to buy time, not too many creditors, and if they all agree. If not, Chapter 11, for all its expense and agony, exists for a reason. It preserves the value of your business, which serves creditors’ interests too.
