If your business is in serious financial trouble, do you try to work something out with your creditors, or let bankruptcy court protect you? If you can reach an out of court workout agreement, you may not have to file for bankruptcy. However, if negotiations fail you still have that option. An attorney experienced in both workouts and bankruptcy can help you make the best decision.
Workout Is Almost Always Preferable to Bankruptcy
A workout is almost always preferable to bankruptcy for the debtor and his or her creditors. The advantage is that a workout gives the parties flexibility and control over terms. You and a creditor can agree on a payment schedule without negotiating with your other creditors, and the arrangement doesn’t need approval from a bankruptcy court. You can tailor the plan to your specific circumstances. If it is successful, it is usually much better for everyone.
Resolving problems with lenders through a workout is far less expensive than going to bankruptcy court, but that does not mean you walk away from attorney fees. Those fees are far lower than the fees charged in bankruptcy cases, and you will not have any of the court filing fees or administrative expenses. The process is entirely informal, which means no scheduling of a notice and hearing as required by the Bankruptcy Code and Rules.
If your business is not publicly traded or the owner is not a local celebrity, a workout is not likely to go public. The agreement is private between the debtor and the creditors, and the debtor has no legal obligation to make it known beyond the parties to the deal. Moreover, the agreement is unsupervised; you are free to decide how to use your cash, what assets to sell, and who to hire as consultants without court or third-party approval. The process is also fast; an agreement can be reached much more quickly than a bankruptcy case.
The biggest downside of a workout is that the creditors do not have to stop pursuing collections against you while you are trying to reach an agreement. The best way to handle this is to ask your attorney to try to obtain a forbearance agreement from them, so that all collection efforts are put on hold while you continue to negotiate with them. Another risk is that one or two of the creditors involved in your workout may decline to accept the reduction or payment plan you want. If that happens you may have to file bankruptcy, since bankruptcy law requires similarly situated creditors to be treated equally. However, if the majority of creditors accept the proposal, you may avoid the need for bankruptcy altogether, or be able to use it as the foundation of a Chapter 11 reorganization plan.
Don’t Be Afraid of Bankruptcy Courts
In most cases workout is preferable to bankruptcy. There are, however, some important advantages to the latter procedure. The biggest of these is that bankruptcy puts the process for working out a company’s debts under court supervision. This is available under chapter 11 for most businesses, chapter 12 for certain farm operations, and chapter 13 for individuals. Court supervision is a protection for the debtor and other creditors against aggressive or unscrupulous creditors. It is for this reason that creditors often prefer a workout under the Bankruptcy Code.
Don’t be afraid of bankruptcy courts. Bankruptcy courts are typically sympathetic to debtors acting in good faith. That is because the Bankruptcy Code’s purpose is to provide honest but unfortunate debtors a “fresh start.” Once you file a bankruptcy petition, the automatic stay goes into effect. It forbids all creditor attempts to collect from you. A creditor needs permission from the court to try to recover your property. The Code and Rules determine the validity of your debts, set repayment priorities, define a time frame for payments, and establish a forum for you to propose and get court approval of a plan of reorganization.
Then there is the cram down. Courts are usually supportive of a good faith effort to reorganize a business by modifying the debts. That means creditors have more incentive to work with you, because they know that if you meet the Code’s reorganization criteria and they receive at least as much money as they would have in a liquidation, the court will grant approval of your plan despite their objections. And once the plan is approved, all other debt is wiped out, and cannot be collected.
Bankruptcy also buys time. In Chapter 11 only the debtor has the right to present a reorganization plan during the initial 120–180 days, and if the business cannot meet the payment schedule it can convert the case to Chapter 7 liquidation.
As much as people like to talk about how horrible bankruptcy is, the worst thing about it is that it costs so much. The court costs, lawyers’ fees and expenses for any other experts that must be brought into the case, all of this gets paid out of the bankruptcy estate. On top of that, the financial records of the debtor become public record. In a chapter 11 reorganization the debtor has to do everything that a debtor-in-possession has to do, like run the business while the case is pending. And pretty much everything the debtor wants to do in that situation requires the bankruptcy court’s approval.
Realistic Financial Statements
Whether a business is going down the road to a workout or to Chapter 11, it must convince the creditor(s) and the bankruptcy court that it is viable and can operate successfully going forward. This means it must have a reasonable opportunity to generate positive cash flow in the future, perhaps because of a new line of business, bringing receivables current, or payment by an associated guarantor. Or, the company must have a new financing source, such as a new lender or equity infusion by either new or existing shareholders. Work all of this out with a financial expert (turnaround consultant or accountant) before proposing a workout. If you cannot project positive cash flow going forward, then you are likely facing liquidation under Chapter 7.
The lesson here is two-fold: workout is usually the better option, as it is cheaper, faster, more private and more flexible, but bankruptcy can make sense when you are facing constant collection efforts or when a holdout creditor is torpedoing the deal, because the automatic stay gives you time to breathe and cram down can force a plan on the recalcitrant party. In either case, make sure you start with realistic financial statements that tell you whether the business can actually live on.
