Yes, in many cases a business can avoid Chapter 11 by negotiating or settling its debts. This does not mean that debt settlement is a magic bullet. It is not. It won’t always be easy, or free, but it is often a cheaper and cleaner way to restart than declaring bankruptcy.
First, a word about the word itself. Being insolvent or running out of money does not equal going bankrupt. “Going bankrupt” is a misnomer. To “go bankrupt” is to file a petition under a chapter of the Bankruptcy Code, even if the underlying reason for filing was insolvency. The terms are related, but they are not the same thing.
Think of your company as a body with an infected toe. The surest way to stop the infection may be to cut off the toe. But sometimes the infection can be flushed out so you can live a healthy life without an amputation. In business terms, you may be able to flush out the infection by settling your debts.
A Traditional Bankruptcy Case Can Be Very Expensive
Chapter 11 certainly provides the highest level of protection from creditors, but a traditional bankruptcy case can be very expensive. Huge amounts of management time and specialists’ time are required. The company also has to live in a fishbowl, publicly making extensive disclosures about its business and finances. That is an ongoing, tedious and costly way to operate. Sometimes the Chapter 11 cost is worth it. But if you can resolve your debt without Chapter 11 you will often come out ahead.
Out-of-court Workout
So what does settling look like? An out-of-court workout is what it’s called. There’s no court supervision involved. Debtor and creditors negotiate in private. They agree that the creditors will be repaid - but at different, and more realistic, terms. Often this means creditors take a little bit less money than they’re entitled to, but it is better to get something than nothing. An out-of-court workout is a very attractive option, but not always an easy one.
Workouts tend to succeed in a particular kind of situation: the business has to be worth saving, struggling but still viable, and the creditor pool has to be reasonably small.
Leverage is a powerful force in the world of business. When a debtor has a “war chest” of available cash, it is more likely to be able to shape the negotiations with creditors to its liking and choose the “road” it is willing to travel. On the other hand, when a secured creditor has a senior lien on all of a debtor’s assets, and is owed substantially more than the value of those assets, the creditor is more likely to be the one choosing.
Not all creditors are in the same boat, or alike in any way really. The point is, you need to understand your creditors’ motivation, because their motivation is what guides the negotiation. Your creditors want you to work out deals or settle your debts so they can collect what they are owed. Each type of creditor has different needs:
- Trade vendors want you to stay in business, so they can keep doing business with you and get their payments for outstanding receivables as quickly as possible.
- Banks and other lenders want their loans repaid, and don’t want to have to invest more than is necessary in the process; they are likely concerned that the value of your collateral might deteriorate in the meantime. They’ll weigh your offer against what they’d receive if they didn’t accept it.
And what about you? As the owner, you want to keep as much of your equity as possible. If you can’t do that, you want to avoid paying company creditors from your personal assets — i.e., because of a personal guaranty you may have given to a bank or other financier. There are also reputational considerations, and of course you may want to keep good relationships with people and organizations. You need to know what you want before you start with the creditors.
If a workout with the creditors fails, the next path is often chapter 11 or, if eligible, subchapter V of chapter 11. Subchapter V was enacted in 2019 and became effective early 2020. It’s still too early to know how well it’s going to work, but subchapter V is designed to provide the benefits of chapter 11 to an eligible business at a fraction of the cost and time. But it is still a form of Chapter 11.
Another option is for an overleveraged company to run a “distressed sale process” with the help of an investment banker and sell all or part of its assets or equity to a party that can pay down the debts. A distressed sale relieves a good business of debt that it cannot carry. The creditors get paid. The drawback is that the owners give up control of the business: either the business doesn’t own its assets any more or the owners’ equity in the business is significantly diluted.
When the business can’t reasonably be “restarted,” it may have to wind down to pay its debts. It can go into Chapter 7, in which a bankruptcy trustee takes over, liquidates assets and distributes proceeds to the company’s creditors. Or it can opt to wind down through an “assignment for the benefit of creditors” or “ABC.” In an ABC, the company hands all of its assets to a private party (a trustee) who sells those assets and distributes the proceeds to the company’s creditors. The trustee is a private party that is selected by the company’s owners or board and ABCs are governed by state law, rather than federal bankruptcy law. It also spares the business the expense of winding down inside Chapter 11.
Receivership is mostly a creature of state law. Often sought by a secured lender against a defaulting borrower. The secured lender has to first file a lawsuit against the borrower and then get a court order to appoint a receiver. Receivership isn’t as public as Chapter 11 and is less likely to be expensive. It has the disadvantage from the owner’s perspective that the owner loses control of the business, and there is no automatic stay against other creditors.
Chapter 11 is not the only way to get financial relief. You have more options. It is up to you to weigh them and to figure out which is right for you and your business. The wrong question to ask is “Should I file bankruptcy?” You should rather ask “What is the best option to get my business back on track?” Sometimes the best option is a negotiated settlement and not a court filing. The solution isn’t always clear, and it can change depending on the circumstances. But if you want to avoid Chapter 11 in favor of a settlement, it’s usually a question of how much you have to work with, and what your creditor wants.
