Can you settle with creditors before filing for Subchapter V bankruptcy? The answer is yes. Settlements with creditors before a debtor files for bankruptcy are very common. In some cases, a business owner chooses this route as an alternative to bankruptcy. Subchapter V is a form of Chapter 11. A potential Chapter 11 case is what typically gets creditors around the table.
The Out-of-court Deal Is Usually Called a Workout
The out-of-court deal is usually called a workout, or an out-of-court restructuring. It is a negotiation with the company’s creditors, and the aim is to reach an agreement with the creditors concerning the ways in which they might accept partial payments, longer payment terms or restructuring the debt. Done well, a workout can avoid the need for bankruptcy and salvage the company’s viability. For a debtor, the deal itself may be a better outcome, with less disruption and fewer costs.
Some workouts are fairly simple, with one creditor or a few, and the owner hires a lawyer to negotiate for them so management can keep running the company. Others are much more complicated, involving many different creditors, sometimes hundreds, and a team of professionals with different specialties. Even when only a few creditors are involved, the workout may be complex, with each creditor having a different set of issues. It takes time, and it takes legal knowledge and skill.
Why would a creditor take less than it is owed? Most creditors will accept some loss so as to avoid the prospect of a debtor filing a Chapter 11 case. A creditor will want to know what it would get in a Chapter 11 plan before it agrees to a settlement. If the bankruptcy settlement is worse than the workout terms, the creditor has a strong incentive to accept an early offer. Whether anyone says it out loud or not, the threat of bankruptcy is always there and generally works to the debtor’s advantage in negotiations. That is why people say a workout takes place “in the shadow” of Chapter 11: Chapter 11 looms in the background and threatens to come into play if negotiations do not go right. In order to successfully lead a workout, you need to understand how a Chapter 11 will work, how it can be leveraged in negotiations and how to utilize it to the maximum benefit. So the person running your workout should be a skilled Chapter 11 attorney. This way they will understand where the pressure points are in a Chapter 11 and how to take advantage of them.
The U.S. Bankruptcy Code Offers Powerful Legal Tools
Chapter 11 of the U.S. Bankruptcy Code offers powerful legal tools that can change the dynamics of a negotiation. No company would choose it as a first resort. It can be expensive and intrusive. But Chapter 11 has numerous ways to give the debtor flexibility that are not available outside bankruptcy. Filing the petition triggers an “automatic stay,” which stops creditors from pursuing collection activities, litigation or foreclosure. In fact, it shuts down virtually all actions against the debtor or its property. A business being sued or chased by judgment creditors gets an immediate reprieve, and management can focus on the business. This relieves pressure on the debtor and provides breathing room to get the deal right. The stay prevents creditors from interrupting operations while the debtor determines the best way to pursue the case. By contrast, if you don’t go into bankruptcy, the creditors in a work out are free to seize your property, repossess your inventory, and even file lawsuits against you.
The debtor can, and usually must, stop paying debts that existed before the filing. This gives a business a way to conserve cash for working capital or other expenses, including the cost of the case itself and the plan that will come out of it. Depending on the case, the value of this flexibility alone can be the difference between liquidating the business and keeping it running. In most other respects, it remains in control of its assets and operations and can continue running its business as usual.
The end product is a reorganization plan, which can erase debt, change payment terms and settle disputes. The plan determines how each creditor will be paid. Once the court approves it, the plan becomes the new contract between the company and its creditors, and it is binding on everyone involved, even if they didn’t vote for it. In a workout, the debtor cannot force any creditor to accept a reduced payment or new terms. The creditor can simply refuse to cooperate.
A Chapter 11 debtor can also reject leases and contracts that work against it. If you are paying above-market rent on a property you will not need after reorganization, you can have that lease rejected. In a workout, the debtor may be able to get a landlord or supplier to agree to that, but it is not something they are obligated to do. If they won’t let go, you’re stuck with the contract. Secured loans can be “crammed down” to the value of the collateral behind them, even if that value is much lower than the balance of the debt, and new interest rates can be set. In a non-bankruptcy workout, however, the debtor cannot unilaterally reject or reduce secured debt. Unsecured creditors can be paid a greatly reduced amount, over time. That can happen in a workout too, but in Chapter 11 you can force creditors to give you a break. This means they may be forced to accept less than what they are owed, in payments the company can afford. And sometimes a debtor can borrow through a DIP loan that puts the new lender in a “super-priority” position ahead of existing lien holders. A DIP loan can be an attractive tool for a debtor, who can get the funds it needs to stay in business. And the fact that the DIP loan gets such a priority is a powerful inducement for the DIP lender. But there is no DIP loan in a workout. These are the pieces that can change the negotiating game.
Should You Settle First, or File
So should you settle first, or file? Well, it depends. Each approach has pros and cons. The decision takes a careful look at a lot of factors, but the two are not mutually exclusive. You can attempt settlements and still go ahead and file if the talks don’t work out. If a reorganization can happen in a workout, it is much cheaper. But sometimes the other side simply will not move. Then Chapter 11 is the next step, and it is not cheap: filing fees, attorneys’ fees, U.S. Trustee quarterly fees and possibly creditors’ committee fees add up. Still, there can be great value in the use of these tools. For many businesses the benefits outweigh the costs. And if you do settle out of court, the lesson is that you should never negotiate a deal without taking into consideration the ways in which a bankruptcy could be used to alter the rules of your negotiations. In short, you should always negotiate in the shadow of Chapter 11.
