When a business can’t pay its bills, the owner eventually faces a choice between a Chapter 11 filing and a workout agreement. Both have their pitfalls. The preferred choice can vary from case to case. Ask most people what happens in Chapter 11 and they’ll say the debtor calls its creditors together and tries to cut a deal, which is all a workout does too. Both are renegotiations between debtor and creditors designed to modify the existing arrangement. So why involve a court at all? The answer is that a Chapter 11 is a lot more than just a meeting of the debtor and the creditors. Chapter 11 is a case where a court oversees the reorganization. A workout agreement is a private affair. It requires nothing of the court. No supervision. No approval.
Very often, though, the deal does get cut without a judge. A workout agreement is nothing more than a commercial contract that changes the terms of one’s debt obligations. As such, it avoids all of the procedural complexities and expense of a Chapter 11 case. For one thing, it allows a business to avoid the costly and lengthy court proceedings. For another, it is a quicker way to resolve a business’ financial problems. A work-out agreement is far less formulaic than a reorganization. Perhaps the biggest benefit of restructuring outside of court is that it minimizes the impact of the financial trouble on your company’s reputation.
The Holdout
Although there are real benefits to an out-of-court workout, they are not without drawbacks. The first is logistics. If there are more than a handful of creditors, the process quickly becomes complicated and slow, and getting all of them to come to a consensus may be impossible. But all those advantages are available only so long as there is a consensus among creditors as to what needs to be done.
The bigger problem is the holdout. In a workout, the debtor cannot compel the creditors to the negotiating table – indeed, it cannot force them to agree with anything. Even if most of them sign on, a dissenter can sit in the corner of the room and wait, knowing it will get a better deal. It can also wreck the whole effort. For example, one creditor could obtain a judgement in court and execute against the business’ assets.
The Automatic Stay
This is where Chapter 11 earns its keep. The first protection is the automatic stay, which instantly stops most creditors from pursuing collection actions. The next is the ability to force creditors to accept a plan they voted against: under sections 1126 and 1129 of the Bankruptcy Code, if there are creditors who won’t sign off on the plan, the bankruptcy judge may still approve it. Under section 365, contracts for goods or services to be performed in the future may be “rejected” if they are too onerous. And chapter 5 of the Code lets the debtor recover certain payments made before the filing. None of this is available in a workout.
There can be a tax difference as well. When a creditor forgives part of a debt, the IRS ordinarily considers this to be income to the debtor, who then has to pay taxes on it. Under section 108 of the Internal Revenue Code, debt cancelled in a Chapter 11 case is ordinarily not included in gross income, although it does reduce the company’s tax attributes. Do the same deal out of court and you may face a big tax bill.
But a Chapter 11 costs money: it costs in cash and time. That cost is what gives the threat of a filing its force. If the only thing wrong with your company is its balance sheet, the threat alone could be enough to persuade your creditors to restructure your debt. Your creditors may be willing to cut a deal now and avoid the time, expense, and trouble of a Chapter 11 filing. Creditors today are also more sophisticated and more willing to settle than they once were.
Creditors sometimes prefer Chapter 11, though. A lender that doesn’t trust management may welcome a judge’s supervision. And outside bankruptcy, every creditor has to worry that others won’t cooperate, and might take the greatest chunk of the business, leaving all the others with a slim pickings. While creditors are always free to sue to get their money out of a company, their concern is that if they sue, someone else may sue faster. The Code answers that worry by assuring equal distribution to similarly situated creditors.
The Prepackaged Bankruptcy
There is also a middle road, the prepackaged bankruptcy, or prepack, which tries to combine the advantages of an out-of-court restructuring with those of a Chapter 11 reorganization. The difference is timing. In a Chapter 11 case, the debtor files a bankruptcy petition and then solicits creditors to vote on a plan. In a prepack, the debtor convinces a majority of creditors to approve a plan before it files a bankruptcy petition. The company drafts its plan and sends it out with a disclosure statement and a ballot, and the creditors vote on the plan before the bankruptcy petition is filed. Then, the debtor files its bankruptcy petition and submits the plan for confirmation. Section 1126(b) lets the court count those votes if creditors had adequate information. Since creditors have already voted to accept the plan, the confirmation process is usually much faster, sometimes as little as 30 to 45 days.
That speed matters most to businesses that depend on their public image, such as retailers. A chain that lingers in bankruptcy may very well find its customer traffic and profits evaporating during this period. If the case drags on, its brand takes a serious hit—and that damage can take years to repair.
A prepack is not for everyone. If you have a bunch of different creditors whose interests are diversified and whose claims have varying amounts and nature, such that it is nearly impossible for a reasonable businessman to win unanimous support for a workout agreement with all of them on an individual basis, then you are a good candidate for a Chapter 11 case. But if you have a small number of sophisticated creditors that would support your restructuring if they had a chance to see what it entailed, you can try a prepack. There is a risk, too, because the court does not approve the disclosure statement in advance. If the vote is clear-cut, it is fast and cheap, and that’s wonderful. But if a judge gets a second look, and discovers that the company didn’t vote the creditors properly, you may have to start all over.
So which should you choose? Is the problem the business or the debt? This is the fundamental question. If the business is sound and the debt is the problem, then it’s usually best to move quickly, before things get too serious, and see if a workout can work. If you need the stay, the power to bind holdouts, or other tools only a court provides, Chapter 11 is the card to play. The truth is, work-out agreements have a place, and so do Chapter 11 cases. You have to know when to use one and when to use the other.
