Bankruptcy Is Expensive
If you own a midsized company and the debt has gotten ahead of you, bankruptcy has probably crossed your mind this year. It should be the last tool you reach for. Bankruptcy is expensive, time-consuming, and has its own repercussions.
The professional fees can be tremendous. The debtor, the secured creditors, and the unsecured creditors all have their own financial and legal advisers, all of whom are paid by the estate, in addition to the filing and trustee fees. The end product is a lot of work and a lot of bills. Then there is the unquantifiable cost to management, which loses focus during the case. Bankruptcy can easily become a full-time job for company executives and senior management. In a bankruptcy, managing the company gets second billing.
Worse, bankruptcy is a public process, and competitors may attack an embarrassed firm. Customers go elsewhere; key employees jump ship. Suppliers also watch out for themselves, especially when their receivables have been frozen as of the petition date. You have to consider that by filing for Chapter 11, you’re not only admitting to your creditors that you have problems, but you are also telling your suppliers and customers the same thing. Bankruptcy has lost some of its stigma over the years, but the hit to what your business is worth is real.
The Out-of-court Restructuring, or Workout
So which services let a midsized company fix its balance sheet without a filing? There are three worth knowing, and the first is the out-of-court restructuring, or workout. The workout involves directly negotiating with the creditors, usually with debt repurchases or equity swaps. The debtor attempts to alter its capital structure without a court proceeding. Workouts are usually cheaper, quicker, and less cumbersome than filing in court, and they let a company avoid the additional disclosure, increased public scrutiny, and risk of litigation. But in a workout, all the creditors have to agree. If they aren’t motivated by the company’s offers, they will drive the company into a Chapter 11 filing.
A workout is not for every company. Before you approach your lenders, ask yourself a few questions. Do you know which of your loans is in default, and why? Do you know which loans are likely to default during the workout period? Do you have access to funding or liquidity to operate the company while negotiations are underway? Do you have a limited number of creditors? The more factions involved, the harder it is to get anything done. Do you know what short-term cash flow and liquidity problems you are facing, as well as what it will take in the long run to cure them? (In other words, do you know how to fix the problem?) Do you have unencumbered assets that can be used as leverage in your negotiations? Before you launch a workout, you need to ask whether you have a fallback. That’s a fancy way of asking: Do you have a viable backup plan in case the workout fails? You need to know before you ever dial the phone.
The trade-off is real. When you stay out of court, you forfeit the tools in the Bankruptcy Code: you cannot bind holdouts, you can’t reject bad contracts, you can’t get the benefit of the automatic stay. You may lose tax advantages of the formal court process. You must get consent from all the creditors. You may have to let liens survive on assets sold outside bankruptcy, making it harder to realize full value for them.
Still, creditors have good reasons to say yes. As a general rule, creditors prefer to be paid in cash. The company with cash has a leg up in negotiating a deal. For creditors, their entire claim is at risk once you file for Chapter 11. They have to weigh “some” or “nothing.” And a restructuring that avoids Chapter 11 can be faster and less expensive for the creditor. What wins them over is candor. Give them the numbers, including an analysis showing how they come out in bankruptcy, and with that forthrightness comes a chance to negotiate a better deal. The more accurate you are when presenting your financial position, the better the chances of a successful workout. You also have to have a viable reorganization plan. Even in a workout you need to think about how the company will come out on the other side.
The ABC and the Pre-pack
The second service applies when the business cannot be saved. The alternative to Chapter 7 is Assignment for the Benefit of Creditors (ABC), a liquidation process governed by state law. Unlike Chapter 7, which is administered by a court-appointed trustee, an ABC is assigned to a third party chosen by the business to take over and wind it down. Because it is not required to follow the same rigid rules and requirements of a federal bankruptcy, it is more flexible and much less expensive, and can be used to quickly and efficiently distribute the proceeds of the business assets to the creditors. The assignee sells the assets with little ability for creditors to object, as long as the maximum value is attained without the need for a court order.
The third option sits on the line between the two worlds: a pre-packaged or pre-negotiated Chapter 11. This isn’t really out of court because the debtor makes a filing, but so many things are settled before the case gets to court that it is almost as good. The debtor and the creditors are working together before the filing to agree to a restructuring plan. So a pre-pack provides the benefits of a workout without having to rely on every creditor agreeing to the terms. With a pre-pack, you can go in the back door of Chapter 11 and then make a straight line to the finish. The court venue also offers a safe haven for tax benefits, including cancellation of debt income, as well as net operating loss carry-forwards. And the pre-packaged Chapter 11 makes sense when the debtor is suffering some operational issues or unperformable contracts that it can’t resolve out of court, but that could be fixed in the bankruptcy context.
Whichever route fits, timing decides a great deal. If you wait too long, you cede all of your negotiating power to the lenders. If you only get into the negotiating process with the lenders once your liquidity is exhausted, you will be negotiating from a position of weakness. Make sure you know what your liquidity runway is, and forecast your cash needs. There’s nothing wrong with bringing in an expert to give you an opinion on what debt the business can sustain. You should develop your plan based on financial reality and realistic forecasting to avoid serial defaults and lender fatigue. Start early, because it’s never too soon to start planning for a restructuring. For a midsized company with a manageable group of creditors, the workout is the service that keeps you out of bankruptcy altogether; the ABC and the pre-pack are there for when it cannot.
