Businesses get into financial trouble for all kinds of reasons. Where should you turn when your business runs into trouble? Is restructuring your business viable, or is the answer bankruptcy? There are two broad paths. In an out-of-court restructuring, the company and a group of creditors work together to negotiate changes to a company’s debt structure. The alternative is Chapter 11 of the Bankruptcy Code. Bankruptcy is a court case. It is referred to as an “in-court” restructuring.
In-court (Formal) or Out-of-court (Informal) Restructuring
Every company’s legal and business circumstances are different, but in general terms, the choice of an in-court (formal) or out-of-court (informal) restructuring depends on three things: how much cash you have, the size and identity of your creditor group, and the relationship with creditors. If your creditors want to assist you, and you can structure your business to get there, do so outside of bankruptcy.
Start with cash. A cheaper, faster out-of-court deal suits a business that is short on money, but you need to have enough cash on hand to keep the business running for the time needed to get the deal done. The worst thing you can do is start negotiating a deal with creditors that you simply cannot complete because you don’t have the cash to keep going until it’s done. When a company runs out of cash it will most likely have to go directly into Chapter 11 bankruptcy.
Next, look at who you owe. The larger the number of creditors and the more diverse the types of claims, the more likely it is that an out-of-court restructuring will fail. The more creditors you have, the higher the chances that someone will not come to the table, and an out-of-court deal needs all of them, from the bank to the trade suppliers. However, if there are relatively few creditors and the claim types are all similar, an out-of-court restructuring becomes a realistic option.
Finally, look to the relationship with creditors. Your lenders and major suppliers have to agree with you on what went wrong and how to fix it. If you have a good relationship with your creditors, then restructuring is more likely to work. If the relationship is weak, and you have a large group of creditors, it would be almost impossible to reach an out-of-court deal.
Out-of-court Restructuring
When it works, an out-of-court restructuring has real advantages. First, cost. A restructuring typically costs a fraction of the legal bills you would spend on a Chapter 11. Second, it’s much faster. Out-of-court deals usually take six to nine months, sometimes less, while Chapter 11 cases average nine to twelve. Third, it keeps your business less visible to the public. In an out-of-court restructuring, there is no need to file public disclosure documents. In addition, employees and trade creditors may respond less favorably to a public airing of financial troubles. And if your creditors agree to work with you outside of court rather than insist on the protections of bankruptcy, that means that they trust you. It also means that they’re willing to give you the benefit of the doubt that you’ll find a way to repay them, and that they see your problems as temporary.
The catch is that nothing forces anyone to go along. In a restructuring there is no automatic stay, which means creditors can sue at any time. They can also keep demanding payment on old debts. For a restructuring to work, all your creditors have to agree. If one creditor doesn’t, you are back to the same problem that you started with and no progress has been made toward solving it.
The Protections of Chapter 11
Chapter 11 is a different animal. The moment you file with the federal court, the automatic stay takes effect, protecting you from creditor harassment. That means your creditors have to stop all collection actions - including all lawsuits. The Automatic Stay can give you precious breathing room to make important decisions about restructuring your debt. Chapter 11 also lets you reject executory contracts you otherwise could not walk away from, such as office leases or equipment leases, license agreements and franchise agreements. In retail cases the amounts can be substantial. And when a bankruptcy judge has looked at a business, scrutinized it, and pronounced it viable, the business is more credible when it emerges.
Sometimes the choice is made for you. If the company is not viable as it stands, creditors will often prefer a Chapter 11 case. Creditors benefit by having a court preserving their rights. The best outcome may then be a sale, and buyers want a court to assure them that they won’t have to worry about uncertain liabilities. A Chapter 11 sale lets them buy the business without the “overhang” of remaining claims.
The protections of Chapter 11 come at a price, though. On top of court fees you pay serious legal fees, professionals’ fees, and other costs that increase a company’s financial burden. The federal court’s formal process also takes longer. And you give up your privacy: your business financials are a matter of public record once you file for Chapter 11. The court requires monthly operating reports and budgets, and online, anyone can read them. Finally, a proceeding before a judge is a very public and formal process. The two sides operate in a context in which they may not be able to exert the same degree of control or take the same risks as they could in a purely consensual arrangement.
So which road is right for your business? Both bankruptcy and restructuring can potentially work, depending on your circumstances. There are pros and cons to each, and you have to evaluate what makes sense for your business and its finances. Both aim to get the company back to steady, profitable operations. Even if a company is technically insolvent it may be viable and can be rescued. The owners who come through it best are the ones who know when they’ve reached a tipping point in the business and step up to resolve it.
