Ask most business owners what Chapter 11 is and they will describe the same scene: a company that can’t pay its bills calls its creditors together, and they strike a deal, or they don’t. So why bring a court into it at all? Couldn’t you just work out a deal with your creditors outside of court? The answer, of course, is yes, if you can get your creditors to agree to your deal. Sometimes the deal works, but sometimes they reject it.
A workout is a voluntary restructuring between a company and its creditors. Everyone involved has to agree to the new arrangement. There is no court filing involved. Workouts can be useful because they’re typically less expensive and time consuming than a bankruptcy. A workout avoids the complications of bankruptcy litigation.
Sounds easy. It’s not. Once you have more than a handful of creditors, it can become extraordinarily difficult to get every one to sign on – particularly if the creditor is one that isn’t going to get full value. If any group of creditors decides they don’t like what’s going on, they’re free to scuttle the deal. They can wait, as long as they have the patience, and hope to get a good deal if they can force other creditors to cave in. Outside of the bankruptcy code, there is no statutory automatic stay, so a company in trouble faces the risk of creditors seizing its assets.
Chapter 11 is different. When you file, the automatic stay goes into effect, and you don’t need any special court order to put it in place. Without it, your workout would be quickly derailed as your creditors would file claims and take legal action against you. This immediate relief allows you to stop the bleeding in order to focus on making a go of the business operation. But wait, there’s more. The Chapter 11 plan can bind the creditors to an agreement that takes away their right to collect what is owed to them without their consent. A workout is typically reached by bargaining with creditors. If you get a holdout, your agreement is undercut. In Chapter 11, if a class of creditors votes for the plan by a majority in number and two-thirds in dollar amount, the remaining holdouts are bound by the terms of the plan. This aspect of Chapter 11 is often the most attractive one: instead of bargaining for unanimity, the plan proponent gets to bind dissenting creditors who do not like the restructuring plan.
Chapter 11 also lets you get out of contracts that have become a burden, such as a lease on a location you no longer need. It’s hard to terminate such contracts in a workout because the company must get the consent of the other contracting party. And the company can recover certain payments it made to creditors before the filing, so that the creditor ends up with no more or less money than a like creditor.
Then there’s the tax bill. When a lender forgives part of what you owe outside of bankruptcy, the forgiven amount can be taxable to the borrower as income. So a company struggling with its balance sheet ends up owing taxes on income it has neither made nor collected, which just kicks the company into a deeper hole. In a Chapter 11, the tax code ordinarily lets you exclude the forgiven debt from your taxable income, although it does reduce some of the company’s other tax benefits.
What, then, are the drawbacks of Chapter 11? Cost, of course. And if the only thing broken is your balance sheet, the threat of Chapter 11 alone is often enough to bring creditors around. Because most of the parties involved—especially lenders and major suppliers—want to avoid the expense and disruption of bankruptcy, they have a strong incentive to negotiate a restructuring.
Creditors sometimes prefer Chapter 11 themselves, even though it costs more. A creditor who doesn’t trust the owner will favor the bankruptcy process, to maintain a watchdog presence. In other words, the creditor may want to keep an eye on the debtor. In bankruptcy it also doesn’t have to worry about everyone else getting a better deal, because Chapter 11 provides a mechanism for leveling the playing field and distributing the assets equally among creditors in the same position.
The Prepackaged Bankruptcy, or Prepack
There is a middle road, the prepackaged bankruptcy, or prepack. In a prepack, you get your creditors to agree in advance to a deal, and then you file the bankruptcy case. Thus, the prepack is the hybrid solution, a combination of a workout and a Chapter 11. The parties can negotiate the plan and how creditors will be treated before a petition is filed, but they have to convince the creditors to vote in favor of a plan by getting a majority in number and two-thirds in value. The Chapter 11 case can then be completed quickly, sometimes in as little as 30 to 45 days. A retail operation may not be able to afford the drag of a bankruptcy case because its brand reputation is critical to its survival. A Chapter 11 that ends before it can do real damage to the reputation of the company might be a better deal.
So why doesn’t every company do a prepack? Because it only works if the company can get creditors to agree to the deal up front. That usually means a fairly small group of creditors holding most of the debt. There may be so many creditors that the debtor can’t persuade them all to agree; even if the debtor does agree to a deal with some of the creditors, there may not be enough votes to push it through.
Prepacks carry their own risk, too. Creditors vote on a disclosure statement the court has not approved in advance. If the creditors don’t receive adequate information from which to decide how to vote, the vote can be attacked, which could blow the whole package to smithereens. If a dissenter challenges the disclosure or the way the votes were gathered and the court agrees, you have to start over; the transaction may be frustrated, and your creditors may break ranks.
There are variations. In a partial prepack, you try to get votes of some classes of creditors before filing, and conduct the rest of the vote inside the Chapter 11 proceeding. Say you owe one large bank and a thousand small suppliers. Lining up the bank before you file is realistic; chasing a thousand suppliers for ballots is not.
In a pre-negotiated or pre-arranged case, the company settles the basic terms with its most important creditors, in writing, before it files. The deal is put in front of the rest of the creditors as part of the Chapter 11. Pre-pack and pre-negotiated cases are distinguished by the votes that the parties take on the plan. In the former, a plan is voted on before the case is filed; in the latter, no vote is taken before the petition date. Sometimes, in place of a vote, key creditors sign a lock-up agreement, or support agreement, whereby the creditors agree to vote for the plan. Courts, particularly in Delaware, have frowned on lock-ups signed after a case begins.
To sum it up: An out-of-court workout is easier, quicker, and cheaper but hard to do. A Chapter 11 is expensive and complicated, but it lets you bind dissenting creditors to the deal you’ve worked out. A prepack sits in between. The more creditors you have, the more likely you are to want to file a Chapter 11, and the less likely you are to try a prepack. If your company’s only real problem is too much debt, a negotiated settlement is usually the place to start. It’s a puzzle that requires you to balance your own company’s interests against the needs and wants of your creditors. Sometimes you can make it work both ways. Often, you can’t. In either case, it’s better to choose the problem you want to face now, rather than letting the consequences of what you owe force your hand.
