Should a struggling business file Chapter 11 or restructure with creditors out of court?

Should a struggling company file for bankruptcy? Nobody wants to ask. But sometimes, when the bills have piled up, it can’t be avoided. The last 16 months forced the question onto many companies’ agendas.

Corporate Chapter 11 filings rose 29% in 2020 over 2019. Companies have been slower to file in 2021, possibly on the hope of an economic turnaround, stimulus aid and continued low interest rates, though a rise in private capital may have helped rescue those that might have gone under in other years.

Economic downturns can put companies under, but even when times are good, some slide into insolvency for reasons having to do with debt, supply chain disruption or an adverse court decision, for example.

Companies large and small will keep using Chapter 11 to shed debt and emerge leaner and more profitable. The CARES Act’s debt limit increase gives more small businesses the opportunity to use the faster Chapter 11 of the Small Business Reorganization Act.

All this doesn’t necessarily mean your business is one of them. And despite greater access to Chapter 11, it doesn’t mean the bankruptcy court is the right answer for every business in trouble.

Depending on your situation, a receivership may better serve your interests. Or maybe an assignment for the benefit of creditors.

Sometimes debts can be restructured without any court process at all. This is sometimes called an out-of-court restructuring. It is often faster and cheaper than filing a case in court, and if it can be done successfully, it’s usually the best choice.

Is your company a good candidate for Chapter 11 bankruptcy? The companies that tend to file for Chapter 11 have certain things in common.

Two things make Chapter 11 attractive. A viable business that could survive if only the creditors are put off for a bit. Or assets with real value in them — especially when foreclosure or repossession would wipe them out.

Some companies rush through Chapter 11 just to sell their assets. The debtor sheds debt and burdensome contracts and sells the assets free and clear of claims in a §363 sale. Afterward, the rest of the bankruptcy process deals with the remainder of the assets and claims.

Some businesses filing Chapter 11 expect to keep themselves going just on cash flow, with huge cost cuts to help bring that about. It rarely works. Almost all companies — especially mid-size and larger businesses — require debtor-in-possession (DIP) financing, meaning they borrow money as the bankruptcy debtor.

If you file Chapter 11, the U.S. trustee and any official creditors committee will have broad powers to investigate you and your business. Chapter 11 often makes sense, but only if you have little to fear from all that.

Chapter 11 offers sweeping relief from debt, approved by the court, and a fresh start. You pay a good deal for what Chapter 11 gives you. There are other ways to reorganize, though.

Restructuring with Creditors Outside the Court

You might get the same, or better, results by restructuring with creditors outside the court. There are two common ways.

One way is called a “creditor composition.” It is an arrangement between you and your creditors (and among the creditors), in which the creditors all or nearly all hold off on suing you. This is usually in exchange for reduced amounts, or extended payment terms, or both.

If you try this, you will usually have to offer creditors certain concessions. Some usual ones are stricter financial reporting requirements. Or a limit on executive salaries. You might also have to limit your sale of assets.

There are reasons creditors may accept this. First, it stops secured lenders and unsecured trade creditors racing to sue and force the company into bankruptcy. Trade creditors may see the value in waiting for their money when they know unsecured creditors get much less in bankruptcy. But usually you have to get almost all of them to go along. That is usually the hardest part.

The other way is to make a deal only with financial creditors such as banks, where you don’t need the consent of nearly every single one. But sometimes it’s just easier to deal with a handful of lenders than dozens of suppliers.

Lenders may agree to postponement of payments, a stretched repayment schedule or even reduced repayment, in a workout. But you usually end up reaffirming the debt and signing over more collateral. You may also have tighter reporting requirements.

If you can find a way to deal with creditors and keep your company out of court, it’s almost certainly faster, cheaper and cleaner. It works best where there are only a few creditors. If there are many of them, it’s hard to get them to stop racing to the courthouse door. Staying out of court also protects your directors, officers and lenders from the investigation and possible lawsuits a Chapter 11 case may trigger.

What it comes down to is, Chapter 11 has real pluses and real negatives. But it’s not the only choice. For each one, there are considerations, benefits and pitfalls. More than ever, you need experienced lawyers and financial advisers.

Nobody wants to think about restructuring, much less doing it. But the longer the delay, the harder the solutions get. The key? Take action early when the signs appear. And be realistic.