Over the years I’ve gotten numerous calls from people who are facing hard times. In general the call is from frustrated business owners. Some are just having trouble making ends meet after a hard economic time or seasonal downturn (revenue shortfall, cash flow crunch). Some face deadlocked partners, shareholder disputes or just failed to manage the business well. Others have failed to keep track of legal and accounting responsibilities. Others are saddled with unproductive assets, contract obligations or legacy employee benefits. Regardless of the cause or the exact amount of liability, the problem is that they have found themselves in a position of no longer being able to pay the debts they owe. The likelihood that a situation like this will just work itself out goes to near zero: at some point in time those who are owed money will get tired of waiting and will take action. That is usually when someone tells the owner to file Chapter 11.
Financially distressed companies may choose to go into Chapter 11 bankruptcy. One of the benefits of this legal strategy is that it allows a company to continue operating while it reorganizes. However, this doesn’t mean it is the only option, nor does it mean it is the best option. If management is prepared, a company in financial difficulty may be able to negotiate directly with its creditors and successfully arrange a work out. It all depends on the level of debt and complexity of the restructuring. More typically, an out-of-court workout (consensual deal with creditors) is the best possible outcome. Only if such deal is not possible or appropriate, then a company and its creditors may resort to Chapter 11. For a business that can still strike that deal, Chapter 11 is overkill.
So how does one determine what kind of problems a company faces and what is likely to be the best course of action?
Review All Financial and Legal Documentation
The first step is to review all financial and legal documentation. Determine the most critical and urgent concerns. Assess the liquidity of assets and total levels of debt. Review monthly obligations, asset and liability reports, position with lenders, suppliers, and employees. Be realistic. Are assets or accounts commingled? Are the books and records current? Is debt secured or unsecured? Are there liens, taxes, judgments, unfunded liabilities, contingencies, or reserves? The answers will tell you whether a workout is viable or not. Just remember that your creditors are not always the most sympathetic people when it comes to financial matters. None of your creditors is going to give you a break for free.
A Chapter 11 Case Really Does Make Sense
Sometimes, a Chapter 11 case really does make sense. If your problem supplier has gone standoffish and is committed to disruptive collection efforts, or if there’s a lawsuit or judgment that threatens to shut down a facility or result in immediate cash depletion, Chapter 11 becomes worth a hard look, provided there are real assets and opportunities to protect. The business continues to be managed (“debtor in possession”) while the plan is being developed and implemented, and the plan must be approved by the creditors as well as the court. The automatic stay prevents the creditors from collecting, getting judgments, seizing property etc. The flip side is simple. It does not make sense to file Chapter 11 when there are no major lawsuits or distressed collections events to be met. We may be able to achieve the same result in another way without all of the costs and embarrassment of a Chapter 11 filing. In these cases, Chapter 11 is not worth the money.
To be fair, Chapter 11 reorganization can be effective. It can help you restructure your debt, clean up your operations, and lay the groundwork for recovery. The company can reject unwanted leases and contracts. The going concern value of the business is more valuable than its assets sold individually. When it goes well, the reorganization lets the business make money again, and its creditors have a better chance of getting paid. For the right case, Chapter 11 is nearly always better than walking away with hands up, if enough is at stake. However, there is no free lunch in life. Chapter 11 costs money and even the best made plans fail.
But it is a long and expensive process because all interested parties must be heard. It can take a few months or several years. It is risky, because there is a good chance it won’t work (many such reorganizations fail) and a trustee can be appointed to sell the assets (with the court’s permission). The whole process is stressful. Most owners hate Chapter 11. It’s seen as a distraction, a drain on resources, a last resort.
Owners should also know what can happen to ownership. In a large business or a publicly-traded company, chapter 11 can end up turning over all or much of the equity ownership of the reorganized entity to bondholders and other priority creditors. Those creditors may take the new entity’s stock in lieu of immediate payment, and hope it will work out. For an owner who started the company out of their own pocket, this can be a painful outcome.
Close Down and Dissolve the Entity
But in some circumstances no workout, composition, court-supervised reorganization or plan of turnaround can save the once-vibrant business. Then it might be best to let it perish a natural death. The purpose then is to close down and dissolve the entity while inflicting the least possible amount of pain on the creditors, employees and owners of the doomed firm. To this end, a team of lawyers should be hired who are experienced in negotiating complex corporate, labor and environmental matters.
Typically, this is accomplished through a consensual (i.e., noncourt) structured winding up and dissolution. If the management cannot agree on this course, it can ask the courts (in an action known as a judicial dissolution — a state court lawsuit) to order the process. Another alternative is the Chapter 7 liquidation, where the Court appoints a trustee to take over and liquidate the assets of the business. Yet another alternative is a state court assignment for the benefit of creditors. In most cases, the owners will seek to protect themselves from any further exposure of their personal assets.
So when does Chapter 11 not make sense? When a workout with your creditors is still within reach, when there is not enough at stake to justify the cost, and when the business cannot be saved at all. It is important to realize that there is not much time to make these assessments and errors can be costly. Communicate with your creditors directly or through a representative, and choose the people who help you carefully.
