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 Distressed
Business Services
Alternative to Bankruptcy
The story of a debtor’s
financial struggles is all too common in today’s economy. It begins by the
debtor describing that its industry is mired in the trough of a cyclical
slowdown … that the slowdown reduced customer demand and created overcapacity
in the industry, and more particularly, in the debtor’s operations … and
that as a result, the debtor experienced operating losses and cash flow
difficulties. The debtor then rides this slippery slope of obscurity into an
enthusiastic picture of an anticipated turnaround to the profitable days of
yesteryear. However, as credit extensions become increasingly rare, and
collection actions more familiar, the debtor finally concludes that
reorganization is the only avenue to remain in the marketplace. Instead of
electing business reorganization under chapter 11 of the Bankruptcy Code or an
assignment for the benefit of creditors, the debtor sends you a “confidential
communication” requesting your presence at a meeting of its creditors to
discuss an out -of-court workout. Should the credit professional be receptive to
this request or solicit others to force an involuntary bankruptcy? It all
depends on the chances for recovery.
Workout Agreements
A financially struggling debtor may propose an out-of-court workout to its
creditors to avoid formal relief under chapter 11 of the Bankruptcy Code. An
out-of-court workout is a contractual agreement made between the debtor and its
creditors to resolve outstanding debt obligations, and at the same time, direct
a course toward financial stability. A credit professional should balance the
advantages of a workout agreement against the advantages of reorganization
through bankruptcy.
A workout agreement enables a debtor to address its primary concern of
burdensome debt without the stigma that a bankruptcy filing may entail. Through
a workout, the debtor avoids the public scrutiny of a bankruptcy case, shields
its customers from competitors seeking to cash in on the debtor’s demise, and
manages internal relations with employees in a much less intimidating manner.
The positive atmosphere that the workout may accomplish assists all parties in
interest by focusing on the issues that led to the debtors’ financial
difficulties and charting a course to profitability. More important, a workout
is usually expeditious, less expensive, and interferes only minimally with the
debtor’s operations.
Workout agreements are proposed and accepted within a short period of time after
the meeting of creditors. In the context of bankruptcy reorganization, a
bankruptcy case may take several months, and perhaps years, prior to the
acceptance of a plan. Even after a plan is accepted, payment of pre-petition
obligations is further delayed thorough post-confirmation litigation of
preference actions and other avoidable transactions. The delay of bankruptcy
reorganization also has a collateral effect on the expenses to the debtor’s
estate. In bankruptcy, the debtors are required to pay for the services and
costs of professionals through administrative expense claims. As an
administrative claim, the professionals are paid prior to the other creditors,
which will affect the amount of a distribution. Further, a workout agreement has
a minimal affect on the debtors’ operations and does not require a court order
for use of cash, filing of monthly operating reports, and other operational
scrutiny. Instead, a workout permits the debtor to focus on returning its
operations to profitability.
Reorganization and the Bankruptcy Code
Although the informal context of a workout is a valuable method to achieve
payment, the more viable alternative may be a formal reorganization. The
Bankruptcy Code provides several statutory protections to assist the debtor
through its reorganization efforts, which are unavailable through a workout. One
of the more useful protections of the Bankruptcy Code is the automatic stay. The
automatic stay imposes a freeze on all suits, foreclosures and similar actions
against the debtor’s assets, which comprise the debtor’s bankruptcy
“estate.” If the debtor is facing a flood of litigation, then the automatic
stay creates breathing space for the debtor to focus its attention on the
reorganization of its operations. Another operational advantage to
reorganization under the Bankruptcy Code is the debtor’s ability to reject
executory contracts and unexpired leases. This is especially important if the
debtor remains liable for burdensome contracts and unexpired leases, which may
be over market or simply no longer a part of its operations.
The Bankruptcy Code also offers unique strategies to achieve a successful
reorganization that are not always available through a workout. If management
concludes that a sale of the debtor’s assets is the only way to effectuate
reorganization, then the debtor is entitled to sell its assets free and clear of
liens and encumbrances, and oftentimes, without the of secured creditors. This
remedy is not available under a workout and may invite protracted litigation by
secured parties in an attempt to protect their individual interests. In
addition, under certain circumstances, the Bankruptcy Code permits the
“cramdown” on dissenting creditors of the provisions of a plan. In the
workout setting, creditors may “opt-out” of the workout agreement and seek
their own recoveries. Further, reorganization under the Bankruptcy Code permits
the recovery of preferential transfers and the avoidance of liens and fraudulent
conveyances. Accordingly, reorganization under Bankruptcy Code provides an even
playing field for all creditors to recover their proportionate share of
available funds whereas a workout may pay certain creditors ahead of others
(i.e., judgment lien creditors).
Meeting of Creditors
The first step toward a successful workout will require the debtor to convene a
“meeting of creditors.” The meeting normally consists of general unsecured
creditors only. At the meeting of creditors, the debtor is usually prepared to
confidentially discuss the issues that created its financial difficulties, its
current revenues and debt structure, prior and future efforts to reorganize its
operations, and other information to convince creditors that a workout is the
best chance for payment.
Formation of a Creditors’ Committee
The formation of a creditors’ committee is also a primary importance at
the meeting of creditors. The role of a creditors’ committee is similar to
that of a chapter 11 creditors’ committees. Essentially, the creditors’
committee serves as the “watchdog” of the debtor’s affairs and makes
decisions and recommendations to the debtor’s creditors. The selection of the
committee should closely correspond to the requirement of the Bankruptcy Code
since a failed workout, or alternatively, a dissenting creditor group seeking an
involuntary petition, may land the debtor in bankruptcy. If the debtor is forced
into bankruptcy, then the workout committee may continue its functions and
relationship with the debtor as a chapter 11 creditors’ committee. Generally,
a creditors’ committee should be fairly chosen after notice is given and
consist of a fair representation of the creditor body. Similar to the bankruptcy
context, the creditors’ committee should seek legal counsel and other
professionals as soon as practicable. It is imperative in the workout process
that the creditors’ committee receives competent legal advice since the
debtor’s are subject to less scrutiny than under the administration of a
bankruptcy case. Generally, the debtor will compensate the creditors’
committee’s legal counsel for its costs and services. The individual committee
members are also entitled to compensation for expenses.
The Workout Agreement
One of the advantages to a workout plan is the flexibility associated with
framing an agreement. The essential components of a workout agreement include
the payment plan, moratorium on collection and similar activity, monitoring
rights of creditors concerning the debtor’s operations, and adequate
protection for creditors that the debtor fulfills the conditions of the
agreement. The terms and conditions of the workout agreement are the result of
extensive negotiation between the debtors and creditors’ committee, usually
through their respective counsel. In addition, if secured debt is involved, the
secured parties may want to be involved in the negotiation of an agreement. In
any event, the terms and conditions of the workout should be framed to mirror
the terms and conditions of a plan of reorganization in the event that the
debtor is forced into bankruptcy.
Payments under a Workout Agreement
Generally, there are two types of workout agreements. An “extension”
agreement restructures the debtor’s obligations for payment in full over a
period of time. Alternatively, a “composition” agreement reduces debt
obligations and creditors receive only a fraction of their claims. There are
also hybrid plans that may pay a fraction of the claim over a period of time or
payment may be received in goods or products of the debtor.
Creditors Subject to the Workout
Agreement
A workout agreement is a contract and only binding on the creditors that
accept the agreement. Accordingly, creditors that do not agree with the workout
are free to pursue their own agendas. Although unanimity is difficult, if not
impossible to reach, the workout agreement should seek the approval of one-half
of the creditors holding claims totaling at least two-thirds in value. Granted
adequate disclosures are made by the debtor, the terms and conditions of the
workout agreement may be incorporated into a plan of reorganization and quickly
enforceable if the debtor is forced into bankruptcy.
Conclusion
An out of court workout agreement is a valuable method to seek payment from the
debtor. The workout may result in a faster plan for payment, reduction in
professional fees, and minimal disruption to the debtor’s operations.
Moreover, it is especially important if creditors’ would not receive a
distribution in a chapter 11 reorganization since payment may be structured to
suit the needs of all parties including the debtor, secured creditors, and
general unsecured.
Call
Robert Davis at NACM-BCS (281.228.6100) or email at rdavis@nacmsouthtexas.org
today for more information on our Adjustment & Workout Services.
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