A company can fall into financial trouble for many different reasons. Often, the gut reaction of management is to file for Chapter 11 bankruptcy. In our practice, we consider bankruptcy a last resort remedy. We always try to keep our clients out of bankruptcy. Why? Because an out-of-court debt restructuring or liquidation has the potential of achieving higher returns for all of the stakeholders at a lower cost. Furthermore, companies increase the chances for a successful operating turnaround by avoiding the negative publicity often generated by a bankruptcy filing. The purpose of this memo will be to describe the secrets of successful out-of-court debt restructuring for debtors and creditors.
The Usual Scenario That Results in Debt Restructuring
The usual scenario can occur in any type of company – manufacturing, distribution, services, retail, etc. Typically, there is a bank lender with a line on accounts receivable, inventory, equipment, land, and trade creditors. If the business does not own real estate or equipment, then there will be a landlord and some equipment lessors. These are small differences and the principles discussed below will apply regardless. Although the bank loan may be current or just a payment or two behind, there are significant covenant defaults and payments to trade creditors are delinquent.
Restructure or Liquidate
The first thing the business must do is determine whether or not to continue operations/restructure or liquidate. This will depend largely on whether or not there is a sufficient market for the company’s products or services. If there isn’t, it is pointless to continue and the decision will be for liquidation. In the event of a decision to liquidate, the Company must then decide whether selling as a going concern perhaps to a competitor or shutting down immediately will maximize the value of the assets. We often recommend that the client hire a competent turnaround professional. They will assist with this evaluation and the creation of a viable action plan. In addition to assisting in this regard, an independent turnaround professional provides the Company with credibility when approaching creditors for concessions.
One might ask why the Company should care about maximizing the value of the assets. The answer is that often, the principals have personal guarantees that need to be satisfied. These guarantees act as a significant incentive for management to obtain the maximum value. Moreover, our experience is that most principals want to achieve the maximum recovery for all concerned. In many instances, they believe the assets are worth more than their appraised value. If the business can be sold as a going concern, then it must be able to run at close to cash flow break even for at least 90 days. This will give management a chance to market the assets as a going concern. If this is not achievable, then the business must shut down.
The Business Plan
If there is a market for the business and the Company can operate at close to cash flow break even, then it must come up with a reasonable business plan for going forward. The business plan is often provided in two stages.
First Stage of a Business Plan: Eliminate Cash Flow Crunch
The first stage is when the Company is in crisis and it simply needs to eliminate a cash flow crunch. At this point in time, the plan must provide at a minimum for the collection of enough revenue to cover the payment of ongoing business expenses such as payroll, taxes, rent, utilities, critical supplies, transportation costs, etc. Ordinarily, this means that the Company will likely have to curtail payments on past due loans, leases, and trade credit while the business operations are being turned around. In addition to curtailing payments on past due debts, the Company usually reduces headcount and undertakes other cost-cutting measures to equalize the sources and uses of cash. Competent turnaround professionals are excellent at identifying areas where business can cut costs and become more efficient. The plan should include current and projected balance sheets, income statements, and cash flows.
Second Stage of a Business Plan: Negotiate Out-of-Court Settlements
The second stage of the business plan is developed at a later date. Hopefully, the Company’s efforts to cuts costs and make operations more efficient has turned a negative cash flow situation positive and the long term prospects for the Company are brighter. At this point, the Company has the ability to negotiate out-of-court settlements with its creditors.
The bankruptcy attorney, the Company, and the turnaround professional work together to negotiate with creditors. There are typically two stages to these negotiations, which also mirror the stages of the business plan. The most important negotiation obviously is with the bank; they typically hold a lien on assets, and therefore, the bank has the ability to foreclose. Contemporaneously with this process, the Company should contact its unsecured trade creditors. First, we will discuss how to approach the bank and then the trade creditors.
First Stage Bank Negotiations
Assuming the Company has identified its problems early in the process, the bank is probably not aware that a crisis exists. The worst thing the Company can do under these circumstances is attempt to continue to hide the crisis from the banker. Rather, the Company must go to the banker and disclose the nature of the crisis and provide a plan for resolving it. This is perhaps the hardest principal for most companies experiencing financial difficulty to accept. The Company almost always believes that the bank will take immediate action to liquidate its collateral. This is almost never the case since the bank really does not want to own the collateral. Also, the bank is often impressed with the honesty and integrity of the Company in bringing the problem to its attention.
Banks are not strangers to financial difficulties. Negotiations are even more effective if the Company has already hired a turnaround consultant who has reviewed the business operation and developed a plausible plan to stabilize the situation. Ideally, the meeting with the bank should be with the Company, the turnaround consultant, and the bankruptcy attorney. The Company should let the banker know that an attorney will attend the meeting, so the banker will know to invite his bankruptcy attorney. The knowledge that an attorney will attend the meeting telegraphs and prepares the banker to expect a problem.
Volunteer Complete Access to Company Records
In the wake of Enron and other corporate fraud, bankers are often suspicious and may believe their borrowers are bleeding money out of the company inappropriately. The best way to combat this problem is to volunteer to provide the banker and/or its auditors with complete access to company records.
Circumstances: Liquidation or Continue Operations
The negotiations with the bank are going to depend on the facts and circumstances of each case. They can run the gamut from a simple request to waive a covenant default or a total forbearance. This depends on the cash flow situation and whether or not the Company has decided to liquidate. If the Company has decided to liquidate, then the banker will want to know the nature of the program for selling the assets, the costs of sale, and how the proceeds of the collateral will be transmitted to the bank. If the Company has decided to continue operations, then it will usually request some form of relief on debt service.
The forms of relief can be a total cessation of debt service for a short period of time while operations are being stabilized. Or it can be an agreement to pay interest only for a certain period. Assuming the Company is honest and has a reasonable business plan, it is a virtual certainty that the bank will enter into an agreement.
First Stage Trade Creditor Negotiations
The negotiations with trade creditors are less involved. This is because they ordinarily do not hold liens and the consequent power to shut down operations. Typically, the Company will create two lists of creditors.
The first list will consist of non-critical vendors. These creditors will be sent a letter requesting a standstill for at least 60 days. Ordinarily, no further credit will be extended by these creditors and the Company will only be able to do additional business with them on a COD basis. In this letter, the Company (or the bankruptcy attorney) will describe the extent of the financial crisis and the steps being taken to rectify the situation. If possible, the letter should include recent financial statements. The concluding sentence should promise to get back to the creditors before the end of the standstill period. Then provide a report and/or an offer to settle the debt. There are several purposes for this letter.
Communication with Creditors & Vendors
First, it is simply good business practice to notify your creditors about the situation. Oftentimes, creditors with past due debts will make collection calls. Then company personnel will do any of the following:
- Duck the calls
- Promise to make payments the Company really can’t afford
- Make phony excuses
These types of responses will only make the creditors mad. Second, the flow of information to the trade creditors will have virtually the same impact as providing information to the bank. That is, most trade creditors will agree to the standstill as an alternative to litigation. Obviously, the purpose of this effort is to avoid the cost and expense of litigation. Moreover, if a creditor obtains a judgment, then it can force the Company to file for bankruptcy, thereby defeating the entire purpose of an out-of-court settlement.
Critical vendors (i.e. those absolutely necessary for the business to survive) must be dealt with separately. In essence, keep these debts current. If the Company cannot keep them current, then it must figure out a way to do business with these vendors on a COD basis.
Equipment lessors are often the most difficult set of creditors to deal with. In the situation where the Company has leased equipment not being used, notify the leasing companies and invite them to repossess. Oftentimes, the equipment lessor will ignore these letters, and they will continue to demand payment. On at least one occasion we have sold equipment and given the proceeds to the equipment lessor who absolutely refused to repossess. If the equipment is being used in the business, then the Company should make the payments if possible or try to reschedule them.
Second Stage Negotiations
Once again, these are going to depend on the circumstances. In a reorganization, the best case scenario is that the business has turned around and is now in a position to propose a restructure or refinance of its bank debt. Here again, turnaround professionals can provide assistance in presenting refinancing requests to asset based lenders, factors or investors. These individuals are typically less risk averse than banks. Furthermore, mail a second letter to trade creditors offering either of the following:
- A discounted cash settlement assuming funds are available
- A payout of a larger percentage over time
Most trade creditors will accept a deeply discounted cash option rather than litigating or waiting for a larger payout over time. This is usually a good decision. We have negotiated many such settlements in the range of ten to twenty cents on the dollar.
If the business has not turned around sufficiently to proceed in this manner, then the Company should meet with the bank again to discuss the process and request an additional extension of time. Make a similar request to the trade creditors.
In a liquidation, the Company should meet with the bank periodically to report on the status of the sale of assets. Issue similar reports to trade vendors. Sometimes, trade vendors demand to be paid something immediately. The parties must note that once the Company is in default under a secured bank loan, the diversion of collateral proceeds to third parties without bank consent is actually a crime. This crime is Hindering Secured Creditors. It is a felony if the amount involved exceeds $1500. See Texas Penal Code §32.33. It is extremely rare for a bank to consent to such payments. Use this little known fact to dissuade trade creditors from taking collection action.
Assuming a Company is honest and trying to fulfill its fiduciary duty to creditors, then an out-of-court workout will produce a higher return to creditors and a quicker payout than a bankruptcy filing. The parties can tell if a company is honest if it provides information upon request and access to records. When you employ a competent and independent turnaround consultant, you greatly improve the likelihood of a successful outcome. Of course, a single creditor can interrupt the process by filing suit and obtaining a judgment. Such a creditor may think that it is jumping ahead of the crowd and gaining leverage to achieve a higher settlement. In most instances, this is faulty logic for several reasons.
Reasons for Faulty Logic
First, if the Company files for bankruptcy, the creditor will forgo the opportunity to be paid out-of-court. Assuming all circumstances are equal, the return will be reduced by the amount of professional fees paid to exit bankruptcy. Second, if the creditor is paid a higher percentage than other creditors, then the additional amount ordinarily is not enough to cover the legal fees the creditor must pay for the collection work. Third, if the Company ends up filing bankruptcy within 90 days, then the payment is subject to being recovered as preference. In most instances, it makes more sense to work with a Company in financial trouble (debt restructuring) than to file suit.
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