This article provides a fundamental understanding of when to use the “bankruptcy tool” and when it is best for owners and management to work with creditors outside of bankruptcy to address the company’s turnaround and liquidity needs. The bankruptcy code is a complicated set of laws and we suggest that you seek professional guidance on your options.
It is not unusual for a company to hit a rough patch. Companies can falter for any number of reasons, including recessions or industry cycles, loss of a large customer, an unexpected loss of key assets, borrowing too much money for growth, or simply experiencing a time when operating expenses are more than their revenue can cover. The typical life cycle for a company is depicted in the chart on the right.
When a company enters a decline, management must evaluate what is causing the decline and determine how to address the situation. One tool that exists for the company is a bankruptcy filing.
This article will help distinguish when to use the “bankruptcy tool” and when it is best to try to work with creditors outside of court to address the company’s turnaround and liquidity needs.
The longer a company languishes in decline, the more its number of options diminishes. Therefore, it benefits all stakeholders to address issues early. In addition, “hoping things will turn around” is not a solution. There is an old saying amongst restructuring professionals: “Hope is a town in Arkansas, not a plan.” Nothing ever works out exactly like you hope or want it to. This statement, and similar ones, has been used by Anderson Cooper, President Obama, James Cameron, and Rudy Giuliani to prove that you must plan for the situation or you are doomed to fail. It is clear that when a business hits a decline, it must plan for how to protect itself and prepare to accomplish a recovery to ensure a rebirth, as shown in the graphic on the previous page.
Executing a plan often requires creditors to participate in a loan restructure, to extend payment terms, or to renegotiate contractual obligations. This can often be done out of court, but there are many times when a filing will improve the company’s chance of success.
Typically, a bankruptcy filing is done to accomplish one of the following:
- To protect assets from creditor actions such as foreclosure, losses in litigation, or contract terminations
- To facilitate a transfer of ownership, such as a conversion of debt into equity or a sale of the business
- To gain breathing room to execute an operational turnaround or to deal with a short-term liquidity crisis
- To obtain financing when lenders may be more willing to provide new money to a financially distressed company in bankruptcy rather than outside of bankruptcy
- To facilitate a wind down and liquidation
Before filing for bankruptcy, the company should determine what outcome it wishes to accomplish. Then, the company’s management must develop a cohesive work plan that supports the outcome, keeping in mind that they must weigh what is best for all the stakeholders of the company, not just the equity. This adds a degree of complexity to the planning. With this added complexity, the outcome is often enhanced by independent advice from a restructuring advisor. To facilitate a “soft landing,” it is best for the company to do some preparation, including:
- Preparation of a cash forecast that has appropriate and realistic assumptions related to a bankruptcy. One example is that all amounts owed prior to the bankruptcy will not be paid without a court order and, on the other hand, vendors may require cash up front. There are many such examples that must be included in the forecast. It is helpful to have some advice on what can happen in a bankruptcy that would impact the company’s cash balances.
- Preparation of first day orders that will help the company operate seamlessly during bankruptcy, including orders that allow the company to pay employees, utilize bank accounts, use cash collateral to fund daily operations, and address payments to critical vendors.
- Preparation for litigation over motions for orders that will be heard during the first few weeks of a case, such as use of cash collateral, requests to lift the automatic stay, and valuation fights to determine if interest or adequate protection payments will be required during the case.
- Preparation of the message that will be delivered to the lenders, trade vendors, employees, and customers, and how that message will be communicated.
- Preparation of a longer-term work plan that sets out critical milestones that must be achieved for the plan to be successful. For example, if the sale of the company or a division is planned to facilitate a restructuring, then you might need to hire an investment banker, market the property, and hold an auction. If cash flow will only support three months to accomplish this process, the timeline must be planned very carefully with the end date in mind.
It is important to know if the company is solvent or insolvent. If the company is solvent and out of bankruptcy, officers and directors have a responsibility to make decisions that benefit equity holders. After a filing, regardless of the solvency of the company, directors’ and officers’ obligations are to all stakeholders; equity’s best interests no longer control decision-making. Thus, it is important that before filing for bankruptcy, company management carefully weigh the potential ramifications for the company.
From a practical point of view, bankruptcies are expensive and each situation has a number of parties that will influence the outcome. The company will end up paying for its professionals, the bank’s professionals, and an unsecured creditor’s committee’s professionals.
All parties of interest will have input in the bankruptcy process. Anything outside of the ordinary course of business will require approval from the court and each party will evaluate it and have the chance to object. In a typical situation, accomplishing a restructure in bankruptcy naturally takes longer than an out-of-court restructuring. This is due to the time it takes to negotiate with all of the classes of creditors on top of the time it takes to obtain court approval.
While each situation is unique and must be evaluated on its own merits, there are generally different advantages from a bankruptcy versus an out-of-court restructure. It is clear that the company’s management should plan for the desired outcome, using the method that helps them accomplish their turnaround goals. The chart below summarizes some of those advantages.
As the company’s management evaluates options, it is important to determine the best course for the company. These advantages may vary based on individual circumstances. The bankruptcy code is a complicated set of laws, and we suggest that you seek professional guidance, as appropriate, based on the particular situation.