Chapter 11 and Out of Court Restructuring as Alternative Strategies

In this article, we consider two alternative strategies to secure the future of your business: Chapter 11 bankruptcy and out of court restructuring.

Some businesses may not be impacted by COVID-19, a number may benefit, but most will face serious challenges through the imminent recession triggered by COVID-19.

The US economy came into this crisis burdened by $10 trillion of inexpensive corporate debt.  While many companies entered this COVID-19 crisis with a stronger balance sheet than in 2008, there are many privately held companies that are over-leveraged.  Consolidation and bankruptcies in many industries is inevitable.  So, what does this mean for your business?

Maintaining liquidity (cash) through uncertain times is critical.  If your cash flow forecast shows a liquidity crisis within the next 90 days, you may want to consider a couple of strategies.  We will consider these strategies in reference to three types of creditors (unsecured vendors, landlords and banks), each with unique characteristics.

Note: If your total liquidated debts (liabilities) are less than $7.5 Million, you are likely eligible as a small business debtor under the SBRA 2019 (Small Business Financial Restructuring Act), which was passed in 2019 and recently expanded under the CARES Act for a limited 12 month period. Watch for our follow up article next week on the Small Business Financial Restructuring Act and a subchapter V filing.

 Unsecured vendors

 As a business owner, you have room to negotiate with vendors.  Chapter 11 bankruptcy or a lawsuit claim are both unfavorable scenarios for most vendors, so they may be more willing to compromise than other creditors.

Vendors with AP outstanding have a claim they can pursue through litigation, but the court system is costly and moves slowly.  In Chapter 11, it is worse for unsecured vendors, because all other creditors are ahead of them in liquidation preference.  According to Section 507 of the Bankruptcy Code, secured creditors (including secured bondholders) get first priority, next in line are unsecured creditors, but not before the administrative and professional service costs of liquidation are paid in full.  Next, employee claims for wages, services and benefits plan contributions, prepetition taxes due, any amounts owed to secured creditors in excess of the value of their security. Then, and only then, is the first dollar paid to unsecured vendors.  Most importantly, every tier in the above liquidation preference is paid in full before the next tier receives their first dollar.

In both litigation and Chapter 11, an unsecured vendor has a low likelihood of repayment, so there is an opportunity to negotiate down amounts outstanding through out of court restructuring.  On many occasions, we have been tasked with out of court restructuring and negotiating with creditors, which achieves many of the same objectives as Chapter 11 bankruptcy, but with far lower costs and a higher likelihood of at least partial repayment to most creditors.  Plus, you exit the restructuring process more quickly with a viable operating business.

Landlords:  In the current environment, many landlords will anticipate a likelihood of tenant default, which may better position the business (tenant) in negotiations and concessions.  Early notice to the landlord is important. Communication should include pro-actively disclosing business challenges and cost-cutting measures already in place, advising a restructuring is underway, and a proposal for rent compromises which may include deferral, abatement or new terms entirely.  A landlord has greater remedies than an unsecured vendor, but state courts will likely be slow in processing landlord eviction actions in this environment.  In many instances, negotiating with an existing tenant is preferable for a landlord than pursuing eviction and being left with an empty space that may be difficult to lease in a recession.  If the property is attractive and sought after by other tenants, the advantage goes to the landlord.  In a chapter 11 case, the tenant has 120 days to accept the lease or vacate the premises.  In either event, the rent must be paid during the bankruptcy case.  If the lease is rejected by the tenant as a part of the bankruptcy reorganization plan and the premises are vacated, then any unpaid (pre-bankruptcy) rent becomes a bankruptcy claim.

Banks:  Regulators have advised banks to work with borrowers and negotiate reasonable resolutions, rather than force foreclosure.  While banks are in a senior secured position, banks do not want to proceed down the foreclosure path either.  Bankers understand businesses are in a truly unforeseen environment.  Bankers want to support business on the path to recovery.  Companies need to help their bankers help them.

Chapter 11 Bankruptcy

Chapter 11 is a form of bankruptcy that allow companies to reorganize and restructure with bankruptcy court protections and supervision.  These protections are in place for the debtor company but also the lenders and creditors.  Chapter 11 is complex, time and energy consuming, and costly.

Chapter 11 advantages include:

  • You are protected against aggressive creditors by an automatic stay;
  • You have the right to present the first reorganization plan versus creditors presenting their plan for your company (this is different under the SBRA and Subchapter V – see next week’s article);
  • You are granted adequate time to reorganize the company;
  • Debt can be discharged within the Chapter 11 rules;
  • The reorganization plan will include a repayment of liabilities over a longer period.

In a Chapter 11 case, the plan and actions are to be determined for the benefit of the creditors, not necessarily for the business owner’s equity stake.  Additionally, the litmus test for the Chapter 11 plan is that creditors will ultimately receive more than they otherwise would in a liquidation of assets.

Out of Court Restructuring

This alternative to bankruptcy allows the company to negotiate with lenders and creditors to develop an agreeable plan to restructure and satisfy the company’s debt and obligations over time, also referred to as a “workout”.

Out of Court Restructuring advantages include:

  • Avoid the supervision and costs of the court system;
  • Renegotiate debts to pay them over time and within the business’ ability to pay them;
  • Enter into a standstill situation to prevent enforcement action;
  • Reset your business model to improve your company’s profitability;
  • Sell some assets, branch operations or divisions to raise cash;
  • Gain replacement debt with new lenders;
  • You still have the opportunity to file for bankruptcy at a later date.

With either strategy, Chapter 11 or Out of Court Restructuring, we recommend gaining the assistance of a skilled and experienced team.  The team includes experienced bankruptcy counsel, restructuring professionals, and likely investment bankers.

 The key message is that you have many options available in times of a cash crisis.  Our experience tells us that acting early and decisively gives you the most options.

We are here to help.

Note:  Bankruptcy is a complicated process.  Nothing contained herein should be construed as legal advice. ClearRidge is outlining topics for business owners to consider in their business continuity and survival strategies for information purposes only.  ClearRidge will work in a coordinated effort with experienced bankruptcy counsel to plan the most effective options and outcomes for you in an out of court restructuring or bankruptcy process.