VideoWhat's more, a company's P&L might belie the fact that the business is on the runway to bankruptcy. When Lindenmuth was hired by Amcast Industrial Corp., a manufacturer of aluminum wheels for cars, after the company emerged from Chapter 11, the near-term financials looked stable. But the auto industry grants parts contracts two years in advance, and during Amcast's period of distress, carmakers hadn't awarded it parts contracts for their new models. So the order pipeline was set to evaporate in a year's time. "[Were we] right then in the zone of insolvency?" asks Lindenmuth. "Sometimes you can look far ahead [to bankruptcy], other times it's sudden." Amcast eventually liquidated.
Dealing with Denial
Once management determines insolvency to be an issue, it should test for it regularly, says BDO's Lenhart. But it isn't just the numbers that trigger the expansion of fiduciary duties. If a company hires a workout firm, an investment banker, or an attorney because of its lack of liquidity, "it needs to be prudent about its practices from that point," says Sheila Smith, a principal at Deloitte Financial Advisory Services.
Rallying management around this necessity is not easy. CEOs and even boards dwell in denial, and many third parties have an interest in keeping a company operating as long as possible. Otto Kubik, who provides CFO support services, has never had to raise the specter of insolvency to a CEO. "But I have had to present bad news of far lesser impact," he says. "Uniformly, this was greeted with negative, dismissive, and sometimes personally hostile reactions."
Last year, Kubik was offered a job at a $200 million (in revenues), privately held recreational vehicle manufacturer. The CPA firm interviewing Kubik told him the company had a robust line of credit and just needed timelier financial reporting and tightened internal controls. At the other end of the building, though, a bank's workout team was poring over the books. After receiving a copy of the financials, Kubik discovered that the company "had died quite some time ago."
It's not the CFO's role to declare that a company is in the zone of insolvency, but rather to report that financial risks are elevated. "The board members have to be advised," Lindenmuth says. "But you're not a legal person. You present the financial statements, the obligations, the cash flow; you point out the substantial risk of busting covenants on loan agreements and delaying payments to vendors. You present the side of the story that is worst-case."
The attorneys have the job of informing the board that the company is in the zone and that decision-making therefore requires a new filter — the interests of creditors as well as shareholders. CFOs must incorporate the filter into all decisions going forward.
Staying Short
Fortunately, much of what's legally prudent fits with what is financially so. Since part of the battle now is to preserve assets, it's time to shorten up, say experts. Purchase inventory and pay bills in smaller increments, for example, and don't make long-term buying commitments. Pull back capital investments, too.
"Changing the culture of a troubled business is a challenge," says Doug Laux, CFO of $1.2 billion auto-parts supplier Remy International. Remy filed for Chapter 11 in 2007 and closed 14 facilities worldwide, ripping costs out of the business. "If you don't know you can make payroll in three months, you have to pull the horizon shorter," says Laux, who has been at the helm of other turnarounds besides Remy.
Conserving cash doesn't rule out new borrowing. For example, Deloitte's Smith ran a building-materials business that was highly seasonal. Lead times for purchasing inventory were long. When the company faltered, she was required to post standby letters of credit to get suppliers to ship lumber, which further dried up liquidity. "We had to borrow money to buy inventory to create sales," says Smith. "That was OK, because buying lumber was a critical commodity for harnessing the business and driving sales."
In the past two years, the Delaware courts have ruled that management can increase leverage when a company is insolvent, modifying decisions judges made earlier in this decade. Those decisions held that officers could be sued for "deepening insolvency" — the "fraudulent expansion of corporate debt and [the] prolongation of corporate life." Now, however, the fact that management drove a firm deeper in the red by borrowing is not a valid cause of action for creditors.
Whether creditors will allow a company to continue borrowing when it is already bleeding capital is another matter. Banks are clamping down on the growth plans of cash-strapped firms, especially if covenant violations loom. Casino operator MGM Mirage got a reprieve from its banks last March, but it came with a $300 million cut in borrowing capacity, a prohibition against incurring a material amount of debt, and a dollar limit on new investments in CityCenter, MGM's unfinished luxury residential complex in Las Vegas.
When confronted with major decisions on assets — the sale of a division, for example — management of a near-insolvent company needs solvency and fairness opinions from a third party, says Tim Cummins, a managing director at Stout Risius Ross. Creditors could accuse management of not obtaining a market-clearing price, and an opinion provides some defense. In a bankruptcy court, a below-market price could translate into a fraudulent conveyance — a transfer done with the intent of moving the asset outside creditors' reach.
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