As the United States and much of the world reel from the coronavirus pandemic, many businesses’ revenues have been shut off (or close to it). Employees must stay home, and customers are holding back payments. Companies looking to make it out of these dark times need to remember a few things.
Avoiding running out of cash and preserving liquidity is a top goal. There are a few related questions, including whether vendors will give better terms for purchases until businesses can recover. Additionally, banks, vendors, and landlords expect timely payments.
For many companies, the questions are who to pay, how slow or fast to do it, and in what pecking order. Negotiating with all stakeholders is imperative, and it starts by looking at the likely worst-case outcomes for each party. Chapter 11 can be a valuable restructuring tool, but it can be costly for all stakeholders.
Unsecured creditors. For unsecured creditors (vendors), the alternative to working cooperatively with companies is litigation. Today, in any state court, cases will move at a snail’s pace. Vendors will spend valuable dollars on legal fees but may not see a recovery until long after the debtor would have paid them under a compromise. That means vendors are better off permitting the debtor to term-out payments.
Further, in Chapter 11, the recovery to unsecured creditors likely will be less after accounting for Chapter 11 costs, the delay in payment caused by Chapter 11, the relatively low success rate in Chapter 11, and the associated devaluation of the debtor’s assets.
Landlords and tenants. Second only to employee costs for many service providers is rent. Astute landlords likely anticipate tenants withholding rent, but tenants must be proactive — and notify the landlord of predicaments and intentions. The landlord will remind tenants that it has debt-service obligations, insurance, and taxes to pay.
Tenants should advise the landlord of all measures taken to reduce costs. The landlord does not want to shoulder the entire burden, and they may threaten to exercise default remedies and lease termination. But state courts during the pandemic (and during recessions) are unlikely to process landlord/tenant actions quickly.
In addition, building and property owners will be hard-pressed to rent vacant space in a recessionary economy — which means they will not want to lose tenants. Re-renting to new tenants (if available) will cost the owner concessions, to say nothing of having an empty space for an unknown period. Vacant space causes other problems, especially in shopping centers where co-tenancy clauses can enable other tenants to escape leases due to vacancy thresholds being exceeded.
Banks and borrowers. Banks have been advised by regulators to work with borrowers toward out-of-court consensual resolutions of the borrowers’ cash-flow difficulties caused by the pandemic. Banks can declare a default, and that can result in the need to seek relief under Chapter 11 of the bankruptcy code. But, at the moment, the bankruptcy court may be an unfriendly place for impatient lenders.
The bankruptcy court will consider whether the lender’s collateral is eroding during the pendency of Chapter 11 and what the lender’s alternatives are if the bankruptcy court grants the lender relief to take possession of its collateral. Even if the lender’s collateral is declining in value, would it decline more if the bank is granted relief? Does the lender want to win its motion, or is the lender seeking just to improve its position?
A debtor can commence Chapter 11 without the lender’s approval and without the agreement of the lender to provide financing during the proceeding. The debtor also can seek court permission to use cash collateral (cash proceeds of collections from accounts receivable) over the lender’s opposition. The debtor must develop a budget reflecting its ability to operate only on cash collateral proceeds.
Additionally, secured lenders must be cautious about asserting that they are under-secured, and that assertion does not necessarily translate to bankruptcy court relief. No prudent lender wants to go on record at the beginning of a Chapter 11 case as to the value of its collateral, as it may come back to haunt the lender at the end of the case. Technically, a secured lender may be paid only the value of its claim. Further, under the U.S. bankruptcy code, an undersecured creditor is not entitled to post-petition interest or legal fees associated with collection.
Personal guarantees change the case dynamic because the guarantor is worried about a hostile lender pursuing the guarantee despite the corporate debtor’s reorganization. While the commencement of a Chapter 11 case does not necessarily entitle a guarantor to the protections of bankruptcy without the guarantor itself commencing a bankruptcy case, there are bankruptcy code provisions for the bankruptcy judge to enjoin actions against a guarantor under certain circumstances.
During times of a pandemic and the accompanying recession, prudent lenders should not test the willingness of these judges to extend protections to guarantors if the judges have a basis on which to believe that a successful corporate reorganization is feasible and that the guarantor will not dispose of its assets.
We can take lessons from what happened in 2008 and 2009 when bankruptcy judges were sensitive to many economic and social factors.
One such factor is job preservation. Unsecured creditors’ committees and lenders should expect the bankruptcy judge to ask, “How many employees does the debtor have?” whenever they seek to terminate the debtor’s operations. But this does not mean the judge will tolerate protracted losses or a hopeless reorganization.
Chapter 11’s long-term success rate is not high. And changes in the marketplace make reorganizations in specific industries — such as retail — particularly tricky. But few debtors will say that using the tools available in Chapter 11 is not worth it. Understandably, debtors are optimistic, especially given the typical preexisting investment of time, effort, and money.
However, Chapter 11 is expensive as there are numerous stakeholders. Each stakeholder will retain professionals. Each will seek to be paid by the debtor, meaning precious capital gets diverted from the business. Also, bankruptcy diverts management’s attention, reduces going-concern value, reduces brand (intellectual property) value, and makes normal operations more difficult — whether in attracting new sales or procuring goods on credit. Nevertheless, Chapter 11 cases often happen if creditors give the debtor no reasonable options.
It is far better for vendors, debtors, and secured lenders to develop consensual solutions. Regardless, a clear understanding of everyone’s downside paves the way to mutually beneficial compromises.
The views expressed herein are those of the author and are not necessarily shared by other persons at Lowenstein Sandler LP. Nothing contained herein is intended to be a complete statement of the applicable law. Every situation is unique. Legal interpretations may vary.
Kenneth A. Rosen leads the bankruptcy, financial reorganization, and creditors’ rights department at Lowenstein Sandler LLP.