Going back in time, in the middle market business world of insolvency practice, honest hard-working owners of companies that were over-leveraged but financially viable had tools available for restructuring the business while maintaining ownership. This was done in bankruptcy through a plan of reorganization or through an out-of-court restructuring with an agreement with the creditors.

Regardless of whether done in or out of court, the concept was to create a “restructuring plan” to enable the company to maintain operations while making payments over a period of time. Banks, which would not otherwise receive as much recovery on their loans through a sale or liquidation, were able and willing to negotiate a restructuring plan. To accomplish this, debt restructurings were based upon realistic financial projections and a subsequent plan designed to pay creditors back on a fair and equitable basis over a future timeframe of typically three to five years.

Dan Dooley

The restructuring plan accomplished these objectives by providing a realistic probability of 1). the secured creditor getting paid back in full or at least far more than it would in liquidation or sale; 2). the unsecured creditors getting a higher recovery than in liquidation or sale, where they typically get 10% or less in recovery; 3). trade creditors maintaining a profitable future customer relationship; and 4). the owner retaining ownership and control of the business with the reasonable opportunity to regain equity value over time.

These options were consistent with laudable goals of the Bankruptcy Code, enacted in 1978, to provide financially distressed companies and their honest, hard-working owners a second chance to rehabilitate their business for the overall good of their creditors and the U.S. economy, as opposed to a liquidation or a sale of assets at far reduced values.

What Changed?

Three primary things have changed that dramatically affected the practical ability to rehabilitate companies through a restructuring plan. The first change was that certain court cases interpreting the “absolute priority rule,” which specifies the order of payment priority to creditors of a business in bankruptcy, created significant barriers for owners to retain their ownership interests. These court decisions determined that “sweat equity” in the form of future services of the owner was not the same as new cash. This meant that to exit bankruptcy via a restructuring plan, a company had to be fully exposed to the market to determine the market value of the business.

The current owner could only use new cash at the market price to maintain ownership through a restructuring plan or sale. (See Sav. Assn. v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999)). As a practical matter, without competitive cash for the assets, the owners could not get a second chance or a fresh start through debt restructuring and business rehabilitation by using bankruptcy anymore. Instead, owners of smaller or moderate size middle-market companies, knowing that it was unlikely they could retain any owner interest, chose to (or were forced to) sell or liquidate the company’s assets. They often chose to do so out-of-court rather than go through the personal stress associated with a bankruptcy process only to exit with no ownership in the company.

Sheryl L. Toby

The second major change was that U.S. banking regulations dramatically changed, causing banks to be penalized economically for holding onto loans for financially distressed companies for longer periods of time. Bank stock prices were penalized if banks held higher levels of debt from financially distressed companies, often referred to as non-performing assets. These two forces disincentivized banks from participating in viable restructuring plans, even if the bank’s ultimate recovery on the loan would exceed the amount to be received through a liquidation or asset sale.

Therefore, today, it is rarely in a commercial bank’s best interest to participate in a multi-year loan restructuring plan, even if that loan workout program leads to a superior financial recovery for the bank. Finally, the cost of bankruptcy increased dramatically in terms of professional fees and special priority payment status given to certain kinds of creditors (who successfully lobbied Congress for changes to the bankruptcy code). As a result, today’s middle-market bankruptcy process is almost solely used to sell company assets as a going concern or to liquidate the business.

A Better Solution?

On the heels of the coronavirus pandemic, the insolvency community (bankruptcy attorneys, financial advisers, and investment bankers), commercial banks, and governmental agencies/bank regulators need to consider “going back to the future” and reimplementing restructuring plans as a means to guide these viable companies back to health. If we treat the pending aftermath of this pandemic on U.S. businesses in the standard manner, a huge number of businesses are going to be destroyed and forever shut down by the economic impact of stay-at-home orders. Even when the U.S. economy is re-opened and those orders lifted, there will be unprecedented financial distress in the process of getting businesses back up and running, as many businesses will have insufficient access to cash to rehire employees and pay for goods and services.

Many companies will need an extended period of time to repay suppliers, landlords, service providers, and other unsecured creditors, because many companies do not have access to cash despite the well-intentioned help of paycheck protection loans. They won’t be able to simply go back to business as usual. There is great uncertainty about 1). when U.S. businesses will be allowed to restart by state governments; 2). whether the pandemic will return a second time as it has in several countries and force a second government-mandated business shutdown; 3). how fast it will take for businesses to ramp up to a stable state; and 4). what stable sales volume will be compared with the sales volume when the business had to shut down. The bottom line is that until the U.S. economy has been restarted and we have a month or two of actual experience, no one can predict with any accuracy how much sales volume any business will have.

Complicating matters will be that the credit risk profiles of many of a company’s customers have now gotten a lot worse and so trade credit will likely become much tighter post-pandemic. Despite tighter credit, bad debt losses will significantly increase as many more businesses continue to fail. Finally, liquidation recoveries and going concern sale values are certain to go down as they do in every recession. So many companies: 1). are cash poor or soon will be cash poor; 2). will have a hard time mustering the cash necessary to rehire people and pay for goods and services; 3). will restart their business with no good understanding of how much sales volume they will generate; 4). will have an inclination to tighten credit terms with their customers; 5). will have reduced valuations and; 6). will expect to experience much higher bad debt losses.

The U.S. bankruptcy system has many good attributes, but no one describes the current U.S. bankruptcy system as either fast or cheap.

It sounds like an incredible mess, doesn’t it?

Many of these companies are going to need debt restructurings done fast and cheap. The U.S. bankruptcy system has many good attributes, but no one describes the current U.S. bankruptcy system as either fast or cheap.

Alternative options include having financially challenged small and midsize companies (as an example, those with under $20 million of secured debt with a relatively simple debt structure) use bankruptcy alternatives such as those identified below. The key to all of these methods is to have an objective third-party financial adviser put together realistic multi-year financial projections for the distressed business. It is critical that business owners seek outside help. An experienced skilled financial professional who is also objective adds credibility in the eyes of the creditor base.

A sample plan (albeit each case is different) would be to use, for example, 75% of free cash flow produced by the company to provide pro-rata distributions to unsecured creditors payable twice a year. Unsecured creditor debt would be frozen as a non-interest-bearing note and set aside in an unsecured creditors pool. Free cash flow would be defined as net income less capital expenditures and less “scheduled” bank debt principal payments. After the term of the plan (typically three to five years), any unpaid unsecured creditors pool balance would be forgiven. The following are venues to accomplish this tactic outside of filing bankruptcy:

  1. Out-of-Court Debt Composition Plan. This venue assumes that you can get at least 90%, for example, of your unsecured creditors by claim amount to consent to an unsecured creditors’ composition plan. You will need a written plan with projections and projected payments to the unsecured creditors’ pool to share with all creditors and you need to have each unsecured creditor vote and agree to be bound if the debt composition plan achieves a chosen voting threshold (90% in this example).
  2. State Court Receivership or State Assignment for Benefit of Creditors (ABC). This is the same as the debt composition plan, but it’s done in state court if it is a receivership. An ABC is either a state court process or a common-law process depending on the laws and practice of the specific state involved. These processes work well if all the major creditors are within the state borders of the company or consent to the process. Having a court process gives the unsecured creditors even more comfort that the debt composition process is fair and objective and not a sham.
  3. Federal Court Receivership. This is essentially the same as a state court receivership and ABC. The difference is that a federal process can bind parties across state borders. So, this is the most powerful tool short of a bankruptcy process. However, it requires that the company be domiciled in a different state than the secured lender to satisfy the federal diversity standard.

If we want to save U.S. businesses by restructuring their debts, then we need to use the above three bankruptcy alternatives in the middle market and not the bankruptcy process. These alternatives offer the advantages of lower cost, greater speed, and the ability of the owner to get a second chance.

However, bankruptcy alternatives can only work to provide the company and the owner a second chance if both the owner and the bank as secured lender work cooperatively for the long-term benefit of all parties.

Dan Dooley is CEO of MorrisAnderson, a financial advisory consultancy located in Chicago. Sheryl L. Toby is business services member at Dykema Gossett PLLC, located in one of the firm’s metro-Detroit offices.

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One response to “Saving Midmarket, Closely Held Companies With Traditional Workouts”

  1. Not sure I understand your version of Free Cash Flow. I understand applying scheduled principal payments (since you are using Net Income as a start). However, it appears that you will be deducting both depreciation and capital expenditures (capex)…..causing a “double-dip” on capital investment. Perhaps, you should use EBITDA less (capex, P&I on scheduled debt and any other interest expense) to arrive at a Free Cash Flow number to distribute.

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