To file or not to file for bankruptcy? It’s a question that no business leader wants to consider, but sometimes it’s necessary. Indeed, given the challenges and uncertainties of the last 16 months, it has been a top-of-mind issue for many companies across different economic sectors.
In 2020, according to data from Epiq AACER, Chapter 11 corporate bankruptcies increased 29% over 2019. Filings are down a bit in 2021, as a resurgent economy, fiscal stimulus, low interest rates, and ample private capital have helped companies remain solvent.
Nonetheless, even when there are macroeconomic tailwinds, there are still discrete forces — such as unmanageable debt, supply chain disruptions, or bad litigation outcomes — that can push individual companies to the brink of insolvency.
Accordingly, businesses will continue to seek protection under Chapter 11 of the U.S. Bankruptcy Code to shed debt and emerge as leaner, more profitable companies. More small businesses are also getting into the restructuring mix, as Congress, pursuant to the CARES Act, increased the debt levels under the Small Business Restructuring Act (SBRA), thereby making more small businesses eligible for the SBRA’s streamlined Chapter 11 process.
However, despite the ongoing need for large businesses to seek bankruptcy protection, and Congress’s efforts to make Chapter 11 bankruptcy protection more widely available to small businesses, bankruptcy courts are not the right option for every struggling business.
Other restructuring options, such as a receivership or assignment for the benefit of creditors, may be more appropriate given a company’s circumstances.
And, in some cases, a company can restructure its debts without availing itself of any statutorily authorized, court-supervised process. Under the right circumstances, an out-of-court restructuring is the best bet for an efficient, less costly process.
When Chapter 11 is the Right Option
Typically, companies that seek to restructure under Chapter 11 share specific characteristics.
- A company is a good candidate for Chapter 11 if there is a viable business that can be preserved if given some breathing space from creditor collection activity. Any debtor who has assets with significant equity that will be lost to repossession or foreclosure may also benefit from Chapter 11.
- Some businesses choose to make a quick trip through Chapter 11 for the specific purpose of selling assets in a transaction under Section 363 of the Bankruptcy Code (called a 363 sale). Such transactions are done in bankruptcy to shed debt and burdensome contracts and transfer assets to a buyer free and clear of claims. The debtor’s remaining assets and creditor claims are then dealt with in bankruptcy.
- In addition, most debtors cannot rely on cash flow alone to get through a Chapter 11 bankruptcy, even if a company is aggressively cutting operational costs during the process. Accordingly, in almost all cases of any size, access to debtor-in-possession (“DIP”) financing is a necessity for a Chapter 11 debtor.
- In bankruptcy, certain parties in interest, such as a creditors’ committee and the U.S. trustee, are granted broad investigatory rights related to a Chapter 11 debtor. Therefore, bankruptcy can be a good option if a debtor has few concerns about scrutiny of its books and transactions.
One of the primary advantages of Chapter 11 bankruptcy is that it can provide comprehensive debt relief and a court-approved fresh start. But that comes at a cost, and it’s not the only restructuring option.
Practicalities and Benefits
There are two primary ways for a company to execute an out-of-court restructuring.
The first is called a creditor composition, which is an agreement between a debtor and its creditors. In such an arrangement, the creditors must also agree among themselves. A composition is structured so that all, or substantially all, of a debtor’s creditors agree to forebear from taking legal action to collect debts they are owed in exchange for agreed-upon payments from the debtor. Often, creditors will agree to a reduction of the amount of the debts they are owed, installment payments of debts over time, or some combination thereof.
In exchange for creditors’ forbearance from bringing suit, a debtor typically is required to make other concessions, such as providing financial reporting, limiting executive compensation, and agreeing not to dispose of assets.
The benefit to creditors of a composition agreement is that, in theory, it will prevent a race to the courthouse among creditors — secured lenders and unsecured trade creditors — which could push the debtor into bankruptcy. In bankruptcy, trade creditor recoveries may be far less than what is agreed to in a composition agreement. Accordingly, a composition agreement requires widespread — close to unanimous — participation among creditors, which can be hard to achieve.
The second type of out-of-court restructuring involves only a debtor’s lenders. Because it is difficult to obtain the agreement of nearly all creditors to execute a composition agreement, a common alternative is to work out an agreement with only the debtor’s financial creditors, such as its bank lenders.
In such a “workout agreement,” the lenders may agree to defer payments, extend the repayment timeline, or reduce the amount of indebtedness owed by the debtor, among other concessions. Typically, a debtor will be required to affirm its debts, provide additional collateral, and agree to more stringent financial reporting.
For a debtor, an out-of-court restructuring has certain advantages over a Chapter 11 bankruptcy. It can be a good option if a debtor has a manageable number of cooperative creditors. It will almost certainly be a faster and less costly process than a court-supervised bankruptcy case. And it can shield a company’s board of directors, executive officers, and lenders from the scrutiny — and potential lawsuits — that Chapter 11 may precipitate.
Thinking Through the Options
When a company is faced with high levels of debt and the threat of insolvency, it has several options. While there are many reasons why Chapter 11 bankruptcy might be a good option, there are countervailing reasons why it should be avoided. There are other restructuring alternatives, such as a receivership or assignment for the benefit of creditors, that may be more appropriate given a company’s circumstances. In certain instances, an out-of-court restructuring is the best path forward. Because there are many alternatives, each with its advantages and disadvantages, it is important to consider the implications with experienced legal counsel and financial advisers.
Although no company is excited about the prospect of executing a financial restructuring, struggling companies must be realistic about their prospects and proactive about taking steps to ensure their survival and get back on the path toward long-term success.