Not Every Financially Distressed Company Should Turn to Chapter 11

Financially distressed companies will find that Chapter 11 can be expensive, slow, and involve lots of oversight and reporting requirements.
David G. DragichApril 29, 2020
Not Every Financially Distressed Company Should Turn to Chapter 11

Given the current crisis, many businesses, large and small, are struggling to stay afloat. A number of high-profile businesses have filed for bankruptcy protection in recent weeks, and a massive wave of Chapter 11 filings is almost certain to crash in the coming months. From retail to energy, hospitality to manufacturing, almost no industry has been — or will be — immune from financial distress.

Chapter 11 bankruptcy can be a useful and effective tool for business restructuring during an economic downturn. Among other benefits, Chapter 11 imposes an automatic stay on creditor collection efforts, it allows a company to reduce its debts, and it provides breathing room to make financial and operational changes that can allow for a leaner, stronger, and more nimble company to emerge. In modern-day cases, in which bankrupt companies must execute their restructuring plans within a tight timeframe, Chapter 11 also provides a venue to sell assets free and clear of creditor liens and claims.

However, Chapter 11 bankruptcy is not always the right option for a struggling business. It can be expensive, slow, and involve lots of oversight and reporting requirements. Most importantly, without adequate funding (known as debtor-in-possession, or DIP, lending) in place, and a core, fundamentally sound business to reorganize around, Chapter 11 is rarely a viable path forward.

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Companies experiencing financial distress have a number of options other than Chapter 11. One is to simply shut down and dissolve, and leave it to creditors to sort out and fight over the scraps. But that’s messy, and can often leave a company’s key stakeholders exposed to liability. A better approach for a business that must shut down, but doesn’t want to do so in an ad-hoc manner, is to utilize a process that enables it to maximize the value of its assets and restructure or wrap up its affairs, in a more organized way.

Assignment for the Benefit of Creditors

In many states, an assignment for the benefit of creditors (“ABC”) can be an effective Chapter 11 alternative. An ABC is an insolvency proceeding governed by state law rather than federal bankruptcy law. In some states, the right to pursue an ABC is rooted in the common law, in others, it’s governed by statute.

Generally speaking, in an ABC, a company (the assignor), transfers all of its rights, title, and interest in its assets to an independent fiduciary (the assignee). The assignee then liquidates the assets and distributes the net proceeds to the company’s creditors. While the process varies by state, in most jurisdictions board and shareholder approval are required to initiate an ABC. In other states, an assignee or assignor must register the ABC with a state court of appropriate jurisdiction.

So, why would a company pursue an ABC rather than Chapter 11, or even Chapter 7, bankruptcy? Some of the primary advantages of an ABC include:

  • Lower Cost. An ABC typically costs less than a Chapter 11 reorganization or Chapter 7 liquidation because there are far fewer administrative obligations involved and little to no court oversight.
  • Speed. One of the reasons ABCs cost less than other options is that the process can proceed much more quickly.
  • Flexibility. Unlike in a Chapter 7 bankruptcy or state court receivership proceeding, in an ABC the company/assignor gets to choose the fiduciary/assignee who oversees the liquidation of assets.
  • Expedited Sale Proceedings. In an ABC, there are no sale procedures equivalent to those found in Section 363 of the Bankruptcy Code, so assets can be sold quickly.
  • Less Oversight. The degree of court supervision in an ABC proceeding varies by jurisdiction (from none to some), but is always less than in bankruptcy.

While there are many advantages to ABC proceedings, they are not appropriate for every circumstance. One of the main disadvantages to ABCs is that, unlike in a bankruptcy proceeding, there is no automatic stay in place. In most receivership proceedings, the court order appointing a receiver also contains some form of the automatic stay that limits litigation against the liquidating company. Accordingly, existing lawsuits may proceed and new ones may be filed against a company pursuing an ABC.

Federal or State Court Receivership

A federal or state court receivership involves the court appointment of a receiver to oversee and, in most cases, operate or liquidate a business. A receiver is a neutral and independent third party appointed to act on behalf, and for the benefit, of all interested parties. Receiverships are often sought by secured lenders as a liquidation-alternative to bankruptcy.

A receiver’s duties and responsibilities, such as monetizing assets and distributing funds, are outlined in an order entered by the court overseeing the receivership. The receiver’s role is, in many ways, equivalent to that of a trustee in a bankruptcy proceeding. A receiver, however, typically has much greater flexibility to perform his or her duties under a more simplified and streamlined framework and process.

A receivership can be an effective option to deal with lender and other creditor claims in an organized fashion when funds are not available to pursue a bankruptcy proceeding. One major difference between a bankruptcy and receivership proceeding is that there is no statutory mechanism to recover preferential transfers in a receivership.

Out-of-Court Workout

A final bankruptcy alternative is an old-fashioned, roll-up-your-sleeves, out-of-court workout. To the extent a troubled company has a viable business but too much debt — secured or unsecured or both — it may be able to work itself out of trouble by pursuing a path that doesn’t require a court filing or the relinquishment of control.

Many lenders, who don’t want to throw more good money after bad and are presented with a workable business plan, may be willing to enter into forbearance agreements with borrowers that allow flexibility in terms of loan payment amounts and timing. For a lender otherwise faced with liquidating the borrower’s collateral, a forbearance that allows the borrower to get back on its feet is often the better option.

The same is true of a company’s unsecured trade creditors. From landlords to suppliers, many creditors would rather negotiate an accommodation that allows a company to continue operating and paying down its debts rather than running into court to seek a recovery. However, because many creditors don’t want to be left holding the bag while others move first to pursue recoveries, a company must often execute a coordinated strategy with all of its creditors that provides a global resolution of claims.

By aggressively and proactively pursuing an out-of-court workout, a company can buy itself time and lessen its debt obligations in order to fight another day.

Determining the right path forward for an insolvent company depends on the specific facts and circumstances at issue, and such a determination should be made in consultation with legal counsel who understands the relative advantages and disadvantages of each option. For any company that is experiencing distress, an ABC, receivership, or out-of-court workout can be an effective alternative to Chapter 11 bankruptcy, especially if speed is of the essence and less oversight of the process is desired.

David G. Dragich, founder of The Dragich Law Firm, represents businesses in all aspects of complex corporate reorganizations, bankruptcy, insolvency, and distressed asset acquisitions and dispositions.