More companies are experiencing distress. Chapter 11 bankruptcy filings rose 105% in May compared to the previous year, according to data from Epiq's Bankruptcy Analytics platform. When a company finds itself in financial distress, it’s important to remember that bankruptcy is not the only option. A viable and beneficial alternative for the right company can be an out-of-court, state-law wind-down proceeding.
Let’s compare and contrast these two options, examining the relative advantages and disadvantages, to inform crucial decisions related to maximizing the value of a troubled company.
Bankruptcy: A Double-Edged Sword
Bankruptcy, a federal court process, is often the first solution that comes to mind when a company struggles financially. It allows for an orderly process in which a company can either restructure its debts (Chapter 11) or liquidate its assets to pay off creditors (Chapter 7).
Advantages of Bankruptcy
- Automatic stay: A significant advantage of bankruptcy is the "automatic stay," which halts all debt collection activities, providing the debtor breathing space to strategize the next steps.
- Restructuring possibility: Under Chapter 11, a company can restructure its debt and negotiate with creditors, potentially enabling the business to bounce back.
- Creditor equality: Bankruptcy ensures that all creditors are treated according to their claim's priority.
Disadvantages of Bankruptcy
- Cost and complexity: Bankruptcy proceedings are often costly and complex, involving legal expenses, administrative fees, and lengthy timelines, which can drain a company’s already limited resources.
- Publicity: Bankruptcy is a public process that can damage a company’s reputation and customer relationships.
- Control: In a Chapter 7 bankruptcy, business control is relinquished to a bankruptcy trustee.
Wind-Down: An Alternative Path
A corporate wind-down, conducted under state law, involves gradually ceasing operations, settling with creditors, and distributing the remaining assets to shareholders.
Advantages of a Wind-Down
- Cost-effective: A wind-down can often be more cost-effective than bankruptcy, especially for smaller companies with fewer creditors.
- Control: Management retains control during the process and can dissolve the company at a pace it determines, avoiding the sudden loss of control that can occur in bankruptcy.
- Discretion: Unlike bankruptcy, wind-downs are less public and thus can mitigate reputational damage and loss of customer trust.
The wind-down process allows the debtor to control the pace and manner of ceasing operations, settling with creditors, and ultimately dissolving.
David G. Dragich
The Dragich Law Firm
Disadvantages of a Wind-Down
- Creditor actions: Unlike bankruptcy, a wind-down doesn’t offer an automatic stay. Therefore, creditors can continue their collection efforts or initiate legal actions.
- Residual liabilities: If the wind-down process isn't thoroughly managed, lingering liabilities may potentially affect shareholders or parent companies.
- Complex negotiations: Without a prescribed hierarchy, as in bankruptcy, negotiating with creditors can become complex.
Making the Right Decision
Choosing between bankruptcy and a wind-down is a nuanced decision that should consider the unique circumstances of the distressed company. Understanding the variables can help guide business leaders toward the optimal strategic decision.
1. Financial Position and Prospects of Recovery
A company's financial status and its potential for recovery play a crucial role in the choice. If the business is heavily indebted and has little prospect for a turnaround, Chapter 7 bankruptcy could offer a clean break. It allows for the orderly liquidation of assets and ensures creditors are paid equitably according to their claim priority.
Conversely, if the financial distress is temporary and the business has a solid chance of recovery, Chapter 11 bankruptcy might be the preferred option. It offers the opportunity to restructure debts and renegotiate with creditors, enabling the business to emerge from bankruptcy in a healthier state.
However, a wind-down could be less disruptive and more cost-effective if the debts are manageable and the company is small to midsize. The wind-dwn process would allow the company to control the pace and manner of ceasing operations, settling with creditors, and ultimately dissolving.
2. Number and Type of Creditors
The number and type of creditors involved impact this decision. Bankruptcy may be advantageous if there are numerous creditors, particularly if the debt owed to them is substantial. The automatic stay provided by bankruptcy can halt collection efforts, providing the company some respite.
However, in a wind-down scenario, management retains the freedom to negotiate individually with creditors without the stringent structure of a bankruptcy process. That could be beneficial if the creditors are few and negotiations are expected to be straightforward.
3. Litigation Risk
If the company is currently facing or is likely to face substantial litigation, bankruptcy might offer greater protection. The automatic stay in bankruptcy not only halts collections but can also stop most litigation. On the other hand, if litigation risk is low, a wind-down might be preferable.
4. Industry and Market Conditions
Industry trends and overall market conditions should also be weighed. In a declining market or industry, a quick liquidation through bankruptcy might minimize losses. In contrast, in a stable or growing market, a wind-down can allow assets to be sold methodically, potentially at better prices.
5. Regulatory Considerations
The industry's regulatory environment could also impact the decision. Industries such as financial services or health care are heavily regulated, and bankruptcy could trigger regulatory actions or implications. A wind-down process might allow for more controlled compliance with such regulations.
6. The Long-Term View
Lastly, the long-term view and potential residual issues deserve consideration. If there is a risk of lingering liabilities that could affect shareholders or parent companies, the comprehensive nature of bankruptcy could provide a cleaner break. Conversely, a well-managed wind-down could minimize residual liabilities if planned meticulously and executed effectively.
Navigating such challenging decisions demands comprehensive analysis, expert advice, and foresight. By understanding the relative advantages and disadvantages of bankruptcy and wind-down procedures, business leaders can make informed decisions that best suit their circumstances and pave the way for the most favorable outcomes for everyone involved.
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.