How should a chapter 11 debtor’s financial information be presented to the bankruptcy court to create the best first impression? To give the court an accurate picture of the results of operations during Chapter 11 and for the debtor to get sufficient time in bankruptcy to achieve its goals?
The pandemic caused painful revenue reductions for many companies. Getting back to normal is happening; but, in many sectors of the economy, business has not returned to pre-pandemic levels.
For some companies, the pandemic simply was the last straw, and chapter 11 now may be necessary to achieve an orderly liquidation of the debtor’s assets. For other companies with good fundamentals, the debtor may need chapter 11 relief. Why? Despite being well-managed, manufacturing a product that continues to be in demand, or adequately investing in itself (or all three), some companies just do not have sufficient capital to weather the storm any longer.
Finally, when interest rates inevitably rise, overleveraged companies, and especially companies that only survived with the help of Paycheck Protection Program funds, will be compelled to consider debt restructurings, whether in court or out-of-court.
At the beginning of a bankruptcy case, all interested parties — especially the bankruptcy judge — want to know what precipitated the bankruptcy filing. Did the debtor file its petition because it produces an antiquated product like Polaroid cameras, and business has steadily declined? Did the debtor file its bankruptcy petition because it suffered an adverse legal judgment? Is the filing due to excess leverage taken on in a prior acquisition? Or, perhaps, is the company just in an industry that has become overbuilt?
The answers to these questions influence a judge’s initial impression of the case and, perhaps, the following: (1) whether he or she grants requests for expedited relief (such as the bulk sale of the debtor’s assets) (2) how much time the debtor has to promulgate a plan of reorganization and (3) whether the judge grants a secured lender authority to foreclose upon collateral.
If reorganization is unlikely and if the debtor is severely cash-flow negative, the judge does not want to hold back liquidation.
In some instances, Rome may appear to be burning — until one looks deeper. Judges do not want to liquidate a debtor prematurely and cause the loss of jobs if they believe that the odds favor a successful reorganization. On the other hand, if reorganization is unlikely and if the debtor is severely cash-flow negative, the judge does not want to hold back liquidation.
In chapter 11 cases, it is usually all about cash flow. Cash flow is reported every month as required by the United States Trustee, the bankruptcy administrative arm of the Department of Justice. Normally, an income statement is not required (but as discussed below, the better practice is to file a three-column income statement anyway). Lenders are most interested in whether the debtor is burning cash. If burning cash, then the lenders worry that they may have to infuse more capital — which they prefer not to do. Burning cash also is a sign that the debtor’s underlying core business has not stabilized.
Although the court may require only a monthly cash-flow statement, the better practice is to present to the court a cash-flow statement with and without (1) items related to the chapter 11 (such as professional fees and one-time financing fees) which would not occur outside of chapter 11 and (2) nonrecurring items unrelated to ongoing operations (such as payments under leases being rejected and severance payments that are part of a downsizing). This is because expenses related to chapter 11 and nonrecurring items will exaggerate negative cash flow or reduce positive cash flow.
Upon commencement of a chapter 11 case, the big question is whether the debtor’s recent actual financial results are a good proxy for how the debtor will do while in chapter 11. Every debtor wants time within which to fix its business, reduce expenses, negotiate with creditors, and prove that it is viable. Unfortunately, few, if any, debtors commence their bankruptcy case and suddenly see the pendulum swing to profitability.
Often, they may know what needs to be done but need time to effectuate the solutions. And it will take time before the solutions show up in the debtor’s financial results. Or the debtor may need time to “burn off” certain extraordinary expenses that are not recurring but which in the meantime have a material adverse effect on financial results. Finally, the debtor just needs time for a disrupted market to return to normalcy in some cases.
The initial financial presentation to the court should be in three columns. Actual financial results alone may present a distorted picture to the bankruptcy judge. Instead, the court should see a three-column presentation. Column one is actual results. Column two is the list of adjustments to line items necessary to restate actual financial results to eliminate the effect of extraordinary items. And column three is the restated financial results — what actual results would have looked like absent the extraordinary items.
Each line item in column two must be explained for the court to determine if it warrants the restatement of that line item in column three. This process should be applied to both the statement of cash flows and the income statement (even though an income statement usually is not part of the U.S. Trustee’s monthly reporting requirements). The idea is for the court to see how the debtor’s core business is performing absent the headaches that brought it to bankruptcy court.
Failure to give the bankruptcy judge a bridge to see (1) what would have been the debtor’s results from ongoing operations before bankruptcy absent extraordinary events and (2) “normalized” results during bankruptcy can reduce the likelihood of success in chapter 11. It also is imperative that the debtor’s financial adviser adequately explain the bases for adjustments. Without them, the court sees a distorted picture.
Kenneth A. Rosen is a partner and chair emeritus, bankruptcy & restructuring department, Lowenstein Sandler LLP.
The views expressed herein are those of the author only and are not necessarily shared by other persons at Lowenstein Sandler LLP. The law is subject to interpretation. Each case is unique. This article is not intended to provide legal advice.