With the economic challenges brought on by the COVID-19 pandemic, many companies are faced with decisions that seemed inconceivable just 90 days ago. For companies experiencing true financial crisis, however, filing for bankruptcy – too often viewed as the last resort – should be considered as a potential strategic path to a fresh start and immediate relief that may enable a company to weather the current economic storm.
When business owners hear the word “bankruptcy,” they often sink into fear and despair. They may imagine the doors of their businesses barred shut and trucks hauling away their company’s property. While no one relishes the idea of bankruptcy, it often is a solution rather than a problem. While bankruptcy will result in a period of change, it doesn’t have to be feared. Instead, bankruptcy often may be more appropriately seen as a strategy to obtain a fresh start.
Despite the complexity of the Bankruptcy Code, there are primarily four strategic options for distressed or insolvent companies. As in-house counsel, your job is to navigate your company into the strategic scenario that will lead to the best result under the circumstances. To maximize your company’s chances of survival, you should consult with an experienced bankruptcy and restructuring attorney at the first sign of trouble.
Strategy 1: Restructure Out of Court
Through the nonjudicial process of an out-of-court restructuring or “workout,” a company can reach an agreement with its significant creditors to adjust the company’s obligations. For this to be successful, participation is required from all the company’s lenders, major suppliers and, depending on the circumstances, other organizations or entities, such as unions or governmental agencies.
With the potential of a bankruptcy filing looming, creditors and equity holders are typically willing to compromise and to agree on an out-of-court restructuring to avoid the time, risk and expense of bankruptcy. A savvy and experienced bankruptcy attorney often can demonstrate to creditors that they are likely to be better off with a voluntary deal than any result they are likely to obtain from the bankruptcy process. Many times, it is the credible threat of bankruptcy that forces the parties to an agreement.
Strategy 2: Reorganization Under Chapter 11
Under this scenario, your company was able to file a plan of reorganization that had no objections by creditors, had at least one impaired class of creditors that voted to accept the plan, and the plan met the requirements of section 1129. Specifically, section 1129(b) requires that the plan (1) must not unfairly discriminate and (2) must be fair and equitable. These tests only apply to a class as a whole and not to individual creditors.
One benefit of Chapter 11 is the debtor may reject leases and other unprofitable contracts. It also allows the debtor to sell assets free and clear of liens and encumbrances under section 363.
The recently enacted Subchapter V of Chapter 11 allows small businesses whose debts are less $2.7 million (now $7.5 million for one year as a result of CARES Act) to reorganize without many of the costs and risks associated with Chapter 11. Under Subchapter V, there is not a creditors’ committee unless appointed by the court for cause, only the debtor proposes a plan of reorganization, there is no need for a disclosure statement because creditors do not vote on the plan, the debtor has 90 days to file a plan, and there is no absolute priority rule so the debtor may “cram-down” creditors and still maintain its equity interest.
Strategy 3: “Cram-Down” in Chapter 11
Under this scenario, your company has exhausted all efforts to persuade creditors to accept a plan of reorganization. Your company is not able to pay the creditors in full. So, your option is a “cram-down” Chapter 11 plan.
Under a cram-down plan pursuant to section 1129(b)(2)(A) and (B), secured creditors and unsecured creditors may be compelled to accept payment for less than the full amounts of their claims. In a cram-down plan, creditors receive the value of their collateral, leaving an unsecured claim for the deficiency. Unsecured creditors are generally paid only pennies on the dollar. As a result, equity interests are canceled because of the absolute priority rule.
Equity owners, however, can maintain their equity interest despite a violation of the absolute priority rule if they provide new value or “money’s worth” to the debtor. The “new value” doctrine is an arrangement permitting equity holders to invest new capital to “buy back” their equity interests, even though unsecured creditors will receive less than full payment. Under the new value doctrine, the equity holders must provide value that is equal to the fair market value of the interests that the equity holders will receive in the reorganized debtor.
Strategy 4: Liquidation
Under this strategy, your company has made the decision to liquidate. It may proceed under Chapter 11 to conduct an orderly liquidation controlled by the company, which would typically provide for the sale of the company’s assets under section 363, with the net proceeds distributed to creditors under a liquidation plan approved by creditors and confirmed by a bankruptcy judge. Alternatively, the company may proceed under Chapter 7, whereby the assets of the debtor will be liquidated by the Chapter 7 trustee.
The bigger point? It is crucial that a company not wait too long to work hand in hand with a bankruptcy attorney/restructuring advisor. Quick action maximizes your company’s options and increases the likelihood your company will experience a favorable outcome.
Brandon J. Tittle leads the bankruptcy and financial restructuring practice at FBFK, with a focus on corporate reorganization, restructuring, acquisitions and litigation.
Patricia Wachsmann is an associate at FBFK, where she concentrates her practice on mergers and acquisitions, franchises and business development.