By:  James Knauer

Over the years I have been asked that question many times.  Some business folks just think when your business is deep in debt a bankruptcy, particularly Chapter 11, is the only way out.  That’s just not always true by any stretch.

A Primer on Chapter 11

The Good, the Bad and the Maybe

On the bright side, most businesses that file Chapter 11 do so under threat of or actual, litigation.  Sometimes there are lots of pending lawsuits. They may be scattered in several states or many counties in the same state.  Multiple law firms engaged to defend the company can be a severe drain on an already impaired cash flow. Chapter 11 stops most litigation in its tracks.  Chapter 11 allows a business to stop paying the unsecured debts accumulated prior to filing until there is a plan in place to pay all or part of the ‘pre-filing’ debts.  Chapter 11 prevents landlords from reclaiming their premises, stops equipment financers from reclaiming their equipment, stops bank foreclosures on the business real estate and most other types of asset seizures. It can even orchestrate the return of assets already seized.  Chapter 11 can allow a business time to formulate a plan to repay all or part of what it owes. If the company can’t pay all it owes, it can usually pay less, sometimes much less, and still survive.  It stops the accrual of interest on unsecured debts. Chapter 11 allows a company to reduce liens on property to the actual value of the property securing the lien and in times of declining interest rates can re-write secured loans to lower rates and eliminate even higher penalty interest rates.  A company in Chapter 11 can shed itself of leases and contracts that are causing it to lose money, converting the claims of those creditors to unsecured debt to be paid as part of the company’s exit plan. Chapter 11 can open the door to renegotiating union labor agreements.  It can provide time to seek replacement financing for matured loans. It can force utilities to continue or restore services.

On the not so bright side, Chapter 11 is an expensive remedy.  It’s complicated and just as criminal lawyers want their money upfront, Chapter 11 counsel usually start out with hefty retainers.  One reason is that use of the company’s cash flow is often restricted after a Chapter 11 filing by the rules of bankruptcy and claims on cash by secured lenders who particularly don’t want their collateral used to finance a fight they are on the other side of.  The attorneys aren’t always paid at regular intervals, or at the struggling company, the cash isn’t always there to pay them and attorneys are needed at every stage of the case. Worse still, the creditors usually are represented by a committee who hires its own counsel and the company must pay the creditors’ committee attorneys too.  Many of the creditors are owed too little to justify the cost of participating individually with their own attorney, so bankruptcy law provides for the formation of a committee (the “Creditors’ Committee”) to represent all the unsecured creditors interests eliminating the need for everyone to act individually.  There are other costs and fees, including additional accounting requirements and fees payable to the government. Borrowed money in Chapter 11 can be quite costly due to increased risk. Most companies that file Chapter 11 don’t survive – historically, about 1 in 10.  That statistic is skewed by a fair number of cases that on closer examination never should have been filed, but it’s a statistic nevertheless.  Some industries and businesses just aren’t suitable for this type of relief, but that is discussed further on.

For the “Maybe” part, almost all of the “Bright Side” benefits described above have exceptions that may result in disputes with the creditors over their implementation. In some instances they may not be available at all.  Although the owners continue to direct the business’s day to day operations, every decision that is not in the ordinary course of business must be approved by the bankruptcy court who solicits input from the creditors’ committee.  Creditors’ committee influence creeps into the day to day operations of businesses in Chapter 11 to some extent as well.  This is particularly frustrating when there is disagreement on key issues and difficult for established management to swallow. It also causes delays and delays cost money, something a company in Chapter 11 can ill afford.  There are also many special tax consequences that can arise from a Chapter 11 bankruptcy, particularly when the business is reorganized.

The Three Types of Chapter 11’s.

The Liquidating 11.  There are basically three types of 11’s.  In all three those in control of the company usually continue running what’s left of it.  The first is a “Liquidating 11”.  Here the business can’t operate profitably and is quickly wound down or just shut down, employees are slowly or sometimes quickly terminated and the assets sold through some form of distress or orderly sale.  If a secured creditor has a lien for a debt which exceeds the value of the assets, sometimes they are just surrendered to the secured creditor.  Why then even file for 11 just to liquidate?  For one thing, the business insolvency usually leads to creditor lawsuits. You can’t manage the  liquidation of a business if you are fighting your creditors in multiple courts.  The owners often know the business better than anyone and have the contacts to insure the asset marketing is competitive.  Owners may have a vested interest in seeing that the liquidation gets done in a manner that maximizes the sale value.  They may have guaranteed some (or all) of the secured debt and want to make sure as much as possible gets paid because they’re on the hook for any loss. They have a fiduciary duty to maximize the asset disposition as well.  In short, they’ll try harder to get the debt paid than a loan officer specializing in troubled loans who’s anxious to move on to the next case, particularly if the owner/guarantors are good for any loss.  Stopping the bleeding may be the only way the unsecured creditors have a chance of getting anything after secured creditors are satisfied. Long ago bankruptcy courts recognized that not every business that files Chapter 11 should continue to operate.

Chapter 11 Sale.   If a business has value as a going concern, then it qualifies for Chapter 11 under one of the two remaining scenarios.  Selling the operating business to a third party is another mechanism to maximize value and getting creditors paid.  Sometimes the company has been attempting a sale for some time prior to entering Chapter 11 and has found a suitor on acceptable terms, so the company seeks to sell itself to a new buyer immediately.  This can create difficulties getting court approval because the creditors (whose input must be considered) are playing catchup since they usually weren’t involved in the prior sale efforts.  Sometimes the new buyer wants the services or knowledge of the former owners, or just wants them to agree not to compete.  Since the owners interests are separate from the company’s, the value assigned to any consideration received by the owners can be problematic. Even though the company has value which exceeds total debt, if its hemorrhaging red ink, balancing the losses incurred while operating long enough to conclude a sale causes more issues for the creditors, the owners and the judge. Buyers can get considerable legal protection from a bankruptcy court approved sale where the business is continued.  The rights of virtually all former creditors are cut off.  Buyer’s counsel may prefer that the sale of a troubled company be done in Chapter 11.

Chapter 11 Reorganization.  Finally, the third type of Chapter 11 proceeding is a true reorganization.  Here the company takes advantage of the bankruptcy law and sheds itself of unnecessary equipment, bad locations, debt amassed from unprofitable decisions, uninsured losses and unpaid account receivables to propose a plan that makes enough economic sense to project a return to profitability and payments to the creditors who followed it into bankruptcy.  Often the owners are required to infuse additional capital or bring in additional investors to obtain the plan’s approval.  There are countless ways in which this can be accomplished.

Making the Decision to File

There are some businesses and business circumstances that have almost no chance of surviving in Chapter 11, in which case a filing leads to failure, rather than resuscitation. Here are some examples of circumstances that will contribute to the failure of a Chapter 11 business bankruptcy.

1. The owners have no means to finance the business after filing and a secured lender with a blanket lien on assets will not permit its cash to be used for post filing operations.  Sometimes this can be overcome, but it creates considerable difficulty.  There are plenty of lenders that will finance Chapter 11 proceedings, but the rates are as one would expect – high.

2. The owners have committed fraud, have alienated the creditors with repeated misrepresentations, the creditors can demonstrate gross mismanagement.  Here control of the business is removed from the owners and a trustee is appointed to operate the business making it difficult to implement many of the alternatives available to owners in control. Due to personal liability concerns, trustees are not inclined to allow such businesses to operate and are likely to shut them down.

3. The company cannot obtain insurance for its assets, fails to pay creditors for debts incurred after filing Chapter 11, fails to pay sales, payroll or other taxes incurred after filing.  Any of these circumstances almost always leads to a shutdown of the business and liquidation by a Trustee.  In short, you can drag a lot of debt into a bankruptcy, but you have to timely pay debts incurred after you file.

4. Businesses that continue to lose money after the filing.

So what types of circumstances are the best candidates for Chapter 11?

1. Businesses that are historically profitable, but have suffered a severe setback resulting from an uninsured loss.

2. Businesses that are historically profitable, but the insolvency of a key customer(s) sticks the company with a loss so large, it can’t recover.

3. Businesses  that are suffering from a large loss based on a bad management decision, not consistent with an otherwise sound business history.

4. Businesses that have cash flow problems, but the value of their assets exceeds their liabilities.

5. Businesses that expanded to a larger size that became unprofitable, but can shrink their operations to smaller, profitable size, but the restructured company revenue of the smaller company cannot pay down the debt created by its larger predecessor.

6. Businesses that have agreed to a sale, but the proceeds will not be sufficient to pay everything that they owe.

7. Businesses with assets best liquidated by the owners due to their special nature.

These category descriptions of good and not so good candidates for Chapter 11 are hardly exhaustive and there are outliers to both.  That is, some of the likely failures can succeed, some the likely successes will fail.  It depends on other factors too numerous to discuss here.  These examples are intended to scratch the surface and act as a general guide to the uninitiated.

Timing; When to File a Chapter 11

Recognizing that ‘stuff’ happens. The bankruptcy laws allow a Chapter 11 filing to occur with very little initial paperwork (with much more required to follow) and it’s not all that unusual for an attorney who never met the client to file a Chapter 11 proceeding within 24 to 48 hours.  It’s not too difficult for a business owner who has nowhere else to turn to conclude he/she needs to put the business in Chapter 11 when bank accounts are seized, landlords lock up the building and the sheriff shows up to start removing equipment. These scenarios are the examples which I give to the answer “You’ll know.” to the question “When should I file?”

The last resort approach is sometimes the right one. However, most business Chapter 11 cases will benefit from advance planning. There are many ways to position a company to maximize the benefits of Chapter 11 that may be lost in a last minute filing.  Moreover, the option to work things out with creditors outside of Chapter 11 is lost when the filing is made.  An insolvency professional can assess the chances of success of out of court creditor workouts with a fair amount of accuracy using the lessons of experience and the facts of the situation.  This lost opportunity by delaying consulting knowledgeable counsel may be worse than many of the other decisions which caused the meeting to occur.