When Chapter 11 Bankruptcy is the Right Option (and when it isn’t)
To file or not to file? That is the question on many business leaders’ minds these days as lots of companies across different sectors of the economy struggle to gain traction, and an increasing number are turning to bankruptcy.
Corporate bankruptcies are on track to hit their highest level in a decade according to a report released by S&P Global. 424 public companies and private companies with public debt have declared bankruptcy as of August 9, 2020, including household names such as J.Crew, JCPenney, Lord & Taylor, and Neiman Marcus Group. That surpassed the number of filings during any period since 2010.
Accordingly, more businesses are seeking protection under Chapter 11 of the U.S. Bankruptcy Code, with the intention of shedding debt and emerging as leaner, more profitable companies. More small businesses may also be getting into the restructuring mix soon, as Congress, pursuant to the CARES Act, increased the debt levels under the recently passed Small Business Restructuring Act (“SBRA”), thereby making more small businesses eligible for the SBRA’s streamlined Chapter 11 process.
However, despite the recent rise in bankruptcy filings due to the economic downturn, and Congress’ efforts to make Chapter 11 bankruptcy protection more widely available, not every struggling business should attempt to restructure under the Bankruptcy Code. Typically, companies that succeed in restructuring under Chapter 11—and those that don’t—share certain characteristics.
Here are a few guidelines that may help determine whether Chapter 11 is the right option (or not):
A Core Business to Reorganize Around and/or Equity to Protect
A company is a good candidate for Chapter 11 if there is a viable business that can be preserved if given some breathing space from creditor collection activity. Any debtor who has assets with significant equity that will be lost to repossession or foreclosure may also benefit from Chapter 11.
It’s rare that a business that is struggling across the board—that is, has no core business that is viable—will enter Chapter 11 and turn around its business to the point where it can successfully emerge from bankruptcy. Indeed, while Chapter 11 offers a breathing spell from creditor collection actions, it comes with its own costs and complexities that can hinder management’s efforts at restructuring the underlying business.
A Strategic Initiative, Such as a Sale, to Accomplish
Businesses are increasingly making quick trips through Chapter 11 for the specific purpose of selling assets in a transaction under Section 363 of the Bankruptcy Code (called a “363 sale”). Such transactions are done in bankruptcy in order to shed debt and burdensome contracts and transfer assets to a buyer free and clear of claims. The debtor’s remaining assets and creditor claims are then dealt with in bankruptcy.
Debtor has Access to Financing
Most Chapter 11 debtors enter bankruptcy with millions of dollars in pre-petition debts—debts they accrued before the filing by withholding payments to lenders, landlords, and other creditors. Accordingly, one might assume that having enough cash to operate the business in bankruptcy would not be a concern. However, in addition to needing cash to operate the business, a bankrupt debtor must pay the costs associated with being in bankruptcy, including administrative costs and professional fees.
As a result, most debtors cannot rely on cash flow alone to get through a Chapter 11, even if a company is aggressively cutting operational costs during the process. In almost all cases of any size, debtors must seek debtor-in-possession (DIP) financing to help them get to the other side.
Debtor has Few Concerns About Scrutiny of its Books and Transactions
Bankruptcy policy requires transparency with respect to a debtor’s business decisions and financial transactions leading up to a filing. Parties in interest, such as a creditors’ committee and the U.S. Trustee, are granted broad investigatory rights related to a Chapter 11 debtor.
To the extent directors and officers have taken prepetition actions that devalued the company, such as issuing large distributions/dividends to themselves, creditors will be highly incentivized to scrutinize every act or omission by such directors and officers. The recovery of assets that may have been transferred fraudulently benefits creditors, as it increases the pool of assets to be distributed to them. Accordingly, a company’s ownership and management should carefully consider whether any actions they took in the period leading up to a possible Chapter 11 bankruptcy filing might give rise to scrutiny that may expose them to liability.
While there are many reasons Chapter 11 bankruptcy might be a good option for a struggling business, there are many reasons why it should be avoided. There are other restructuring options, such as a receivership or assignment for the benefit of creditors, that may be more appropriate given a company’s individual circumstances.
To learn more about various corporate restructuring options, please contact David Dragich at email@example.com or 313.886.4550.