Alternatives to Bankruptcy Options for Corporate Recovery
Overview Strategic guidelines Analytical framework Causes of business failure Restructuring options The turnaround process DIP financing structures and sources Valuation influences Priority of claims The Chapter 11 benchmark Out-Of-Court workouts Assignment for the benefit of creditors Receiverships
Strategic Guidelines Out-of-court restructuring options should be evaluated using the provisions of Chapter 11 of the Bankruptcy Code as a benchmark The net benefits of an out-of-court restructuring should exceed those of a Chapter 11 reorganization Out-of-court restructurings generally entail either a voluntary renegotiation of the terms of the debtor s existing liabilities, or an exchange of interests with its key creditors An out-of-court restructuring may not be effective or feasible if inappropriate give the nature and scope of the debtor s operational and financial problems, not all creditors are willing to consent to the proposal
Analytical Framework Are the firm's problems internal or external, operational or financial? What is the current value of the firm's total assets as a going concern and in liquidation? Given the current value of the firm's total assets, what is the current value of the related interests and claims? What capital structure is appropriate for the firm considering its future prospects, expected operating results and requirements? What is the reorganization value of the restructured firm? In what form and amount might the debtor s reorganization value be allocated among remaining interests and claims?
Causes of business failure Internal Ineffective management Inadequate internal control, planning, budgeting and information systems and processes Inflexible organizational structure and culture Under/over capacity Excessive operating and financial leverage Fraud/Torts External Competition Macro- and micro-economic cyclicality Changes in product and geographic markets, technology and regulation Natural disaster
Restructuring Options Selection of an appropriate turnaround strategy will be influenced by factors including the history, size and prospects of the debtor, as well as the perspectives, types and amounts of creditor claims Sale or divesture of the business as a going concern as swiftly as possible to minimize diminution of, and obtain, a reasonable fair value Liquidation/wind down where specific assets of the business have greater value if otherwise deployed In place, but not in current use In exchange in an orderly disposition In exchange in a forced liquidation Reorganization if feasible and debtor worth rehabilitating as a going concern
The turnaround process Stabilization SWOT analysis Operational and financial restructuring Normalization Reduce losses and cash requirements Establish controls over cash to eliminate negative CFFO Raise interim financing needed to develop plan Improve working capital management Reduce operating costs Rationalize product portfolio Sell noncore assets Assess debtor viability through analysis of its industry, competitive position, management, operations, cost structure and capital Organization structure Product and geographic markets Customers, suppliers and competitors Production and distribution functions R&D pipeline Regulation Profitability, liquidity, solvency, efficiency Formulate turnaround objectives, strategies and action steps to increase profitability and shareholder value Operational Increase revenue Decrease costs Divest assets Product differentiation Financial Develop a capital structure consistent with expected operating results and requirements Develop and institute controls, policies and procedures that serve to maintain focus on factors underlying profitability and shareholder value Sustained revenue growth Operational efficiency Low cost production Internal control processes Relevant and reliable cost of production data Optimal capital structure Alignment of management compensation plans
DIP financing structures Unsecured debt Court authorization not required In the ordinary course As between the debtor and lender and in the debtor s industry No significant alterations in debtor s pre-and post-petition activities» If not, lender may not be granted administrative claim for post petition loan Outside the ordinary course If for legitimate business purpose» Otherwise, administrative claim not sufficient to assure repayment in case of administrative insolvency
DIP financing structures (continued) Secured debt Court may authorize if adequate financing unavailable on an unsecured basis Super priority claim senior to all other administrative claims Lien on debtor s unencumbered property, or junior lien on encumbered property Lien senior or equal to any encumbering prepetition collateral Only if unable to otherwise obtain credit,» No duty to search for credit from all sources, however Requires that prepetition lien holder be adequately protected from diminution of collateral value during reorganization» Measured as the equity cushion, or excess of the going concern or fair market value of the collateral over the debt
DIP financing structures (continued) Extraordinary provisions must be disclosed conspicuously and justified in a motion for approval of postpetition financing Grant of superpriority claim superior to, or a lien on, Chapter 5 claims including preferences and fraudulent transfers to a postpetition lender Funding of DIP loan preconditioned on judicial rulings and debtor waivers Perfection Prepetition credit facility is a valid and binding liquidated obligation not subject to any defenses or counterclaims Prepetition lien is valid, enforceable and encumbers substantially all assets Good faith DIP loan is fair, reasonable and an arm s length transaction Absent lender s consent, waiver of debtor rights to seek use of cash collateral, file a plan of reorganization or challenge perfection and scope of DIP lender s prepetition liens
DIP financing structures (continued) Cross collateralization A security interest given to a prepetition lender covering all assets of the debtor, both those existing on the date of the DIP financing order and those created during the Chapter 11 proceeding, for new loans funded in Chapter 11 and for its prepetition debt Roll-up of prepetition secured debt Prepetition debt repaid by postpetition facility Can be structured to take place at once or over time DIP waiver of right under Section 506(c) to surcharge a secured lender s collateral to the extent an administrative claimant has benefited from the collateral Carve-outs from the lender s collateral to provide for payment of administrative costs Commitment fees Expedited relief from the automatic stay
DIP financing structures (continued) Second lien loans Debt secured by liens on some or all of the collateral encumbered by first lien loans Structured such that the lender has secured claims against the borrowers and guarantors of the first lien financing that are not subordinate to the first liens First and second lien lenders typically enter into intercreditor agreements wherein the second lien lender agrees to limit its rights as a secured creditor and to shared collateral Regarded as senior secured debt and of interest to nontraditional institutions Unlike traditional subordinated debt, second lien lenders are not Required to give up payments received to the first lien holder until it is paid in full Only required to relinquish proceeds of shared collateral Subject to payment stoppage provisions Junior in priority to unsecured creditor claims
DIP financing sources Prepetition secured lenders Often lender of last or only resort given debtor inability to provide adequate protection, resulting in the ability to Levy high rates of interest Exercise control over debtor s day-to-day operations through provisions requiring Expedited sales of substantially all of the debtor s assets Approval of cash expenditures, advances under the financing agreement and sale or use of property outside the ordinary course of business An event of default if reorganization plan filed or confirmed absent consent Changes to or replacement of senior management; i.e., CRO
DIP financing sources (continued) Section 363 acquirer Opportunity to preclude a third party lender from acquiring a superior claim Provide unique access to debtor s books, records and operations Place the acquirer in a position to compel the transaction Provide only enough financing to facilitate sale process Tie DIP loan to purchase agreement such a default under the agreement causes the DIP loan to become due and payable Customers Ensure sources of supply with title to goods transferred immediately to lender without first becoming property of the estate Equity sponsors and venture capitalists Preserve interest or option to acquire equity under advantageous terms
Valuation influences Lower value Higher value
Priority of claims Secured claims Superpriority claims DIP Financing Priority Claims Administrative expenses, Wages, salaries and commissions, Employee benefits, Claims against facilities that store grain or fish produce, Consumer deposits, Alimony and child support, Taxes, Unsecured claims from commitment to federal deposit regulatory agency General unsecured claims Preferred stock Common stock
The Chapter 11 Benchmark Advantages Automatic stay from any action against debtor Access to Court approved DIP financing and use of cash collateral Ability to reject or assign executory contracts and leases Right to sell property free and clear of any interest Power to bind dissenting creditors Mechanism to estimate contingent and unliquidated claims Extension of period to avoid fraudulent and preferential transfers COD income not taxable; amount discharged used to reduce favorable tax attributes 120-day exclusive right to file reorganization plan Risks Loss of control as debtor operations subject to supervision and review by the Court and creditors Extensive operating and financial information disclosure requirements Negative publicity Loss of management and employees Disruption to operations and relationships with customers and suppliers Time and expense required to develop and confirm a plan
Out-of-court workout Advantages Existing management able to retain control of the restructuring process Time and expense required to reach agreement potentially lower Avoidance of negative publicity Comparatively limited disclosure of operating and financial information Less disruptive to operations, customer and supplier relationships Risks Inability to reach consensus with creditors and bind dissenters Absent automatic stay, debtor subject to creditor attack No formal process for the recovery of fraudulent and preferential transfers Difficulty in rejecting executory contracts and leases Tax treatment of COD income
An ABC is a transfer of legal title to all of a debtor s assets to an assignee with authority to sell them and distribute the proceeds to creditors equitably under state law Advantages Orderly liquidation Quicker and less costly than Chapter 7 Debtor has right to choose assignee Places property out of reach of creditor s direct collection actions Less negative publicity Ability to recover fraudulent transfers Risks Does not discharge debts, allow for reorganization or sale of property free and clear of liens Does not preclude a voluntary or involuntary bankruptcy filing during pendency of the case Applicable laws vary widely between states Consent of secured creditors required for liquidation of collateral encumbered prior to assignment No automatic stay Recovery of preferences not allowed or limited by state law
Advantages A receivership is a remedy in which a disinterested person is appointed by a court to protect or collect property that is subject to diverse claims Ability to avoid fraudulent transfers Claims less likely to be barred by in pari delicto doctrine Ability to consolidate assets into a single fund and treat all entities in the estate as a unitary enterprise Faster and less costly then bankruptcy Assets may be sold free and clear of liens Does not discharge debt Reorganization unlikely Unable to recover preferential transfers Automatic stay does not apply Lack of rules regarding notice to creditors, filing of claims and objections Unwillingness of other jurisdictions to recognize authority of presiding judge Receiver appointed by and works as an officer of the court Risks
Alternatives to Bankruptcy Options for Corporate Recovery