When a client files for bankruptcy and a Plan of Reorganization no longer looks possible, I am often asked, "How do we get out of here?"
Creditors ask me the corollary: "How can I get any money back?" The short answer to both is that there are three ways.
But first, let's look at the basics of bankruptcy, so we can understand the ways out.
In an old school bankruptcy, the basic hope is to reorganize.
First, the company ("the debtor") files for bankruptcy. Next, new equity is injected or debt is swapped for equity and creditor groups agree to haircuts. Finally, the agreement is memorialized in a Plan of Reorganization that is blessed by the Bankruptcy Court. The blessing takes the form of a Confirmation Order and the Plan is referred to as "Confirmed." (Yes, I have skipped a lot.) The Confirmed Plan of Reorganization allows money to be paid to creditors.
This is the traditional way debtors leave bankruptcy and creditors get paid. (Note that technically, debtors don't leave bankruptcy until the major aspects of the Plan are complete and the Court issues something called a Final Decree.)
As an example, back in 2000 I assisted a company called NutraMax Products that reorganized itself through bankruptcy in the District of Delaware.
The senior lenders took a large haircut as did the mezzanine debt; a pot of several million dollars was distributed to unsecured creditors; the loan on the building that was secured with a mortgage continued on; and the majority owner of the formerly public company injected new equity while the old equity was wiped out. The Plan of Reorganization was Confirmed by the Delaware Bankruptcy Court and when the steps in the plan had been completed and the pot of money distributed to unsecured creditors, the Judge issued a Final Decree. These days, however, what happened for NutraMax is the exception.
Why? Several common reasons:
- New equity won't invest in the existing company, even though the source of that equity may be willing to buy the assets;
- Secured debt (and there is lots of it these days) may just want to be paid and not become equity;
- The creditors can't agree on enough haircuts.
Then what? There are three options from here... But first, liquidate.
Sell the assets. Hopefully, the bulk of the assets can be sold as an ongoing business. The bulk buyer may even assume or pay off some of the liabilities. Secured lenders can usually credit bid - that is, they can match any offer up to the amount owed the lender.
Then, shut down remaining operations and sell the small assets. Some of the small assets can be meaningful, such as trade names, internet names, patents, trademarks and so forth
. For example, I became the CEO and Director of a company in bankruptcy called eToys. They owned the domain name Kids Are Us. Toys R Us paid a hefty price for the domain name and those proceeds are what paid me.
Litigate and collect something called preference and avoidance actions to raise money. (A lengthy subject in itself.)
Pay off the expenses incurred during bankruptcy. Once enough assets are liquidated, the preferred approach to leave bankruptcy is a Plan of Liquidation.
Similar to a Plan of Reorganization, a Plan of Liquidation describes how the assets will be disposed and is Confirmed by an Order of the Bankruptcy Court. But, like a Plan of Reorganization, a Plan of Liquidation must pass several hurdles to be Confirmed:
- The necessary Administrative expenses must be paid in full with funds available at the time the Plan is Confirmed and the creditors must receive more than if the case were converted to Chapter 7 (see below) and a Trustee takes over. (Plans of Liquidation are often thought to yield more than converting to Chapter 7 because of the cost of the Trustee and his/her learning curve and new professionals.)
- Administrative expenses can be sizable and include the expenses for the professionals of both the debtor and the Creditors Committee and include something called 503(b)(9) claims for goods received the last 20 days prior to filing for bankruptcy. For retailers, distribution businesses and manufacturers, these claims are often sizable.
Sometimes, all of the above does come together.
- Secured creditors get their collateral or its value.
For example, in one case where I advised the debtor, Sturgis Iron and Metal, a scrap metal company, the largest customer, a steel mill, was willing to buy the assets to keep the company from operating and to keep scrap metal prices for its mills depressed. The steel mill was willing to pay more than the large secured loan to prevent another buyer from operating the business and buying scrap metal, as that would drive scrap prices up. But often, these conditions can't be met.
The secured creditor wants and is entitled to the value of its collateral and that may not leave enough money to confirm a Plan of Liquidation. Those Administrative expenses often exceed what is left after the secured lender is paid. What then?
Some of the administrative creditors can agree to defer payment from the time of Confirmation to when more funds are available. In one situation where I entered late in the case, the first thing I discovered was that the case was administratively insolvent: there wasn't enough cash to pay off all administrative claims. First, we tried collecting the balance of some deposits and avoidance actions. Not surprisingly, that didn't provide enough, so the professionals agreed to defer payment until there were enough funds to pay them. That allowed the liquidating plan to be Confirmed. The motivation? A strong chance of winning big in one particular law suit. Convert to Chapter 7
Under the bankruptcy Code, the Chapter 7 Trustee, with the Court's approval, can distribute the proceeds according to a priority scheme set by the bankruptcy Code and without a Plan of Liquidation. Often, however, impaired creditors that are looking at a loss don't like the idea of a Chapter 7 Trustee.
They add expense which comes out of what is left for the creditors, and add time.
Worse, in Chapter 7, the secured lender will likely file a motion seeking relief from the automatic stay and foreclose on the collateral. The remaining creditors then risk having the Trustee declare the case a "no asset" case. Then, the Court dismisses the bankruptcy and all parties go back to where they were before with state court remedies - a place creditors and the debtor didn't like, otherwise they would have reached an agreement outside of bankruptcy. Agree to a Structured Dismissal
This is a newer way out. The Court dismisses the case as in the no asset case just mentioned, but issues instructions that govern authorizing the distribution of funds to particular creditor groups.
Some Courts allow secured creditors to "gift" funds that are their collateral to select classes of unsecured creditors and bypass other creditors in the priority scheme such as tax authorities. A few final recommendations
- Always know where you are headed before filing for bankruptcy. Estimate administrative claims and the proceeds from a bulk asset sale and check that they are likely to exceed the value of secured claims.
- Keep tabs on administrative expenses during the case, particularly professional fees and 503(b)(9) claims. In the insolvent example, the contract CFO was not properly tracking professional fees.
- Early in the case, ideally before filing, prepare a waterfall to creditors and update the waterfall for changes in expected expenses and proceeds from asset sales.
Bankruptcy is never an easy process. Understanding your available options, whether as a debtor or creditor, will help make this difficult situation a whole lot easier.