Out-of-Court Restructuring

Out-of-Court Restructuring: Alternative to Chapter 11

Upon filing for Chapter 11, the Court offers a range of features to contribute towards the debtor in being able to create a viable reorganization plan and achieve a turnaround.

But in either case, a Chapter 7 liquidation was deemed unnecessary for the time being, which is an achievement in itself.

The assumption implied in both an out-of-court and in-court restructuring is that a turnaround can be achieved, as long as the right strategic decisions are made and the prepetition capital structure is normalized to become appropriately suited for the company’s financial profile.

Considering the company is either in a state of financial distress or on the verge of defaulting on its debt obligations (and at risk of foreclosure due to a breached covenant, missed interest, or principal repayment), reorganization becomes paramount to restore the financial health of the troubled company to a normalized state.

In both in-court or out-of-court restructuring, the shared objective is for the debtor to return to operating on a sustainable, “going-concern” basis – with no more concerns of insolvency. But for an out-of-court restructuring, the process can be simpler, more cost-effective, and more efficient as it modifies the company’s capital structure.

Out-of-Court Restructuring vs. In-Court Restructuring

Before we begin, the table below outlines the key advantages and disadvantages of coming to a resolution out-of-court vs in-court:

Out-of-Court Restructuring Considerations

Liquidity and Capital Structure Complexity

• Liquidity Urgency: The swift process and less expensive aspect of out-of-court restructuring can be appealing to cash-constrained companies, but there are other factors to consider like the current state of liquidity. The liquidity of the company dictates whether it even has time to propose an out-of-court restructuring in the first place. In the absence of sufficient liquidity, the company in question has minimal optionality but to commence an in-court bankruptcy.
• Capital Structure Complexity: In general, the more creditors there are and the complex the capital structure, the less likely an out-of-court restructuring is going to be. As the number of creditors increases, the probability of there being at least one stubborn creditor that opposes the proposal rises as well. For simpler capital structures, adjustments can be made easily as there are fewer tranches of debt. But for more complex capital structures, there is an extensive list of creditors each with different rights and protective measures in place (e.g., liens, covenants, contingency liabilities) that can make modifications more complicated matters. In short, the number of claim holders, each with different risk tolerances and demands, must be manageable.

Debtor-Creditors Relations

To reiterate, out-of-court restructurings are more plausible when the number of internal stakeholders is limited.

If a borrower comes to the table to renegotiate debt terms with its creditors, more constructive negotiations could occur if the following four points are outlined:

Furthermore, convincing lenders to work out a solution out-of-court can depend on:

• Framing the underperformance as a temporary setback caused by their misjudgments, which implies fixing the mistakes is also within their control
• Providing “evidence” that the management is capable of enduring the challenging period ahead and has the capacity to solve the problem if support is received from creditors
• Coming across as transparent and trustworthy – thus, easier to communicate and work with

In effect, rather than coming across as pleading for another chance with neither a valid reason nor an actual plan that shows real effort, a management team that came prepared would strive to be perceived as:

1. Having made a regretful mistake in hindsight (or simply bad timing in some cases)
2. And is now putting in their full effort to fix the problem that they are responsible for

Out-of-Court Restructuring Advantages

Avoidance of Costly Court Fees

• An out-of-court restructuring is when a financially troubled company and its creditors come to an agreement without having to resort to Court.
• If successful, a collaborative out-of-court restructuring is far less expensive than a Chapter 11 bankruptcy proceeding. For this reason, the vast majority of cases begin with attempts to negotiate a consensual out-of-court restructuring.
• From a purely financial standpoint, an out-of-court restructuring would be the most ideal scenario, as it is the most cost-effective and the most “free will” is given to the debtor to put into motion different strategies to drive growth and improve upon its profit margins.

Urgent Implementation of Plans

In Chapter 11, the Court cannot rush its decision-making and deviate from established, standard procedures – thus, the process cannot be expedited, which can frustrate debtors in time-sensitive situations.

• In-court RX process can be very systematic with strict policies that must be followed (i.e., the process cannot be rushed). Once under Chapter 11 protection, the debtor is prohibited from issuing cash payments on prepetition obligations without prior Court approval.
• The pattern observed throughout the entirety of the restructuring is that each decision made by the debtor requires formal authorization by the Court.
• The time-consuming filings with strict deadlines are required to avoid violating their contractual duties as part of receiving bankruptcy protection.
• In contrast, the Court has no active involvement during out-of-court restructuring. The financially troubled company must take the initiative to identify and correct the root cause of the problems (and communicate with creditors on their own accord). But these processes tend to move along faster since the Court is not overseeing each step.

Out-of-Court Restructuring ➔ Trust from Creditors

• An approved out-of-court restructuring, regardless of the outcome, signifies a willingness by creditors to work along with the company and to take risks for the sake of the company. This can be favorable as the creditors are prepared to go out of their way to help the struggling company.
• While not always the case, the “green light” for out-of-court restructuring by creditors can be construed as meaning that the creditors trust the management team and their ability to execute the plan they proposed – and this could be interpreted as them hoping for the actual turnaround of the company
• The cause of the financial distress is likely not “irreparable” – hence, the creditors approved it as the underperformance was seemingly temporary (i.e., if the problems were too significant to recover from, most creditors would not hesitate to force the debtor to file for bankruptcy)

Privatized Process

• Out-of-court restructuring is usually a more efficient option in terms of monetary expenditures as well as being able to come up with an action plan.
• Additionally, out-of-court restructuring allows for private, behind-closed-doors negotiations among the debtor and its creditors. As a result, an out-of-court RX results in less disruption to the ongoing day-to-day operations of the company.
• In comparison, in-court restructuring requires public regulatory filings which air the debtor’s financial distress openly. The negative press surrounding the debtor can create further complications for its situation, and cause further damage to its operations and financial performance.
• The news of the company’s distress can not only cause reputational damage to its brand image and the customer’s perception of the company, but it can also lead to suppliers viewing the debtor negatively and current employees looking to go elsewhere to leave a “sinking ship.”

Out-of-Court Restructuring Disadvantages

Creditor Collection Efforts

Simply put, the downsides of out-of-court restructuring are mainly the absence of the benefits of in-court restructuring. The outflows of cash related to in-court restructuring might have been avoided, but the debtor is still left in a vulnerable state:

• Creditors can continue their collection efforts and take legal action against the company for its breach of the lending agreement
• Former suppliers could refuse to work with the company, as there is no incentive for them to accept the risk of doing business with a company where receiving compensation is in doubt
• Since the risk of holding up their end of the bargain and subsequently being left hanging is a serious concern, suppliers could require the payment to be made upfront in cash (and often at unfavorable, above-market rates)

Holdout Problem and Lack of “Finality”

• One shortcoming of out-of-court remedies is the lack of relief from creditors whereby the collection pursuits are legally allowed to continue and a single vocal critic from a significant creditor has the potential to make an out-of-court restructuring unattainable.
• A single creditor could object, extend the duration of negotiations, and force the company to file for bankruptcy, in what is referred to as the “holdout” problem. The fact that the creditor is the minority, and an outlier does NOT matter, as the company is required to receive each creditor’s approval before proceeding. For example, the creditor may be a senior bank lender that prioritizes the preservation of cash, and the company in question breached a covenant outlined in their lending agreement.
• If the creditor is uncertain about the management and mistrusts their ability to turn their recent underperformance around, the lender has no obligation to approve such requests when a full recovery is near-guaranteed if the company files for Chapter 11 protection.

The example above shows how out-of-court restructuring cannot produce absolute finality in being able to override one creditor against the plan. Other instances include:

• The inability to protect the debtor from litigation threats and creditor collection efforts
• distressed M&A transactions completed out-of-court, the buyer is making the purchase unprotected from various risks (e.g. fraudulent transfer)

In-Court Restructuring (Chapter 11 Bankruptcy)

Since Chapter 11 is intended to serve as rehabilitation and to support a “fresh start”, the common theme amongst the provisions is the preservation of the value attributable to the debtor.

For a reorganization to be possible, the issue of liquidity must be addressed immediately.

If not promptly addressed, the value of the debtor will continue to deteriorate, which harms creditors and their recoveries. Thereby, it is in the best interests of all parties involved in the restructuring that the debtor continues to operate to prevent any further decrease in value.

The rationale behind protecting the debtor is not only to benefit the debtor but to offer an equitable resolution to the creditors by the end of the process.

Chapter 11 is often criticized as being an expensive, time-consuming, and disruptive process for the ongoing operations of the debtor, but the Court provides as many tools and resources as it can to positively impact the debtor and contribute towards its turnaround.

In-Court Restructuring Advantages

“Automatic Stay” Provision

• The automatic stay provision goes into effect immediately once the filing is made to the Court. Once enacted, the creditors are legally restrained from continuing their collection efforts through litigation threats or any other sorts of harassment to the debtor.
• Such provisions can take a large burden off the debtor, who can now focus on creating a plan of reorganization without the distraction of constantly being belittled by creditors who are owed money.
• This is another reason why the petition date carries such importance in bankruptcies, as the treatment of claims will be bifurcated between prepetition and post-petition claims. The specific classification can have significant implications on the recoveries received by the claim holder.

DIP Financing and Critical Vendor Motion

Two of the most common first day motion filings in Chapter 11 are:

1. Debtor in Possession Financing (DIP): DIP financing allows for the operations of the debtor to continue running during the restructuring process. Up until now the debtor likely encountered difficulty in raising capital while its shortage of liquidity persisted. To entice lenders to provide debt capital to the debtor, the Bankruptcy Code allows for the lender to receive “super-priority” status and/or liens on the assets of the debtor. In effect, lenders are placed near the top of the capital structure and given a compelling reason to provide funding.
2. “Critical Vendor” Motion: In the critical vendor motion, the Court encourages suppliers/vendors to continue doing business with the debtor by approving prepetition payments. In return, the supplier or vendor, which the Court determined to be vital for the debtor to retain its value and continue operating – agrees to provide the products or services as done in the past.

Bankruptcy Court Protection: Side Benefits

• The formal approval by the Court for DIP financing, priming liens, prepetition vendor payments, and the final approval of the plan of reorganization (POR), suggests the Court found the debtor to be on a sound footing to be prepared to turn itself around post-emergence from Chapter 11.
• While there are no guarantees in restructuring, the backing of a debtor by the Court can assure supplier/vendors, customers, and other stakeholders that as long as the debtor is under its bankruptcy protection – it should be safe to do business with the debtor.

“Cramdown” Provision

• If one class of creditors opposes the proposed POR, the plan could still be confirmed as long as certain conditions outlined in the Bankruptcy Code are met.
• If the restructuring were done in court, the “cramdown” provision would force the final decision to be accepted by the objecting creditor(s) as long as certain criteria are met (e.g., voting requirements, minimum standard tests of fairness).

Executory Contracts

Under Chapter 11, the debtor has the option to either assume or reject executory contracts based on the “best judgment” from management.

• An executory contract is an agreement in which one or both participants have a legal obligation to perform a certain task to uphold the contract terms.
• The debtor and party on the other side each have unmet “material performance obligations”.
• Given the freedom to decide which contracts to assume or reject, a rational debtor would opt to assume beneficial leases and contracts while rejecting those it no longer wants. If the debtor desires to continue receiving the benefits from a certain contract, the debtor must cure all defaults with adequate assurance of future performance. On the flip side, if the debtor wants to get rid of a certain contract, the debtor can file a notice to reject the contract.
• But in the latter case, the creditor can seek to recover some of its losses due to the rejection damages. A rejection of a particular contract by the debtor is treated as being equivalent to an immediate breach of the contractual obligation, and the creditor now has a claim against the debtor for the monetary damages caused by the debtor’s rejection. The claim by the creditor would be categorized as an unsecured claim, and therefore the recovery rate is most likely going to be on the lower end.
• One important distinction to be aware of is that the debtor cannot “cherry-pick” portion of a contract it wants, as it is an “all-or-nothing” ordeal.”

Post-Petition Interest: Unsecured and Under-Secured Debt

• In Chapter 11, only fully secured creditors (i.e., over-secured lenders) are entitled to receive post-petition interest. But to the benefit of the debtor, the interest expense payments owed to unsecured and under-secured debt cease (and the unpaid interest will not accrue to the ending balance).
• Because of this Court provision, the debtor’s cash position and liquidity improve. And when coupled with access to the DIP financing, the liquidity concerns are effectively reduced for the time being.

Section 363 Provision and “Stalking Horse” Provision

• In an out-of-court restructuring, an asset sale by the distressed company will NOT be free and clear of all claims unless the debtor obtains all necessary creditor consents – which makes marketing the asset more difficult (and less competition results in lower valuations).
• But under Chapter 11, Section 363 asset sales are made free from existing claims. Instead, the claims will determine the proceed distribution from the sale, but the buyer can rest assured that the acquired asset and purchase will not be disputed at a later date.
• In effect, such provisions have a positive impact on the ability of the debtor (and their sell-side representative) to market the asset and sell for a higher valuation.
• There are also other provisions afforded to the debtor in-court; most notably, the “stalking horse” provision, which is when a potential bidder sets the auction into motion with a floor valuation. Before the auction process begins, the bidder and debtor would have signed an asset purchase agreement (“APA”) that defines the purchase price and related terms of the purchase such as the specific assets to be purchased (and the excluded assets).

Downsides of In-Court Restructuring

Professional Fees & Court Costs

• The predominant concern with filing for Chapter 11 is the build-up of fees. Often, debtors are reluctant to have the Court become an influential participant in the restructuring process and help dictate the outcome because of the costs. But despite the costly nature of in-court reorganization, the incurred fees can sometimes be worth it over the long haul.

Chapter 11, in particular, comes with a multitude of fees associated with filing for bankruptcy, such as:

• Professional Fees (e.g., RX Advisors, Turnaround Consultants, Legal Representatives)
• Bankruptcy Court Costs (e.g., U.S. Trustee)

The more prolonged the process and challenging the negotiations are, the more fees are incurred by the company who is already in a weakened state.

In recent years, however, the emergence of “pre-packs” has helped alleviate these concerns as the average duration between filing and exiting Chapter 11 has gradually decreased.

Court-Mandated Obligations

• In Chapter 11 bankruptcies, the debtor must strictly abide by each Court mandated obligation as part of the agreement to receive the protections, as well as features such as DIP financing. Therefore, an in-court restructuring requires substantial demands from the end of the management of the debtor.
• The legal duties of the debtor, such as having to file monthly financial reports and submit requested documentation on schedule to promote full transparency across all creditors, are not necessarily a waste of time, per see.
• But in contrast to an out-of-court restructuring, the required depth in the filings such as the proposed restructuring plan, forward-looking business plan, and supporting financial projections all lead to more expenses and could be distractions from the priority on hand (i.e., the POR).
• A significant amount of time will be allocated to court hearings and negotiating with creditor committees in a relatively unproductive process due to the extra steps, which are a byproduct of the existing regulations, standard practices, and the supervision required.
• Collectively, all of these Court-ordered obligations and the systematic structure of the Court to ensure full compliance contribute towards a less efficient overall process.

Public Regulatory Filings: Limited Privacy and Disruption Risk

• Another downside of in-court restructuring is how the privacy of the debtor erodes and the financial circumstances become an open book to the public. The debtor’s troubles will become widespread knowledge by external stakeholders, such as customers, suppliers, and even competitors.
• The effect could be very unfavorable to the debtor and cause suppliers and employees to not want to associate themselves or do business with the debtor.
• Because of the damaging news on the debtor, the public filings can result in even more disruption to the operations of the business.
• In comparison, during out-of-court restructurings, negotiations are kept more private since there is no regulatory filing required to be submitted and made available for viewing, which results in less reputational damage and less strain on existing relationships.

Debtor / Creditors: Subordinate to Court Rulings

• The holdout problem often cited in out-of-court restructuring can be taken care of by the Bankruptcy Court. But this applies both ways, as the debtor and creditor are subject to the rulings of the Court – the Court’s rulings thus hold the highest authority.
• Neglecting the occasional mishaps when the Court’s rulings can be appealed and overturned, the main takeaway is that the Court’s decisions are final, which is why the debtor and all creditors lose negotiating leverage during in-court bankruptcies.