During difficult times, company management (“debtor”) may consider a restructuring of the company’s financial obligations in order to weather the storm of financial distress and restore the financial health of the company. This can be accomplished through a formal court-supervised reorganization under Chapter 11 of the Bankruptcy Code or an out-of-court restructuring or “work-out.” A work-out is a nonjudicial process where the significant creditors and the financially distressed company reach an agreement to adjust the company’s financial obligations.
Generally speaking, a work-out is less expensive than a formal Chapter 11 Bankruptcy proceeding. Although attorney and possibly consulting fees may be incurred through a work-out, these fees are typically far less than the fees resulting from a formal Chapter 11 Bankruptcy proceeding. This is because the work-out is informal, unsupervised (no judicial oversight), and private compared to a formal Chapter 11 Bankruptcy process which has specific rules and procedures that have to be followed.
However, work-outs have some negative attributes as well compared to a Chapter 11 Bankruptcy proceeding. The primary negative is that the company does not receive relief from creditors and collection pursuits. Also, dissenting views from significant creditors can also complicate and prolong the work-out process.
The table below summarizes some of the main pros and cons of “In-court – Chapter 11 Bankruptcy” vs “Out-of-Court – Workout.”
Pros and cons of out-of-court restructuring versus in-court bankruptcy
In-Court – Chapter 11 Bankruptcy
Out-of-Court – Work-out
|Chapter 11 (reorganization) in-court bankruptcy procedures||A “workout” process or “out-of-court” restructuring where financially troubled company and its creditors reach an agreement to adjust the company’s obligations|
|Filing may automatically disqualify the entity from eligibility for federal loans and “forgivable” loans under CARES and other related stimulus packages.||May qualify for eligibility for federal loans and “forgivable” loans under CARES and other related stimulus packages.|
|Automatic stay stops secured lenders’ foreclosure and suspends all interest and principal payments on pre-bankruptcy debt until a reorganization or liquidation plan is reached||No automatic stay and creditors can continue to enforce their rights|
|Company can assume, reject or reassign leases and contracts||No automatic ability to assume, reject or reassign leases and contracts|
|Direct costs of in-court bankruptcy can be very expensive||Savings on professional fees and expenses, which may amount to millions of dollars for large companies|
|Public knowledge that the company is going through a Chapter 11 filing; customers, suppliers and employees may not view as favorably||Unless company is publicly traded, negotiations are kept private resulting in less damage to a company’s reputation|
|Could lead to a substantial increase in the number of claims because claims that otherwise would not be immediately made, such as unfunded pensions, employee injuries, and disputed payments, would be filed||Fewer creditors may know about the restructuring|
|Time-consuming process for management addressing legal process||Management does not spend time dealing with court hearings or gathering information for court-appointed committees|
|Generally, preserving net operating losses (NOLs) is easier in a formal bankruptcy than in a private workout; also, generally, cancellation of debt income is not taxed if the debt is cancelled in a formal bankruptcy||Debt repurchases and exchange offers may result in the recognition of cancellation of debt income and have negative tax impacts|
Source: Altman, Edward I, et al. Corporate Financial Distress, Restructuring and Bankruptcy. 2019
Regardless if the solution is a work-out or a Chapter 11 Bankruptcy proceeding, the company must be able to show financial sustainability. Financial models and analysis are necessary to demonstrate to creditors the impact of:
- Reorganized operations
- New sources of capital (debt and/or equity)
- Positive cash flows (most important)
Many companies may find it necessary to hire independent financial and accounting experts to assist in compiling these analyses, as the technical knowledge does not reside within the company or creditors find an independent third-party a more reliable source for this information. It is also important to retain appropriate legal counsel to assist in the interpretation and construction of amendments or supplements to the legal documents as well as understating debtor rights under existing agreements. There are also potential tax implications that would need to be evaluated by the appropriate accounting professionals.
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