Is your Customer Proposing an Out Of Court Workout Instead of Bankruptcy
When Should a Credit Sweat with a Debtor?
By Richard J. Ruszat II
The story of a debtor's financial struggles is all too common in
today's economy. It begins by the debtor describing that its industry
is mired in the trough of a cyclical slowdown ... that the slowdown
reduced customer demand and created overcapacity in the industry,
and more particularly, in the debtor's operations ... and that as
a result, the debtor experienced operating losses and cash flow difficulties.
The debtor then rides this slippery slope of obscurity into an enthusiastic
picture of an anticipated turnaround to the profitable days of yesteryear.
However, as credit extensions become increasingly rare, and collection
actions more familiar, the debtor finally concludes that reorganization
is the only avenue to remain in the marketplace. Instead of electing
business reorganization under chapter 11 of the Bankruptcy Code or
an assignment for the benefit of creditors, the debtor sends you
a "confidential communication" requesting your presence at a meeting
of its creditors to discuss an out -of-court workout. Should the
credit professional be receptive to this request or solicit others
to force an involuntary bankruptcy? It all depends on the chances
A financially struggling debtor may propose an out-of-court workout
to its creditors to avoid formal relief under chapter 11 of the Bankruptcy
Code. An out -ofcourt workout is a contractual agreement made between
the debtor and its creditors to resolve outstanding debt obligations,
and at the same time, direct a course toward financial stability.
A credit professional should balance the advantages of a workout
agreement against the advantages of reorganization through bankruptcy.
A workout agreement enables a debtor to address its primary concern
of burdensome debt without the stigma that a bankruptcy filing may
entail. Through a workout, the debtor avoids the public scrutiny
of a bankruptcy case, shields its customers from competitors seeking
to cash in on the debtor's demise, and manages internal relations
with employees in a much less intimidating manner. The positive atmosphere
that the workout may accomplish assists all parties in interest by
focusing on the issues that led to the debtors' financial difficulties
and charting a course to profitability. More important, a workout
is usually expeditious, less expensive, and interferes only minimally
with the debtor's operations. Workout agreements are proposed and
accepted within a short period of time after the meeting of creditors.
In the context of bankruptcy reorganization, a bankruptcy case may
take several months, and perhaps years, prior to the acceptance of
a plan. Even after a plan is accepted, payment of prepetition obligations
is further delayed thorough post-confirmation litigation of preference
actions and other avoidable transactions. The delay of bankruptcy
reorganization also has a collateral effect on the expenses to the
debtor's estate. In bankruptcy, the debtors are required to pay for
the services and costs of professionals through administrative expense
claims. As an administrative claim, the professionals are paid prior
to the other creditors, which will affect the amount of a distribution.
Further, a workout agreement has a minimal affect on the debtors'
operations and does not require a court order for use of cash, filing
of monthly operating reports, and other operational scrutiny. Instead,
a workout permits the debtor to focus on returning its operations
Reorganization and the Bankruptcy Code
Although the informal context of a workout is a valuable method
to achieve payment, the more viable alternative may be a formal reorganization.
The Bankruptcy Code provides several statutory protections to assist
the debtor through its reorganization efforts, which are unavailable
through a workout. One of the more useful protections of the Bankruptcy
Code is the automatic stay. The automatic stay imposes a freeze on
all suits, foreclosures and similar actions against the debtor's
assets, which comprise the debtor's bankruptcy "estate." If the debtor
is facing a flood of litigation, then the automatic stay creates
breathing space for the debtor to focus its attention on the reorganization
of its operations. Another operational advantage to reorganization
under the Bankruptcy Code is the debtor's ability to reject executory
contracts and unexpired leases. This is especially important if the
debtor remains liable for burdensome contracts and unexpired leases,
which may be over market or simply no longer a part of its operations.
The Bankruptcy Code also offers unique strategies to achieve a successful
reorganization that are not always available through a workout. If
management concludes that a sale of the debtor's assets is the only
way to effectuate reorganization, then the debtor is entitled to
sell its assets free and clear of liens and encumbrances, and oftentimes,
without the of secured creditors. This remedy is not available under
a workout and may invite protracted litigation by secured parties
in an attempt to protect their individual interests. In addition,
under certain circumstances, the Bankruptcy Code permits the "cramdown" on
dissenting creditors of the provisions of a plan. In the workout
setting, creditors may " opt-out" of the workout agreement and seek
their own recoveries. Further, reorganization under the Bankruptcy
Code permits the recovery of preferential transfers and the avoidance
of liens and fraudulent conveyances. Accordingly, reorganization
under Bankruptcy Code provides an even playing field for all creditors
to recover their proportionate share of available funds whereas a
workout may pay certain creditors ahead of others (i.e., judgment
Meeting of Creditors
The first step toward a successful workout will require the debtor
to convene a "meeting of creditors." The meeting normally consists
of general unsecured creditors only. At the meeting of creditors,
the debtor is usually prepared to confidentially discuss the issues
that created its financial difficulties, its current revenues and
debt structure, prior and future efforts to reorganize its operations,
and other information to convince creditors that a workout is the
best chance for payment.
Formation of a Creditors' Committee
The formation of a creditors' committee is also a primary importance
at the meeting of creditors. The role of a creditors' committee is
similar to that of a chapter 11 creditors' committees. Essentially,
the creditors' committee serves as the " watchdog" of the debtor's
affairs and makes decisions and recommendations to the debtor's creditors.
The selection of the committee should closely correspond to the
requirement of the Bankruptcy Code since a failed workout, or alternatively,
a dissenting creditor group seeking an involuntary petition, may
land the debtor in bankruptcy. If the debtor is forced into bankruptcy,
then the workout committee may continue its functions and relationship
with the debtor as a chapter 11 creditors' committee. Generally,
a creditors' committee should be fairly chosen after notice is given
and consist of a fair representation of the creditor body.
Similar to the bankruptcy context, the creditors' committee should
seek legal counsel and other professionals as soon as practicable.
It is imperative in the workout process that the creditors' committee
receives competent legal advice since the debtor's are subject to
less scrutiny than under the administration of a bankruptcy case.
Generally, the debtor will compensate the creditors' committee's
legal counsel for its costs and services. The individual committee
members are also entitled to compensation for expenses.
The Workout Agreement
One of the advantages to a workout plan is the flexibility associated
with framing an agreement. The essential components of a workout
agreement include the payment plan, moratorium on collection and
similar activity, monitoring rights of creditors concerning the debtor's
operations, and adequate protection for creditors that the debtor
fulfills the conditions of the agreement. The terms and conditions
of the workout agreement are the result of extensive negotiation
between the debtors and creditors' committee, usually through their
respective counsel. In addition, if secured debt is involved, the
secured parties may want to be involved in the negotiation of an
agreement. In any event, the terms and conditions of the workout
should be framed to mirror the terms and conditions of a plan of
reorganization in the event that the debtor is forced into bankruptcy.
Payments under a Workout Agreement
Generally, there are two types of workout agreements. An "extension" agreement
restructures the debtor's obligations for payment in full over a
period of time. Alternatively, a "composition" agreement reduces
debt obligations and creditors receive only a fraction of their claims.
There are also hybrid plans that may pay a fraction of the claim
over a period of time or payment may be received in goods or products
of the debtor.
Creditors Subject to the Workout Agreement
A workout agreement is a contract and only binding on the creditors
that accept the agreement. Accordingly, creditors that do not agree
with the workout are free to pursue their own agendas. Although unanimity
is difficult, if not impossible to reach, the workout agreement should
seek the approval of one-half of the creditors holding claims totaling
at least two-thirds in value. Granted adequate disclosures are made
by the debtor, the terms and conditions of the workout agreement
may be incorporated into a plan of reorganization and quickly enforceable
if the debtor is forced into bankruptcy.
An out of court workout agreement is a valuable method to seek payment
from the debtor. The workout may result in a faster plan for payment,
reduction in professional fees, and minimal disruption to the debtor's
operations. Moreover, it is especially important if creditors' would
not receive a distribution in a chapter 11 reorganization since payment
may be structured to suit the needs of all parties including the
debtor, secured creditors, and general unsecured creditors.
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley
LLP Summer 03