Is your Customer Proposing an Out Of Court Workout Instead of Bankruptcy Protection:
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 for recovery.

Workout Agreements

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 to profitability.

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 lien creditors).

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.

Conclusion

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