Corporate Reorganization and Bankruptcy: Myth vs. Reality

As promised, some special commentary on some of the Myths and corresponding Realities of bankruptcy, from a practitioner with a view of both sides. William Freeman is a partner with Pillsbury Winthrop Shaw Pittman LLP (http://www.pillsburylaw.com), who has represented both debtors and creditors, in both bankruptcies and out-of-court settlements, and has written on both current practice and case examples. You can find his bio and background at http://www.pillsburylaw.com/index.cfm?pageid=15&itemid=20594. He's not yet a FohBoh member, but his partner Anna Graves, who heads Pillsbury's Restaurant, Food and Beverage practice, is (http://www.fohboh.com/profile/AnnaMGraves). She introduced us recently, and Bill has been kind enough to send some thoughts for today's column and offer a suggestion for future discussion, which we'll happily use.

A brief note about Pillsbury, in appreciation for Bill's work and Anna's introduction. Pillsbury not only serves restaurant, food and beverage clients (the center of our universe), but has deep experience in many related fields -- employment law, intellectual property, and financing -- which have direct bearing on the success and prosperity of restaurant businesses. The firm also occasionally hosts webinars relevant to our industry. Please check them out.

Here's Bill's commentary:

It is my pleasure to supplement Rod’s recent blogs on Chapter 11. Although I have been practicing in the bankruptcy field for over 20 years, this is by far the most exciting time for bankruptcy professionals—not just because we are busier than ever before-- but also because the business realities of our time are rapidly changing the role of Chapter 11 in the US economy. Readers need only analyze the GM and Chrysler bankruptcy cases to discover that even longstanding and previously inviolate bankruptcy precedent may be challenged depending upon politics and the influence of negatively impacted constituencies.
But despite these truly exceptional cases, there are several “myths” and “realities” in Chapter 11 bankruptcies that everyone in the capital structure needs to understand. Here are a few:

MYTH No. 1: The purpose of the Bankruptcy Code is to “restructure” excessive corporate debt.

The reality is that over the past 20 years, there have been 4 primary purposes to the Bankruptcy Code:

First, to facilitate and encourage the rehabilitation of a business. This is the traditional view of a business reorganization; that an entity with excessive debt can obtain a “fresh start” from its creditors. Unfortunately, as will be set forth below, this is the rarest and most difficult type of bankruptcy case to accomplish.

Second, to avoid a “race to the courthouse” by creditors that are separately initiating litigation, repossessing collateral or otherwise attempting to get ahead of other creditors. Thus, one of the purposes of the Bankruptcy Code is to establish clear repayment priorities for different categories of creditors (e.g., post-bankruptcy “Debtor-in-Possession” lenders; senior pre-bankruptcy lenders; subordinated creditors; trade creditors, landlords; equity holders, etc.) that both borrowers and credit-providers can rely upon.

Third, bankruptcy is a sophisticated corporate business tool used by business entities to deleverage their balance sheets, to increase liquidity and to maintain the going-concern value of their business. Examples include selling a business by consummating a “bankruptcy sale”; filing a “pre-packaged” or “pre-arranged bankruptcy” case with the support of critical creditors; resolving impending litigation through bankruptcy; and/or obtaining new credit terms from suppliers and lenders that will no longer provide credit outside of a bankruptcy case.

Fourth, bankruptcy gives a borrower tools to “undo” pre-bankruptcy transactions. This is where the laws of “preferences”, “fraudulent transfers”, “equitable subordination” come in. Each of these legal concepts are legal theories that potentially allow a Bankruptcy Court to retroactively “reach back” in time for several years prior to a bankruptcy and determine if improper, unfair or inequitable conduct took place by a business, its principals, its lenders or its creditors.

MYTH No. 2: Your secured lender will fight you all the way in a bankruptcy.

The reality is that your pre-bankruptcy lender (better known as your “pre-petition” lender) may be your biggest ally in a bankruptcy case. The days of threatening your bank with a bankruptcy filing are long gone. Modern financial institutions understand that bankruptcy has advantages and disadvantages to both the lender and the borrower. Sophisticated businesses understand that their primary secured lender—just like their critical trade vendors—can be one of their best allies in a bankruptcy case.

On the other hand, in most Chapter 11 bankruptcy cases, a drawn-out fight with the company’s senior lender will be exceedingly expensive (both financially and as a toll on human resources within the business organization). Sometimes a lender fight is unavoidable and bankruptcy is the only way to save the business. This can happen when a litigation judgment is about to be entered, or if a foreclosure sale on real estate is imminent. In these and other instances, a bankruptcy filing is critical to save the business. However, in most instances, a “pre-arranged” or “pre-packaged” bankruptcy—i.e., a bankruptcy that has its exit strategy already in place on the day of the bankruptcy filing—has a much greater chance of success.

Any good insolvency professional will tell you that filing bankruptcy is easy—it’s just paperwork. The best way to be maximize your chances of success in a bankruptcy case is to plan your EXIT from bankruptcy even before you go IN to bankruptcy. Similarly, a business’s chance of survival and success in the world of Chapter 11 increases dramatically if that business can adequately prepare its vendors, customers, employees, lenders and other critical constituents before the bankruptcy filing.

MYTH No. 3: “Bankruptcy is too expensive for a small business to survive”.

Smaller businesses tend to have more simplified capital structures; good relationships with their vendors; greater customer loyalty; and management willing to commit to the reorganization process. Each of these relationships will be tested in a Chapter 11 case.
Moreover, Congress has provided unique advantages to facilitate a business going through Chapter 11. These tools will be discussed in detail in subsequent blogs, but include the right to limit claims for above-market or abandoned real estate leases; the right to obtain post-petition or “DIP Financing”; the right to renegotiate pre-bankruptcy contracts; and the right to deleverage the pre-bankruptcy debt on the company’s balance sheet.
The cost of a Chapter 11 can be expensive—sometimes prohibitively so. The distressed business will need a team of professionals, including attorneys, accountants and perhaps a financial advisor. This is indeed a hefty price to pay for a business with liquidity challenges, but there simply is no substitute for critical strategic legal and financial guidance. More to the point though, bankruptcy involves rules and procedures that even most experienced corporate and business attorneys have no experience with. Thus, as with any service provider, the quality and skills of various bankruptcy professionals can vary widely, and any business considering a Chapter 11 filing should interview several qualified professional firms.
In future blogs we will address the practical realities and strategies that businesses use to successfully navigate through Chapter 11 bankruptcy.
William B. Freeman