Monday, October 28, 2002 CORPORATE RESTRUCTURING & BANKRUPTCY Searching for Common Ground Out-of-Court Workouts Require Critical Players in the Process to Build a Consensus BY PAUL D. LEAKE result from a clear evaluation of available Choosing a Path options that is informed by a thorough EADLINE-GRABBING understanding of the Bankruptcy Code and In most cases, the determination whether scandals involving corporate an accurate assessment of the rights and to restructure out-of-court or in bankruptcy mismanagement and accounting remedies available to the various constituen- is driven by economics. The most significant Himproprieties have recently con- cies in a Chapter 11 case. A successful question confronting the company and tributed to six of the 10 largest corporate restructuring also requires professionals that creditors considering whether to participate bankruptcy filings of all time. The notoriety have substantial experience with the in an out-of-court workout should be of these bankruptcy cases has overshadowed Bankruptcy Code and the bankruptcy courts. whether the workout has a reasonable the importance of a far more prevalent and With these ground rules, the company and prospect of solving the company’s problems. potentially useful restructuring tool available its professionals can make reliable judgments For instance, if the company’s cash flow is to financially troubled companies seeking to negative and liable to remain so due to ------sort out a host of problems in a volatile operational or market-oriented problems, economic climate. The objectives of an out-of- any workout that fails to significantly reduce Chapter 11 is not the only way to deal court restructuring are existing debt service requirements is more with financial woes. In fact, given the right certainty, control and a likely than not doomed to failure. Visionary circumstances, restructuring out-of-court schemes contemplating cash flow production may be far preferable for a number of reasons, business solution fashioned by at historically unprecedented levels fall into including reduced transaction costs, the parties with a real this category as well. In either instance, enhanced ability of existing management to financial stake in the bankruptcy would probably be the preferred control the restructuring process and outcome. alternative. Economic reality must inform avoidance of the adverse publicity often any decision to undertake or participate in ------associated with a bankruptcy filing. Any a workout. company confronting financial problems There are two basic types of out-of-court would be prudent to consider both in- and about the substantive and procedural issues restructurings. The first contemplates a debt out-of-court restructuring options, and often that are crucial in deciding whether to payment moratorium to afford the company in tandem. The purpose of this article is to pursue a negotiated out-of-court restructur- time to resolve its problems through a explore briefly some of the benefits and ing or to resort to a bankruptcy filing. refinancing, major divestiture or infusion of drawbacks of restructuring in and outside of Two key concepts underpin an out-of- new capital. The second involves some form bankruptcy court. court restructuring. First, management, the of adjustment of the company’s obligations to board of directors, shareholders and creditors creditors, much in the same way that a Establishing Ground Rules must recognize that businesspersons are Chapter 11 debtor-in-possession might better suited than judges and litigators to propose to restructure its debts pursuant to a Arguably the most important thing to make the business judgments to formulate a plan of reorganization in bankruptcy. Either remember when considering restructuring feasible restructuring strategy. Second, given type of restructuring may impact some or all options is that federal bankruptcy law the uncertainty and dilution of control of the company’s creditors. provides the benchmark against which all inherent in court proceedings, restructuring Opting for an out-of-court workout does decisions in a restructuring should be made. out-of-court may be preferable because it not necessarily foreclose the alternative A successful restructuring is far more likely to allows management and the board of bankruptcy case. In fact, a successful directors to maintain control over the restructuring can and frequently does include Paul D. Leake is a partner in and co-head of the process. The objectives of an out-of-court a Chapter 11 filing after the major players business restructuring practice of the New York office of Jones, Day, Reavis & Pogue. Mark G. restructuring are certainty, control and a have reached a consensus or agreement Douglas, the practice development facilitator, business solution fashioned by the parties concerning the parameters of the restructur- assisted in the preparation of this article. with a real financial stake in the outcome. ing. In most cases, “pre-packaged” or NEW YORK LAW JOURNAL

“pre-negotiated” Chapter 11 cases are the agreements, except to the extent that the authorized by the Bankruptcy Code to retain product of a successful out-of-court debtor during the case uses property pledged professionals, including attorneys, account- restructuring and satisfy as nearly as possible as security to a pre-bankruptcy lender, in ants and financial advisors, to represent them the customary objectives of the extra-judicial which case it is obliged to make “adequate during the bankruptcy case. For the debtor, workout. The principal issue in determining protection” payments that are typically this may mean hiring and compensating a whether to attempt an out-of-court equivalent to interest payments at the non- phalanx of lawyers in addition to counsel restructuring is whether the advantages of an default rate under the lender’s prepetition that it utilizes in matters arising in the out-of-court workout outweigh the benefits loan agreement. In addition, a Chapter 11 ordinary course of its business. All of restructuring in Chapter 11. debtor has the ability to “reject,” or cancel, professionals retained by the debtor and the Chapter 11 of the Bankruptcy Code burdensome contracts and agreements in official committees during a bankruptcy case creates an orderly court-supervised effect on the bankruptcy petition date. The are compensated from the debtor’s estate. In framework within which to restructure debt debtor may also derive value from valuable some cases, the estate may also be required to and rehabilitate the debtor’s business. contracts by assigning them to third parties foot the bill for expenses (above and beyond Chapter 11’s most significant advantages are notwithstanding provisions in the agreement legal fees) incurred by the members of the ability to bind dissenting creditors (and that prohibit such assignment. None of these official committees. shareholders) to a plan of reorganization and powers exists outside of bankruptcy. Though potentially a short stint in the the automatic stay of acts against the debtor The Bankruptcy Code also benefits case of a “pre-packaged” or “pre-negotiated” and its property pending implementation of creditors. In addition to the automatic stay’s filing, Chapter 11 is more commonly a long that plan. Chapter 11 also provides a preclusion of a race to the courthouse and drawn-out process. The statutory controls centralized forum within which to sort out all the piecemeal dismantling of a debtor’s designed to protect creditors make of the debtor’s financial and operational assets, the Bankruptcy Code provides that Chapter 11 a cumbersome vehicle for the problems, if any such resolution is possible. management is prohibited from engaging in restructuring of a debtor’s business. In the All creditors — dissenting and otherwise transactions outside the ordinary course vast majority of cases, creditors can expect — are bound by the terms of a plan of without court approval. If a company’s delays of anywhere from six months to many reorganization, so long as each class of claims management is not competent or breaches its years before recovering anything in respect of accepts the plan by two-thirds in claim their claims. ------amount and a majority in number of Being before a bankruptcy court may also creditors voting, and the plan otherwise Any company confronting be a mixed blessing for certain creditors. As satisfies the statutory requirements for financial problems would be fiduciaries of the estate and all creditors and acceptance, or “confirmation.” By contrast, prudent to consider both in- shareholders involved in the bankruptcy, the economic terms of debt instruments management of a Chapter 11 debtor and the generally cannot be modified outside of and out-of-court restructuring committees appointed in the case are bankruptcy without the consent of each options, and often in tandem. obligated to maximize the value of the estate. creditor. Therefore, a very high percentage of ------In part, that entails examining the pre-bank- creditor cooperation is required for an out-of- ruptcy conduct of deep-pocket creditors and court restructuring to work. Frequently, this fiduciary obligations to the company or the other parties in an effort to determine places the burden of the success of an out-of- bankruptcy estate, creditors can ask the whether or not the estate has potential court workout on one group of creditors, such bankruptcy court to appoint a trustee to causes of action against them based upon, as lenders who feel pressured to make manage the debtor’s affairs during the case. among other things, lender liability and concessions rather than risk pulling other All that said, there are significant fraudulent or preferential transfers. Creditors creditor groups into the restructuring. advantages to an out-of-court workout, wishing to avoid the spotlight may be better The automatic stay provided in §362 of provided the circumstances are right. A off elsewhere. the Bankruptcy Code creates an automatic bankruptcy case is formal, complex and That is not to say that restructuring statutory moratorium on all debt collection costly. Many actions that management would out-of-court is necessarily easier or less efforts, including litigation commenced ordinarily take with little difficulty or fanfare expensive. In fact, in many cases, quite the against the debtor. No such shield protects a require formal application to the bankruptcy opposite is true. If the company’s problems company outside of bankruptcy. Recalcitrant court and a public hearing at which any party are complex and involve a wide array of creditors are at liberty to pursue their involved in the case may object. In creditor and shareholder groups, a substantial remedies, and creditors participating in a most cases, a committee representing the amount of time, effort, resources and money workout must constantly be vigilant lest company’s creditors (and, sometimes, a will be required to initiate, develop and other creditors either enforce their remedies committee representing shareholders) will be implement a workout. Time and money are to the disadvantage of the entire creditor appointed to act as watchdogs, thereby merely devoted to different efforts. body or extort special concessions or advan- subjecting management’s conduct to an In most out-of-court workouts, the tages in exchange for their forbearance. unprecedented degree of scrutiny. The expenses of lenders’ professionals are funded A bankruptcy filing also effectively company will also be subjected to financial by the company on a current basis. The suspends the accrual of interest on unsecured reporting requirements in addition to those company itself will need the advice of the debts, and relieves the debtor from its mandated by federal securities laws. same bankruptcy professionals that it would obligation to make current debt service The debtor, any trustee appointed in the retain in Chapter 11 because, as noted, payments under pre-bankruptcy loan case and every official committee is management cannot make an informed MONDAY, OCTOBER 28, 2002 decision concerning the terms of a proposed basis, funding lender costs and avoiding the intends to do, that the company is following workout unless it is well aware of the manner cost of professionals for trade and other its operating protocol and treating similarly in which creditors and shareholders involved unsecured creditors and equityholders. situated creditors equally except as necessary, in the workout would be treated in a For every participant in an out-of-court justifiable and disclosed, and that the bankruptcy case. restructuring, the process operates on two continued operation of the company Management’s conduct will also be subject levels: the individual mechanics of restruc- preserves and enhances value. to heightened scrutiny during a workout, turing each lender’s or investor’s position; In addition, the company should which cannot in any case succeed without a and the overall dynamics of restructuring portray resort to Chapter 11 as a matter meaningful dialogue between the company the enterprise. All workout participants wholly within the creditors’ control. The and its creditors and the disclosure and (including the company) must recognize and company must successfully communicate its exchange of relevant information. In fact, understand this parallel track. Naturally, the commitment to the rigors of an out-of-court once the company is in the vicinity of company, its owners and lenders participate restructuring, while at the same time making insolvency, management’s fiduciary obliga- in the overall dynamics of the restructuring. it clear that any attempt by aggressive tions begin to shift to encompass the As a consequence, the workout should be creditors to thwart the equal treatment company’s creditors, who will be intent upon premised on strategies that lay a reasonable principle will precipitate a bankruptcy filing ensuring that company executives act in the basis for agreement or for objectively identi- as a last resort. Finally, the company should best interests of themselves as well as the fying a range of potential outcomes. act through credible and appropriate fiduci- company’s shareholders. An overall restructuring should be aries. Operating expertise and institutional dedicated to maximizing the value available memory are necessary but not sufficient Plotting the Course to its constituents. The company must qualifications for officers and directors of a recognize that, as a financially distressed company that is attempting an out-of-court Managing the out-of-court restructuring enterprise, it must be independent of, and restructuring. The company’s stewards must process entails searching for common ground may have differing interests from, its equity be perceived as individuals capable of acting or areas of mutual interest between and owners. This is an abstract and disorienting as fiduciaries for multiple constituencies. among the company, its lenders and concept for most managers. Mastering the its owners. Absent adequate consensus or concept of fiduciary responsibility to Conclusion the ability to find areas of mutual multiple constituencies will frequently be interest, the process will more than likely the key to obtaining lender confidence, Restructuring out-of-court requires a gravitate toward bankruptcy. Situations credibility and tolerance for a resolution that company, its lenders and owners, and their involving multiple lenders or lenders having does not pay creditors in full in cash. respective counsel to balance intricate legal multiple relationships with the company The company should be perceived as an and business judgments. Counsel is frequently facilitate the identification of “honest broker” among competing interests instrumental in designing, assessing and common ground. in the enterprise. The board of directors and explaining the various available options and At a minimum, for a workout to succeed, management must come to realize that they strategies. Negotiating leverage is almost the critical players — usually consisting of work for the enterprise, which encompasses always dynamic and elusive. Lenders have a management, the board of directors, lenders both creditors and shareholders. In addition, tremendous ability to extract information, and any controlling owners — must build a the company should voluntarily accept disclosure and other commitments from a consensus for a negotiated resolution that certain of the burdens of Chapter 11 by company as a price for staying out-of-court. leaves everyone in a better position than the adopting operating procedures comparable The company has an almost unique ability to uncertain outcome of a free-fall Chapter 11 to those imposed in Chapter 11, while convince a lender that its documentary case. Achieving that consensus depends identifying necessary exceptions. For remedies are inadequate or unattractive upon building communication bridges and example, cash conservation and liquidity under the circumstances. identifying mutually beneficial objectives. limitations may lead to a moratorium on In seeking flexibility from a lender, the Potential common ground might include, payment of debt service, though many company places a tremendous burden on a for example, the common benefit of companies will and should continue to lender to manage its conduct to avoid maintaining a going concern or enterprise, pay trade debt and employees in the waiving its rights, or at the other extreme, to an uninterrupted flow of product or services ordinary course. avoid precipitating a Chapter 11 case which to customers, tenants or clients, selling or The company should also be able to may prove to be disastrous. Yet the business otherwise disposing of losing lines of business demonstrate that it is providing at least as benefits to be obtained by staying out-of- or locations, or rebuilding, preserving and much information and disclosure to lenders court may highlight the wisdom of a creative protecting the core business of a franchise as creditors would receive in Chapter 11. consensual solution over a foreclosure, which may ultimately fund recoveries for Equally important, the company should collection lawsuit or the less flexible rules of lenders and owners. There are also other, systematically disseminate information that a bankruptcy case. more practical consensus factors, such as enables lenders to verify that the company is, avoiding chaos, paying interest on a current in fact, doing what it has stated that it

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