Smart Companies are Shedding Debt in Chapter 11 as PPP Hopes Fade
For many businesses, PPP pushed back disaster and kept them out of bankruptcy. The problem: Pandemic conditions have outlasted any temporary relief provided by the federal aid programs. Many businesses are now living on borrowed time, especially after taking advantage of low interest rates to increase debt loads over the last few years.
Like everyone, business owners are hoping for a near-term COVID vaccine and a robust recovery. In the meantime, many are looking, with growing frustration and despair, to Congress for another round of PPP funds. By watching private equity and venture capital owned businesses, it is clear that smart money is taking advantage of these unprecedented times to shed debt, retain ownership, and position for future growth by taking advantage of Chapter 11.
Living on Borrowed Time
According to an August 2020 U.S. Census Bureau Small Business Pulse Survey, more than 75% of small businesses have experienced a moderate-to-large negative effect from the pandemic. Other research shows that almost a quarter of small businesses are considering closing permanently due to COVID-19. Businesses are grasping for further help. Personal, non-housing debt is estimated at more than $14 trillion and when the moratorium on foreclosures are fully lifted, millions may lose their homes. The statistics are bleak.
Even without COVID-19, some businesses were already in trouble. Balance sheets were heavily leveraged because of the availability of credit and historically low rates. Even if a business has been hoarding cash, COVID-19 has likely depleted the reserves. Business need to balance their balance sheets, re-negotiate or shed leases and contracts, and have a reliable plan and goals to move forward. The continued and apparently sustained economic depression has left many businesses confounded and searching for help to survive.
What Help is Out There?
Many have tied their hope of survival on another round of PPP, but the Senate failed to pass its latest stimulus bill, and there is looming uncertainty because of the election. Relief in 2020 is unlikely. It may be time for business owners to seek other relief, but even some of those avenues have serious drawbacks.
Quick relief options include lines of credit or other funding, but these often require personal guaranties (see Courtney Gilmer’s article on Guaranty issues) and higher interest rates. If a business is already fully leveraged, these quick cash options are likely unavailable. There are various low-cost small business loan programs, but these are often paper-work heavy, and without a plan to repay those loans, these are no better than band-aids. Borrowing more money may provide a temporary cash influx, but it does not solve many of the underlying problems businesses are facing including the need to renegotiate leases and contracts, deleveraging with their secured lenders, or selling off assets, or even winding down a business.
Chapter 11 is Under-Utilized and Commonly Misunderstood
Wall Street fully appreciates the advantages Chapter 11 offers. This is evident by how much more often VC firms, PE firms, and institutional investors use Chapter 11 to deleverage their investment companies and position them for future growth and profits. But it is an under-utilized and commonly misunderstood option among Main Street companies, incluing family and entrepreneur owned businesses. While a forgivable loan is hard to beat, with all the changing rules surrounding PPP it is impossible to know whether the money will actually be forgiven or just add to a company’s debt burden.
In so many way, Chapter 11 provides more significant benefits than taking on new debt. Through Chapter 11, a company can reduce its debt, improve terms, shed unprofitable contracts, terminate burdensome leases, and stop collection actions from creditors – all of which gives management breathing room to build up cash, make operating decisions, and formulate the best plan to maximize value through a reorganization, sale or orderly wind down.
Large companies such as J. Crew, Neiman Marcus, Hertz, the parent company of Ann Taylor, Chuck E. Cheese, J.C. Penny’s and many others have already used Chapter 11 as an effective tool to overcome COVID-19 challenges and reduce debt to emerge as stronger companies. It is time for mid-size and small businesses to pivot from thinking about Chapter 11 as the death-knell of a company to using Chapter 11 to fix distressed businesses, reduce debt, and come out of the pandemic ahead of competitors.
Benefits of Chapter 11
Chapter 11 may well serve as the backbone of the country’s economic recovery. Many scholars believe the economic recovery following the 2008-2009 crisis was accomplished more quickly and successfully because of companies using Chapter 11. Chapter 11 helps distressed companies maximize value, retain their employees, re-evaluate operations, deal with lenders, and provide a collective solution to all of the challenges facing the company.
Distressed businesses can flip the script and take control of their own destinies instead of waiting on a government bailout that may never come, or letting lenders dictate terms of a company’s existence and forcing it to give up rights and collateral. Some of the valuable tools that are only available in Chapter 11 include:
Breathing Room: Filing a Chapter 11 immediately establishes an automatic stay. Creditors must cease all collection activity, including proposed and commenced lawsuits. Creditors may not take any action against the company once the petition is filed without permission from the Court.
Accumulate Cash: All monthly debt service to Lenders would stop, (but may resume in some lesser amount if a Lender is not “adequately protected” by their collateral), and the company would accumulate cash to pay creditors when a plan of reorganization is filed.
Business as Usual: All Company management stays in place and the Company can continue to operate in the “ordinary course of business.” This allows operations to continue and employees to continue working. All employees will continue to be paid and the company’s daily operations, including health insurance plans, retirement plans and other programs are unaffected by the filing. In the first days of the case, it is common to ask permission to continue these plans.
DIP Lending: Many lenders see Debtor in Possession financing as a compelling lending opportunity because of the special treatment that business bankruptcy loans receive under bankruptcy law. A DIP Lender must receive the payment before other creditors, and this means that a Lender will commit to a DIP loan that they would not make to the same business outside of Chapter 11. This can be hugely beneficial to a company who could not otherwise get a loan or needs to take-out or refinance with a current lender or provide funding to emerge from Chapter 11 stronger.
Sale of Assets: There are significant advantages to the sale of some or all of a company’s assets in the bankruptcy context.
Key benefit of a sale is that a purchaser takes the assets free and clear of any liens and encumbrances.
A sale in Chapter 11 can take as little as 3 weeks and the title that the buyer gets is as good as it gets- an order from a federal judge that the assets are sold free and clear of liens and encumbrances.
Oftentimes, a sale of non-producing assets in Chapter 11 provides the emerging company with needed money to fund the reorganization, or to confirm a Chapter 11 plan that pays off creditors faster. Only Keep What Contracts and Leases Are Beneficial: After filing, a business can choose whether to assume or reject executory contracts and leases. This means that an unprofitable contract or burdensome lease can be rejected. This is a benefit that is only available in a Chapter 11 filing.
Certainty: The reorganization plan would provide certainty to the Company going forward with regard to Company obligations.
Plan can possibly include reduced amounts owed and/or reduced interest rates, which ultimately means that the Company would have less debt.
Any PPP money borrowed prior to filing Chapter 11 if not forgiven, can be discharged in a Chapter 11 plan.
A Chapter 11 business debtor can propose a plan that deals with all aspects of the company’s finances. Confirming a Chapter 11 plan means a comprehensive solution for the company, all creditors, any pending lawsuits, and all contracts and leases. It is a fresh start.
No Forbearance Agreement: Many times, a distressed company’s loans have already been moved over to their bank’s special assets group. At this point, a business should contact bankruptcy counsel right away. If the company decides to file, it would be better to do it IN LIEU of signing a Forbearance Agreement. The Company’s options inside Chapter 11 are greater if a lender does not have the restrictions of a Forbearance Agreement to rely on.
Benefits Over an Out of Court Restructuring or Workout: Out of Court Restructurings or Workouts are another option to be seriously considered. In the short-term, it may be less expensive than filing Chapter 11, but it is does come with its own difficulties. First, none of the benefits of a Chapter 11 filing, including the automatic stay, the power to reject leases, or confirm a plan over a creditor’s objection are available. This is why many of the large retail companies have elected to file Chapter 11 rather than try to do it outside of bankruptcy. Secondly, it requires consensus, and the distressed business has no real leverage to force creditors to agree. If just one creditor holds out for a better deal, the time and money invested to get the restructuring out of court could fall apart, and the pressure for a business to sign a burdensome Forbearance Agreement may force a Chapter 11 filing in the end.
Chapter 11 is a collective remedy. It brings all interested parties together in one place. In no other setting can a business gain leverage over creditors and encourage a global resolution of all claims and disputes of every kind. Chapter 11’s entire purpose is to provide a safe space for a distressed company to pursue negotiations with its creditors in a streamlined process, which injects efficiency, fairness, and certainty into the reorganization process.
What Chapter 11 Looks Like in a Pandemic
First of all, the advent of Subchapter V, (the “SBRA”) provides new and meaningful relief for small business debtors. If a distressed business has debts less than $7.5 million, then the SBRA provides a streamlined Chapter 11 experience that is faster, less expensive and more efficient than traditional Chapter 11 filings. (See Nancy King’s article summarizing the SBRA provisions--the $7.5 million dollar debt limit reduces back down to $2.75 million in 2021).
Secondly, most Chapter 11 filings in the last decade or so have been more about sale of assets than traditional reorganizations. Going forward under COVID-19, however, the pendulum seems likely to swing back toward reorganization plans being confirmed and businesses re-emerging. This is because the pandemic has created a situation where businesses need to refuel and rebuild, and the economic recovery of the country depends not upon companies shutting their doors, but instead upon using tools like Chapter 11 to take a breath and restart.
If a business is distressed, it is probably already past the time its owners or managers should have consulted with bankruptcy counsel. The time to act is before a business becomes so distressed that its outlook is dire. It is not uncommon for businesses to engage bankruptcy counsel late in the game, but earlier is always better. Now, more than ever, though, the time to act is now. If there is to be a massive “wave” of bankruptcy filings, then the bankruptcy courts could become overwhelmed. There are currently about 350 bankruptcy judges to handle all personal and corporate bankruptcy filings. There are limited number of experienced bankruptcy professionals, accountants and turnaround management professionals available. Failure to engage the needed professionals will slow the recovery of any distressed business.
Furthermore, most experts agree that there are large amounts of private sector capital potentially available to support distressed businesses. For now, most banks and fund operators have investment cash available that they would be willing to lend with the protections afforded by a Chapter 11 filing. Knowing that they get repaid first is a powerful incentive to loan to a chapter 11 debtor. Pandemic conditions may continue longer than anticipated or a vaccine may fuel a faster recovery. The unknown makes Chapter 11 protections even more attractive.
A distressed business risks defaulting on loans and often needs a large infusion of cash to survive. When that is not available, Chapter 11 is the mechanism to help companies survive and thrive. The foundation of our bankruptcy system is to promote entrepreneurial spirit and rebuild businesses that have fallen on hard times, not to kill or end businesses.
When a distressed company hires skilled lawyers, and other professionals to guide them through Chapter 11, a business can emerge with significant advantages over their competitors. Chapter 11 is part of our financial and social safety net, and once viewed in light of its intended purposes of promoting, rebuilding, and strengthening businesses, it can be seen as a tool to fuel the economic recovery needed after COVID-19. Chapter 11 is a vital avenue for honest people to utilize and is much more efficient than waiting on some form of relief from the government that may or may not ever happen.
Elliott Jones guides companies and their owners through workouts and business bankruptcy cases. He is a 1975 graduate of Vanderbilt Law School.