Understanding the Difference Between a Workout and Chapter 11

by Elliott Jones


Many businesses throughout their lifecycle will experience periods of success and struggle. When business problems become existential threats, legal help is needed. There are two legal strategies for businesses that can’t meet their current obligations, but also aren’t willing to throw in the towel. Knowing the difference between a workout and Chapter 11, and when to employ each strategy, can be the difference between revitalization and disaster.


Workouts

A workout is a negotiation with a company’s creditors. The aim is to reduce debt or extend payment terms so the company can service its obligations going forward. Often called an "out-of-court restructuring," a workout is designed to get a company the relief it needs without resorting to the more complex, formal, and expensive Chapter 11 process.


Some workouts are relatively simple, involving just one to several creditors, where the company hires an experienced restructuring lawyer to handle the process so management can stay focused on running the business. On the other side of the spectrum are complex workouts that may involve hundreds of creditors and require a team of professionals.


In just about every workout, it is the credible threat of Chapter 11, overt or implied, and the creditor's likely outcome in a hypothetical Chapter 11 case, that motivates them to negotiate. Put another way, a successful workout takes place "in the shadow" of Chapter 11. That's the reason Chapter 11 is discussed in the context of a workout even though the goal is to avoid it, and that's why it's crucial a company hires a highly skilled Chapter 11 attorney to run its workout.

Chapter 11

Chapter 11 is a complex legal action, and no company would choose it as a first resort. But when survival is on the line, Chapter 11 protection is a powerful tool that can be the difference between future strength and profitability on the one hand, and liquidation on the other.


Filing a Chapter 11 petition triggers an "automatic stay," which stops nearly all lawsuits, collection actions, and payments on debts that existed prior to the filing. This allows the company to stockpile cash, and gives management much-needed breathing room to focus on profitability, make operating decisions, and formulate a reorganization plan. In most other respects it's business as usual while operating under Chapter 11 protection.


Once approved by the court, the reorganization plan -- which can erase debt, change payment terms, and resolve all manner of disputes -- becomes the new contract between the company and its creditors. The company then emerges from Chapter 11 as a newly constituted enterprise with clear and manageable obligations.


Protections that are Only Available in Chapter 11

There are several protections Chapter 11 offers that are just not available to a business that is trying to deal with financial hardship outside of Chapter 11:


The Automatic Stay

The automatic stay prevents creditors from taking any actions to collect on their debt, and it goes into effect immediately when a Chapter 11 petition is filed. This means that businesses involved in litigation or facing collection efforts by judgment creditors get an immediate reprieve. The issues will ultimately need to be dealt with in a Chapter 11 plan, but the automatic stay gives a business breathing room to make the decisions it needs to reorganize.


Accumulate Cash

The Debtor can and usually must stop making payments on pre-petition debts, allowing it to stockpile cash that can help the business afford the cost of the Chapter 11 process, fund its reorganization plan, and strengthen the business after it emerges.


Reject Contracts and Unexpired Leases

A Chapter 11 debtor can reject unfavorable leases or contracts. This allows a business get out of above-market rents, close locations, and negotiate more favorable deals.

“Cram Down” Loans: Secured loans can be “crammed down” to the value of the collateral that secures them, and new interest rates set.


Restructure Debts

One of the most powerful features of Chapter 11 is the possibility of paying a greatly reduced amount to unsecured creditors, and paying over time. While this is also possible in a workout, the difference in Chapter 11 is that the creditors can be forced by a court to accept payments the company can afford.


Debtor-in-Possession (“DIP”) Financing

The Debtor can sometimes borrow funds through a DIP loan that will put the new lender in a “super-priority” position ahead of existing lien holders. This is a powerful incentive for lenders to put new money at risk to help a struggling enterprise.


Conclusion

The decision to attempt a workout or file a Chapter 11 case is not an easy one, and it requires a careful assessment of many factors. They are also not mutually exclusive – often a company will attempt a workout first and only seek Chapter 11 relief if it is not successful. While some troubled businesses can turn around outside of bankruptcy, Chapter 11 offers additional tools that can make the difference between success and failure. Although the costs of Chapter 11 (filing fees, attorneys’ fees, U.S. Trustee quarterly fees, possibly creditors’ committee fees) are significant, for many businesses the benefits of Chapter 11 outweigh them.

Elliott Jones guides companies through workouts and Chapter 11 reorganizations. He is a 1975 graduate of Vanderbilt Law School.

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