Proactive vs. Reactive
Preparation Is Key
Finding Resolution

Successfully reorganizing a company through Chapter 11 of the Bankruptcy Code is a challenging task even in the best of circumstances. But for small businesses, the challenge is even greater.

In a reorganizing situation (as opposed to a liquidation), the first question to ask is, “Does the organization intend to use Chapter 11 for the right reasons?” Namely, as a means to implement a viable strategy for the company, rather than a last-minute refuge when all else has failed.

A company might use Chapter 11 to shed unprofitable locations or lines of business; reject unwanted leases or executory contracts; restructure the terms of secured obligations, trade payables or other unsecured liabilities; or sell unneeded assets. Additionally, a company might take advantage of the exemption from registration under a Chapter 11 plan for issuance of new debt or equity securities in order to recapitalize.

Whatever the case, there are guiding rules no reorganizing small business can afford to ignore: first, Chapter 11 should be used proactively. Second, devote ample time for advance preparation. And third, seek quick resolution.

Proactive vs. Reactive

The importance of being proactive is best highlighted during workout negotiations with lenders before bankruptcy. Following a default, lenders typically want the financially troubled company to grant them security interests in all of its assets, and will seek to persuade owners and management to either infuse additional capital to fund loan paydowns or personally guarantee the debt.

Although these may seem like better alternatives than foreclosure or bankruptcy at the time, such concessions may make later reorganization through Chapter 11 more difficult. A debtor that no longer has any unencumbered assets will have substantially less flexibility in restructuring, and is at greater risk of a lender lifting the automatic stay in order to foreclose on its collateral.

If the out-of-court workout proves unsuccessful for the company, owners and management may be unable or unwilling to again contribute capital in a Chapter 11 reorganization.

Preparation Is Key

Advance planning allows management to evaluate the risks and rewards of a Chapter 11 proceeding, develop realistic goals and a timeframe for the reorganization plan, and consider the most opportune filing date.

When evaluating the best time to file, be sure to minimize disruption to paychecks to continuing employees, withholding tax payments and employee insurance payments. Also, time the filing for when the business has reached the bottom of its economic cycle or has already begun to recover. A business that grows steadily weaker in Chapter 11 is likely to be either converted to a Chapter 7 liquidation or the subject of a secured lender’s attempt to cut off additional use of cash collateral on the grounds that its interests are not being adequately protected.

Planning also will allow time to develop a coordinated game plan involving the debtor’s team of attorneys, accountants and other professionals, who will be responsible for guiding the reorganization effort. They will need to work together well if the case is to move forward efficiently.

Advance preparation for Chapter 11 is important for two reasons: The debtor’s counsel will need to prepare certain legal motions to file at the commencement of the Chapter 11 case, and the debtor will need to inform both internal (employees) and external (clients, vendors, etc.) audiences of its intentions.

A press release explaining the filing should be prepared in advance, along with communications with suppliers and customers. Perhaps most importantly, management should plan how and when to communicate the news to employees. These tasks are best done prior to the filing date to minimize disruption.

This advance planning should minimize both the duration of the Chapter 11 case and the disruption it causes to the business. A shorter case will help keep everyone focused on the goal of reorganization, keep costs (legal, accounting and other professionals) to a minimum, and lessen management’s distraction from running its business. A shorter case also translates into a shorter period of time in which employees feel uncertain about their futures with the company, and in which competitors can take advantage of the uncertainty.

Finding Resolution

Many potential issues in a Chapter 11 proceeding may end up without substantial economic significance, particularly if they involve pre-petition claims against the debtor, which ultimately will be paid for in fractional dollars under a plan.

Finding ways to settle or efficiently litigate such issues is critical. For example, the debtor may be able to schedule litigation of similar issues together so that its cost is distributed among a number of disputes. The bankruptcy court may be available to mediate the settlement of disputes. Disputes that are not cost justified are best avoided altogether.

The debtor also should avoid actions that could count against it in its Chapter 11 case. Failure to file timely and accurate operating reports with the court may be grounds to dismiss or convert the Chapter 11 proceeding, for example. Inaccurate or untimely reporting to lenders and other creditor constituencies may jeopardize what already may be a strained relationship.

Similarly, cooperation where possible with the other parties in interest, including lenders, the committee of unsecured creditors, lessors and the United States Trustee, is important in keeping the case moving forward smoothly. Of course, cooperation may not be possible where the debtor’s interests are directly threatened.

Be aware that certain issues in Chapter 11 may have a later impact on the debtor’s situation. For example, early in a case a debtor may tend to over-emphasize the value of its assets in response to a secured lender’s attempt to modify the automatic stay or request for adequate protection. However, at the end of the case (when it’s time to consider confirmation of a plan), the debtor will be required to essentially pay creditors for the value of its assets in order to retain them. The debtor needs to fully understand the overall reorganization process and avoid the negative consequences of trying too hard to bolster its position early in the case.

A small business in Chapter 11 may have only enough time and resources for a single efficient reorganization effort. Effective management of the process may mean the difference between a successful restructuring and liquidation.

About the Author
Stephen T. Bobo is a member of the Chicago law firm of Sachnoff & Weaver, Ltd. For the past 19 years, his practice has been focused on bankruptcy, corporate reorganization and related litigation.

Reprinted courtesy of INSIGHT Magazine, published by the Center for Corporate Financial Leadership.

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