Chapter 11 Diagnostic Tools: How We Determine if a Distressed Business is Salvageable
By Julianne Frank & David Markarian
Chapter 11 is a powerful medium. Using it, the debtor can often reduce loan balances on secured (collateralized) debt to the distress value of the collateral, pay very small amounts of unsecured debts (general payables) over very long periods of time, completely eliminate debt owed to certain creditors, cancel contracts and leases that are burdensome, and surrender burdensome assets. Much of this can be done in many instances without the consent or vote of certain creditors.
There are several criteria that we in the restructuring business utilize to determine if our client’s business can be successfully reorganized or restructured using the Chapter 11 process. Below are some of the most common tools we use to diagnose whether a business is a good candidate, and to determine whether we can get it back on solid footing.
What are the root causes of the distress?
The causes of the distress often govern whether a business can be saved. The most frequent causes are bad management, economic downturn, unanticipated competition, excessive debt, infighting or poor marketing. If management is incompetent or the principals are at war, Chapter 11 will often be an inadequate solution because no amount of number crunching or court edicts are going to turn around a business when its problem is the people involved.
What do the numbers tell us?
Chapter 11 works best when the problem is a numbers game. To determine that, we employ the art of the spreadsheet. We create projections that take the current fixed operating expenses of the business and the average monthly income based on historical perspective, adjusting them for any projected delta going forward. We remove all secured debt payments from the analysis, and all accounts payable other than cost of goods going forward. We analyze the collateral value to loan balance ratios to determine if we can strip loans. If so, we project the restructured and reamortized loan payments, and plug those back in. Finally, we make sure there is some net income left that can provide some unsecured dividend. All of that gives us an analytical framework to determine if the tools of Chapter 11 can right the ship.
Are the prime players “all in”?
Our clients come to us already having a difficult time running their business. Now, we add a whole new full-time job to their daily grind, which is effectively what Chapter 11 requires. The investment of time and energy that management must devote to the process is substantial. The lawyer is the guide or conductor. The real work is in the trenches and must be done by the insiders. If we do not perceive that our clients are willing to contribute some serious overtime to the effort, it will diminish the chances that our legal team will be able to help them. If we have to play “dentist,” constantly pulling teeth to get what we need from the client, this will handicap the client’s chances for success. We advise our clients to be prepared for a highly interactive exercise and that if their heart and head are not into saving their business, no amount of superb lawyering will be enough to pull them through.
Who owns what?
Very often, business distress encompasses several related entities. For example, the owners may have an interest in the real estate that houses their business. Cash flow issues may be causing upstream payments toward the real estate loans to fall behind. These issues can add complication to the Chapter 11 process because filing for the business alone may not protect the business from losing its location, thus mandating the filing of multiple Chapter 11’s. This adds expense and, of course, creates procedural and sometimes ethical issues to the equation. Multiple filings and case consolidation require a careful analysis of each entity as if it were filing on its own and seeking of a global non-conflicting resolution.
The two most important words: Exit strategy.
Too often Chapter 11 cases fail, and a primary cause of failure is inadequate preparation, failure to do the homework and to roadmap an exit strategy. Pre-filing analysis is, in our opinion, the secret to successful outcomes in Chapter 11. Benchmarks and waypoints along the way should be plotted and the expectations monitored to compare with projections as the case unfolds. The lawyer who is first pondering the reorganization plan as the case unwinds will rarely be steering their client into a safe harbor.
How do your clients find the right lawyer?
Experience, credentials, and track record are keys. The prospective Chapter 11 client should ask how many cases the lawyer has filed and what percentage of cases have been successfully confirmed. Advise them ask to talk to other clients who have gone through the process.