Broke But Not Broken: Private Workouts in Lieu of Bankruptcy

Once a company acknowledges it is in financial distress, a fork in the road appears: either 1) seek bankruptcy protection; or 2) try to negotiate a private work-out. Each option carries certain advantages and disadvantages but they also share many common traits concerning general insolvency.

First, what is insolvency? A debtor is “insolvent” if its debts exceed its assets (excluding assets that have been transferred, concealed or removed with intent to hinder, delay or defraud creditors). The above definition is generally known as the “balance sheet” test. See 11 USC § 101(32)(A); In re Sierra Steel, Inc. (9th Cir. BAP 1989) 96 BR 275, 277.  For municipalities, the Bankruptcy Code defines insolvency as the inability of the entity “. . . to pay its debts as they become due.”  11 USC § 101(32)(C).

Insolvency is not required to file bankruptcy.  To afford the bankruptcy courts maximum flexibility, Congress did not expressly limit Chapter 11 protection to debtors who are insolvent or who suffer any other particular form of financial distress.  In re SGL Carbon Corp., 200 F.3d 154, 163 (3rd Cir.1999).  An individual or corporate Chapter 11 debtor may, under certain circumstances, prosecute a reorganization case when the entity is not insolvent under the balance sheet test.  In sum, solvent debtors, generally, can survive motions to dismiss the Chapter 11 cases where they face an existing and worsening litigation crisis of massive dimensions (In re Johns-Manville Corp., 36 B.R. 727, 741) (Bankr. S.D.N.Y. 1984), an imminent undoing of an essential support for their ongoing businesses (Fields Station LLC v. Capital Food Corp. of Fields Corner) (In re Capital Foods Corp. of Fields Corner), 490 F.3d 21 (1st Cir. 2007)), or a portentous wave of debt maturities under conditions of severe credit uncertainty (In re General Growth Properties, Inc., 409 B.R. 43) (Bankr. S.D.N.Y. 2009). The general condition pre-requisite is that the petition be filed in good faith.  In re Marsch, 36 F.3d 825, 828 (9th Cir.1994); In re Sylmar Plaza, L.P., 314 F.3d 1070, 1075 (9th Cir.2002).

In light of the above, when, then, should an individual or corporate debtor consider a private workout in lieu of a bankruptcy filing?  The answer usually turns on two factors: 1) access to available cashflow and whether the “burn rate” and amount of available cashflow will allow the debtor sufficient time to propose and consummate a private work-out arrangement with creditors; and 2) the extent of urgency to obtain the protections afforded by a bankruptcy filing under the general principles of the automatic stay.

With enough time, foresight, and yes, cashflow, a debtor may be able to avoid a bankruptcy filing and access certain advantages that a “private workout” holds over a “public workout” (bankruptcy filing), as follows:

1. Less costly: A bankruptcy filing oftentimes can increase the cost of a restructuring via the increased fees and expenses of professionals, secured lenders, an indenture trustee, a collateral agent, and/or an administrative agent, as well as the costs necessary to prepare the filing.
2. Less disclosure:  In exchange for the protections of the automatic stay, the Bankruptcy Code and related Federal Rules of Bankruptcy Procedure require significant disclosure from a company regarding its finances, operations, transfers, and payments to insiders.  Such disclosures may not be required in an out-of-court workout, though a diligent creditor certainly can and may seek to require the same level of disclosure in any workout, in or out of court, as a condition pre-requisite to any workout.
3. Less disruption:  a bankruptcy filing may disrupt relationships with vendors, public perceptions, employees, and even property sales, especially if a debtor must sell property quickly and is unable to locate to locate a “stalking horse” bidder to test the waters and maximize true market price.

Should a company decide to attempt a private/out-of-court workout, it is critical to initiate and maintain an open and constant dialogue with creditors regarding workout plans. Doing so may run contrary to a longstanding belief to not consult creditors about a company’s internal financial situation until it is absolutely necessary to do so. A solid and open-ended working relationship with creditor groups is the sine qua non of a successful workout – whether in or out of court.

Lastly, and especially in the case of a private work-out, it is important to remember that the constructive trust doctrine applies to an insolvent entity, even out of bankruptcy. Under a long-standing principle of corporate law, corporate officers and directors generally occupy a fiduciary relationship only towards their corporation and shareholders; however, in the event of insolvency, the fiduciary relationship is expanded to include the corporation’s creditors. See Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991).  In Berg & Berg Enterprises LLC, the California Court of Appeal analyzed and recognized this relationship, but held that, under California law, there is no broad, paramount fiduciary duty of due care or loyalty that directors of an insolvent corporation owe to its creditors. 178 Cal.App.4th at 1041.  Rather, the extra-contractual duty owed by corporate directors to an insolvent company’s creditors is a “constructive trust,” “. . . consistent with the trust-fund doctrine, to the avoidance of actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditors claims.”  Id. at 1040.  Thus, even when structuring a private workout, pro-rata to all!