By Eric Hall
The current Covid-19 crisis has tested the financial solvency of many companies. Chapter 11 bankruptcy may be the last resort (or next to last resort) for an orderly reorganization of a company’s debt before an outright liquidation in Chapter 7. Both kinds of filings are expensive and procedure-bound. Bankruptcy attorneys, accountants, advisors, etc., must be engaged to represent the various classes of claimants to the corporate estate, and once the filing has been made the bankruptcy judge is in charge and must approve everything: budgets, contracts, financial restructurings, etc., and the process is often protracted. However, there are alternatives to bankruptcy that provide workouts and restructurings amongst creditors and equity holders without the pain, expense, disclosure, and shame of actually having to file.
The “LBQ”: Simulating the Chapter 11 Bankruptcy Process but Without Filing for It
Years ago, during the early dot-com v1.0 period, I was introduced to Lincoln Brooks, an accomplished bankruptcy attorney in the Bay Area. Lincoln had pioneered a way of avoiding Chapter 11 bankruptcy at a company while returning more to a company’s creditors than they would normally receive from a formal Chapter 11 bankruptcy filing. He affectionally called it the “LBQ,” short for Lincoln Brooks Quickie – the non-Chapter 11 Chapter 11, more formally known as an out-of-court workout. The beauty of the LBQ was that a company actually went through the bankruptcy process but without filing and getting the courts involved. I had the opportunity to work with Lincoln directly as we implemented the LBQ for clients and I can assure you that it works!
LBQ vs. Filing for Chapter 7 or 11
When might you choose this alternative vs filing for bankruptcy?
The first question you have to ask yourself is “Does my company have a future?” Is the current financial condition of your company one it can recover from when the economy or business conditions turn around, where the orderly restructuring of a Chapter 11 can be a path forward, or are things beyond repair? If it’s the latter, then you should file for Chapter 7. But if you believe that you can eventually work your company out of the current situation and you just need more time and debt relief to do this, you should try the LBQ approach.
Negotiating with Creditors
Banks and other secured creditors are more willing to work with debtors these days. Small unsecured creditors are more difficult to deal with since they often feel they have more at stake. You can reach an agreement with both groups of creditors.
The LBQ process starts with the company preparing a pro forma workout plan showing that the creditors will get back more of what they are owed than they would receive in a Chapter 11 bankruptcy filing. This plan is key to your negotiations with creditors and establishes your credibility with them. It is key to show them that without an orderly workout they may get little to nothing. Your plan should incorporate a cash flow analysis that shows payments being made to creditors. We recommend that you try to defer any payments to existing creditors for the first 12-18 months. This provides you with working capital necessary to jump start your recovery. You will probably be paying on cash terms going forward until you complete your workout and every penny you have needs to support continuing operations. You may get only 3-6 month of relief from existing creditors, but that is still better than shutting down.
Creditors are banking that they will get a greater return under your plan than through Chapter 11. Even secured or other priority creditors will be willing to work with you if your plan shows them getting more of their debt returned. Just because a creditor is a secured or priority creditor doesn’t mean they’ll get paid. After paying the employees, the court and its trustee, and agents of the court (attorneys and accountants don’t work for free), there may be very little money left over to pay anything else. The out-of-court workout can also buy you more time with your creditors. In one case, the workout period lasted over four years. Creditors were able to receive 50¢ on the dollar for their patience.
Negotiating with Venture Investors
VCs present a different challenge. They’re a creditor like everyone else in bankruptcy, but as equity owners they’re at the bottom of the list. Most venture investors will want to cut their losses and get out. Once in the zone of insolvency, equity owners lose their priority in the balance sheet and – in fact – lose their ability to control the company. Getting the VCs to understand that at some pre-petition point equity holders are no longer the primary fiduciary obligation of the board is important for securing the support of creditors and equity holders for your workout plan.
Hiring the Right Legal and Financial Advisors
You need to have competent counsel in your corner for managing creditors. This is important to avoid lawsuits alleging that management and the board were not being aggressive enough to protect creditor rights and priorities. Experienced counsel is also key to convincing creditors that your workout plan is sound and provides the greatest return for them.
Finally, you need to get agreement from your creditors. That’s where both your bankruptcy legal counsel and FLG Partners can provide valuable insights and assistance You will need to meet with your creditors, either individually or as a group, present your pro forma workout plan, negotiate any final terms, and codify the agreement. We strongly recommend that you get agreement from each creditor in writing. It’s for the protection of your company, you, and the other creditors. You want to prevent any creditors going “rogue” and initiating an involuntary Chapter 11 proceeding on their own. It only takes one creditor with a minimum claim of $16,750 to initiate an involuntary bankruptcy proceeding. The odds are in your favor that your creditors are not going to enforce an involuntary bankruptcy if there’s no upside to them. You still need to have the protection of a written agreement in case the odds go against you.
Once you have negotiated and secured your out-of-court workout, you need to deliver. This means that you need to pay creditors on time and in the amounts agreed upon. Failure to do this will result in a loss of credibility, your ability to conduct business with your vendors, and the likelihood of an involuntary bankruptcy filing.
Besides helping with creditor negotiations, FLG Partners can help you prepare the pro forma workout plan. We’re experts at cash forecasting and financial management. Using a third-party like FLG also lends credibility to your solution. Please reach out to us at FLG Partners if you need assistance evaluating your options when faced with financial insolvency. We’re happy to help.
Covid-19 and its impact on conducting business has forever changed the landscape. These strategies, however, should give you inspiration to come up with a plan to save your company instead of filing for bankruptcy while also being a win for creditors and debtors. Best of all, your company can continue to exist and, hopefully, be successful in the future.
The author would like to thank Lincoln Brooks, now retired, for his invaluable contributions to this article.