Contrary to the implication of statistics, some companies still try to avoid the stigma and costs of filing bankruptcy by resolving their money problems outside a federal or state proceeding.

In the United States, a company on the brink of bankruptcy generally has three options: file for formal reorganization under Chapter 11 of the U.S. Bankruptcy Code, file for liquidation under Chapter 7, or seek an informal reorganization.

The informal reorganization (called workout) involves restructuring the debt owed to creditors either by:

changing the existing debt terms – an extension postponing the payment date; or
reducing the amount owed to less than 100%, so many “cents on the dollar” – a composition; or
negotiating both an extension and a composition with the creditors.

In many, if not most instances, informal reorganizations [of legitimate, honest companies] are the best method of resolving the distressed company’s situation. They circumvent the heavy administrative expense involved in a formal bankruptcy, thus maximizing the potential return for creditors, while at the same time minimizing the financial distress of the debtor.

Advantages of Informal Reorganizations Source: Credit Research Foundation

Less negative publicity in the legal and business community
Less expensive and time consuming than bankrupty
Less interruption in debtor’s conduct of business
Greater debtor control of business operations
Less risk in losing a management team and skilled labor
Greater flexibility for cash flow control
Avoidance of triggering default clauses in leases and security agreements
Better atmosphere for refinancing, capital infusion or new borrowing
Sale or lease of assets is less cumbersome
Less possibility of reduction in salaries and benefits to key employees
Greater protection of confidential business matters

Despite the advantages (see Advantages at right), however, informal reorganizations often do not succeed. Why? Generally due to ignorance. Ignorance on the part of the creditor, the debtor, or even the debtor’s attorney.

Debtor/Attorney Ignorance

The key to the success of an offer of, say, 30 cents on the dollar is adequate disclosure. At the time the offer is made to the creditors, the debtor’s attorney should provide:

audited financial statements and/or the last two or three income tax returns. Obviously, the financials will usually show a negative net worth, requiring an infusion of new money to make the plan work. Thus, the offer will also need to reveal …
the source of funding for the plan. It may be a principal’s additional investment or an outside investor. In either case, the discount on the debt will be required to limit the amount of new money needed to resurrect the business.

Unfortunately, some debtors retain attorneys unfamiliar with insolvency law. The outcome is an offer that basically states: “Either accept 30 cents on the dollar or we’ll file bankruptcy.” In these cases, it is absolutely understandable that a creditor would ignore the proposal and take independent (often legal) action immediately.

Creditor Ignorance

Many creditors, especially those unfamiliar with informal reorganizations, are uncomfortable agreeing to take less than the full amount owed, perhaps fearing the debtor is trying to take advantage of them, or possibly working out better deals with other creditors under the table.

However, where there is adequate disclosure, and it is clear that money will come into the debtor company that will not otherwise be available to settle a legal action, creditors should give such a proposal serious consideration. But not without some further research.

First, the creditor should supplement the information provided by the debtor in the disclosure statements.

One source of information is the creditor’s collection agency. Does the agency, or one of its correspondent attorneys in the debtor’s locale, have any other claims against the debtor or know about the attempted workout? If they do, what is their recommendation regarding any structured settlement?

Second, the creditor should determine if he will be protected against other creditors taking independent action.

Creditors are not compelled to sign a composition or extension agreement; and those who do not sign it, are not bound by it. In fact, probably the greatest difficulty to overcome in informal reorganizations is getting all the creditors to agree to the plan.

Disadvantages of Informal Reorganizations

No protection against secured parties or judicial or statutory lien creditors
No ability to halt action by taxing authority
Inability to stay federal or state court proceedings against debtor
Inability to reject collective bargaining agreements with employees
Inability to sell or transfer assets free and clear of liens and encumbrances, except with full agreement of all lien claimants
Inability to reject leases or other burdensome executory contracts
Unavailability of bankruptcy cram down provisions to deal with under-secured creditors’ claims

Source: Credit Research Foundation

A debtor attorney familiar with insolvency law will usually recommend the formation of an informal creditors’ committee that includes both the largest creditors and those representative of all those with whom the agreement must be negotiated. The committee will usually retain a Secretary – often a local creditor’s association, such as a unit of the National Association of Credit Management (NACM).

This committee will be responsible for negotiating a final restructuring agreement, as well as furnishing all of the creditors status reports, and undertaking the solicitation of their consent to the agreement. It may also retain counsel for the formal preparation of the agreement and/or an accountant to conduct an independent investigation of the debtor’s financial affairs.

Generally, if this representative committee of creditors agrees to a restructuring plan, then it can be considered a fair settlement for all concerned, and should provide a large dividend than would result in a bankruptcy filing.

Additionally, in some cases the debtor may be convinced to give a lien to the secretary covering all the company’s assets. This lien acts as:

an enforcement mechanism. If the debtor fails to pay creditors as agreed, the lien is foreclosed upon.
a discouragement to creditors taking independent action against the debtor. As all assets are liened, there would be nothing for the creditor to gain.

A caveat: under current U.S. bankruptcy law, this lien would be considered a preference. It could be set aside if a Petition of Involuntary Bankruptcy is filed within 90 days of the filing of the lien. However, if the creditor’s committee is truly representative of the credutirs, than this may not become an issue. And, in case such an involuntary petition is filed, Section 305 of the Bankruptcy Code permits the Bankruptcy Court to abstain an involuntary petition in bankruptcy if the dismissal would better serve the interests of the creditors and debtors.

In the final analysis, if adequate disclosure is available from the debtor, supplemented by additional inquiries of the creditor, and there is assurance that there is no vulnerability to independent action of others, agreeing to the information composition could well mean more money in the creditor’s pocket.

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Disclaimer: This article is not intended to be legal advice and is not a substitute for competent legal advice on the referenced subject.

Information provided by ABC-Amega Inc. Since 1929, providing first party accounts receivable collections outsourcing and third party debt collection for management of your commercial receivables portfolio. For further information on our receivable management services, email info@abc-amega.com.