According to the American Bankruptcy Institute, a record 18,760 businesses filed for bankruptcyin the first quarter of this year an increase of 5.3 percent over the same quarter of 1991. In myexperience, a lot of these companies could have avoided such a drastic step. My firm has worked withfamily companies that feel that bankruptcy will somehow rescue them from disaster without their havingto make fundamental changes in the business. Unfortunately, this hope for a magical cure is oftenmisguided.
Bankruptcy judges will tell you that some 85 percent of companies that file for bankruptcy die on theoperating table. Most fatalities occur because the company lacks a workable plan to reorganize. Inother cases, the company has basic misconceptions about its prospects in bankruptcy and loses controlover major business decisions once the proceedings have begun. This often leads to sale of thebusiness at a greatly reduced value.
For example, many owners file for protection when they become short on cash and find difficulty payingcreditors and employees. What they don't consider is that the filing can make the cash shortage worse.When a company goes into bankruptcy, some customers divert purchases to more financially stablecompetitors. Suppliers may no longer extend credit, asking for cash up front.
The experience of one auto parts manufacturer is typical. The company's cash shortage was caused byoperating losses, and the losses continued uninterrupted after the bankruptcy filing. The company wasnot able to cut costs, increase sales, or sell assets quickly enough to reverse the losses. Our firmput a cash control plan in place that bought the time needed to develop a "workout" a plan forrestructuring the company's balance sheet and debts to satisfy creditors. The business emerged frombankruptcy, and the owner was able to sell it at a good price; eventually, it became the strongestdivision of the acquiring company.
We try to help our clients avoid filing for bankruptcy, and find that out-of-court workouts are thebest solution in most cases. When an out-of-court settlement with creditors is not possible, it stillmakes economic sense to determine the viability of the company, plan the turn-around, and do thefinancial restructuring before the actual filing. These steps are appropriate even if the company hasto file immediately to head off financial disaster.
There are many misconceptions about bankruptcy. For example, the process may provide immediate relieffrom old payables, thereby improving cash flow, but the relief is only short-term. A company thatcontinues to operate at a loss will die just as surely in bankruptcy as out of it.
Another misconception is that the business owner can selectively wipe out debt, thereby enhancing orat least protecting his equity in the company. In fact, his equity may be reduced or wiped out in theprocess. The bankruptcy code provides specific guidelines and priorities for the reorganization ofdebt. The guidelines put secured creditors first and unsecured creditors second; certain legal feesand other expenses are considered super-priorities that must be paid even before other debts. Becauseowners are, in effect, the last in line to share in the business assets, the company cannot usuallyerase debts without erasing equity.
The mistaken belief that creditors will be wiped out while owners will escape unscathed can often betraced to poor legal advice. Sadly, just to save a few dollars some business owners hire lawyers whoare not experienced in bankruptcy law, even when their fortunes and life's work are at stake. Theywrongly assume they can avoid paying secured creditors and can pay trade creditors when they feel likeit, only to find out that creditors have grounds to challenge such treatment in court, which means thebusiness will be further saddled with huge litigation costs.
However, even the best legal counsel cannot save a company if the family does not have the will tocure its business ills or know how that can be done. Many business owners mistakenly believe that theycan solve the problem simply by reshuffling their balance sheet. A wheel manufacturer who sought ourcounsel, for example, had figured out that the company could replace existing debt with debt that hadmore favorable repayment terms, such as a Small Business Administration loan. The pitfall in thisscheme was that it did nothing to improve the company's running rates its recent levels of sales,gross revenues, and expenses. Even after balance-sheet restructuring, it would continue to pile uphuge losses until operations were reorganized to bring expenses within sales volume, while ensuringthat sales projections were actually achieved.
A company in financial trouble has to deal with its P&L statement before focusing on restructuringthe balance sheet. Only if the company can be stabilized and returned to profitability can it meet itsobligations under any restructuring scenario.
A turn-around specialist can help an underperforming company determine if the business can beturned around. Such a third-party advisor can give the family an objective view of whether it has themanagement, organization, and financial controls to carry out a recovery plan. Together, they can workout a strategy to cut costs, increase sales, and redeploy assets. Such a plan is essential toestablishing credibility both with creditors and the bankruptcy judge. It is also vital to gainingtime. Delays are common in bankruptcy proceedings because the law requires frequent notice and hearingopportunities. To avoid unnecessary delays and soaring legal costs, the company must convince thecourt and creditors that it has a restructuring plan and is moving ahead to implement it.
When one of our clients tells us he is contemplating bankruptcy, we never say never. Obviously,protection from creditors can in some cases help restore a company to health. If after an objectivereview a company determines that it has no alternative, it should plan its turn-around as far aspossible ahead of filing and achieve advance support for restructuring from its creditors.
If a company can accomplish a workout outside of bankruptcy, it will emerge in greater control of itsfate and will be able to move more rapidly to reduce losses. Of course, the company must eschewout-of-court settlements that can be construed as "hindering," "delaying," or "misleading" some of thecreditors. Creditors who feel they are thus mistreated can seek to unwind such transactions in court.The workout process can be expedited with competent legal counsel and seasoned turn-aroundspecialists, at a lower total cost in expenses than is normal in a bankruptcy.
It is true that businesses must sometimes act even more quickly than that in order to preservecorporate assets. For example, a $6 million ladies' apparel firm filed for bankruptcy in order toprevent a former owner from seizing inventory. The former owner, who had sold the business through aleveraged buyout, retained a position in the inventory as part of a secured note from the purchasers.Seizure of the inventory would have sharply reduced the going-concern value of the business and forcedthe company to shut down. So in this case the company had to file a bankruptcy petition beforedeveloping a restructuring plan. The assets were ultimately sold, but everyone came out better than ifthe business had gone under precipitously including the former owner,whose inventory position kept itsvalue.
In some situations a bankruptcy filing can prevent a creditor who won't cooperate with areorganization plan from getting a judgment against the company and sapping its resources. In disputeswith landlords, a company can use bankruptcy to stop large past-due rent payments from piling up whenattempts to renegotiate a workable lease have met with resistance.
Nevertheless, bankruptcy is a double-edged sword which should be used only with extreme caution tosettle conflicts. The process is very costly in terms of time, fees for professionals, and loss ofcontrol over decision-making. In addition, many companies suffer even more from the loss of customersand valuable suppliers. The uncertainties in the legal process are such that even before consideringbankruptcy, companies should first take a long look at the likelihood of a turn-around.
Many of our firm's family business clients have accomplished turn-arounds without ever filingfor bank-ruptcy. Most recently, a $50 million manufacturer of fishing gear succeeded in evading thetrammels of bankruptcy court by reorganizing sales management, overhauling it's marketing plan, andradically cutting costs. A new cash infusion from the owners and some excellent legal advice helped uscarry out these reforms, which enabled us to restructure $45 million in bank and subordinated debt.Thanks to avoidance of bankruptcy's delays and expenses, the creditors were treated fairly and thefamily remains in control.
Baker A. Smith is managing director of the Atlanta office of Morris-Anderson &Associates, a consulting firm that specializes in financial crisis management and turn-arounds.