Chapter 11 can cure all your business ills. . . Not!

Bankruptcy judges will tell you 85 percent of companies that file die on the operating table.

By Baker A. Smith

According to the American Bankruptcy Institute, a record 18,760 businesses filed for bankruptcy in the first quarter of this year — an increase of 5.3 percent over the same quarter of 1991. In my experience, a lot of these companies could have avoided such a drastic step. My firm has worked with family companies that feel that bankruptcy will somehow rescue them from disaster without their having to make fundamental changes in the business. Unfortunately, this hope for a magical cure is often misguided.

Bankruptcy judges will tell you that some 85 percent of companies that file for bankruptcy die on the operating table. Most fatalities occur because the company lacks a workable plan to reorganize. In other cases, the company has basic misconceptions about its prospects in bankruptcy and loses control over major business decisions once the proceedings have begun. This often leads to sale of the business at a greatly reduced value.

For example, many owners file for protection when they become short on cash and find difficulty paying creditors 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 stable competitors. 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 by operating losses, and the losses continued uninterrupted after the bankruptcy filing. The company was not able to cut costs, increase sales, or sell assets quickly enough to reverse the losses. Our firm put a cash control plan in place that bought the time needed to develop a "workout" — a plan for restructuring the company's balance sheet and debts to satisfy creditors. The business emerged from bankruptcy, and the owner was able to sell it at a good price; eventually, it became the strongest division of the acquiring company.

We try to help our clients avoid filing for bankruptcy, and find that out-of-court workouts are the best solution in most cases. When an out-of-court settlement with creditors is not possible, it still makes economic sense to determine the viability of the company, plan the turn-around, and do the financial restructuring before the actual filing. These steps are appropriate even if the company has to file immediately to head off financial disaster.

There are many misconceptions about bankruptcy. For example, the process may provide immediate relief from old payables, thereby improving cash flow, but the relief is only short-term. A company that continues 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 — or at least protecting — his equity in the company. In fact, his equity may be reduced or wiped out in the process. The bankruptcy code provides specific guidelines and priorities for the reorganization of debt. The guidelines put secured creditors first and unsecured creditors second; certain legal fees and other expenses are considered super-priorities that must be paid even before other debts. Because owners are, in effect, the last in line to share in the business assets, the company cannot usually erase debts without erasing equity.

The mistaken belief that creditors will be wiped out while owners will escape unscathed can often be traced to poor legal advice. Sadly, just to save a few dollars some business owners hire lawyers who are not experienced in bankruptcy law, even when their fortunes and life's work are at stake. They wrongly assume they can avoid paying secured creditors and can pay trade creditors when they feel like it, only to find out that creditors have grounds to challenge such treatment in court, which means the business 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 to cure its business ills or know how that can be done. Many business owners mistakenly believe that they can solve the problem simply by reshuffling their balance sheet. A wheel manufacturer who sought our counsel, for example, had figured out that the company could replace existing debt with debt that had more favorable repayment terms, such as a Small Business Administration loan. The pitfall in this scheme 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 up huge losses until operations were reorganized to bring expenses within sales volume, while ensuring that sales projections were actually achieved.

A company in financial trouble has to deal with its P&L statement before focusing on restructuring the balance sheet. Only if the company can be stabilized and returned to profitability can it meet its obligations under any restructuring scenario.

 

A turn-around specialist can help an underperforming company determine if the business can be turned around. Such a third-party advisor can give the family an objective view of whether it has the management, organization, and financial controls to carry out a recovery plan. Together, they can work out a strategy to cut costs, increase sales, and redeploy assets. Such a plan is essential to establishing credibility both with creditors and the bankruptcy judge. It is also vital to gaining time. Delays are common in bankruptcy proceedings because the law requires frequent notice and hearing opportunities. To avoid unnecessary delays and soaring legal costs, the company must convince the court 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 objective review a company determines that it has no alternative, it should plan its turn-around as far as possible 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 its fate and will be able to move more rapidly to reduce losses. Of course, the company must eschew out-of-court settlements that can be construed as "hindering," "delaying," or "misleading" some of the creditors. 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-around specialists, 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 preserve corporate assets. For example, a $6 million ladies' apparel firm filed for bankruptcy in order to prevent a former owner from seizing inventory. The former owner, who had sold the business through a leveraged 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 forced the company to shut down. So in this case the company had to file a bankruptcy petition before developing a restructuring plan. The assets were ultimately sold, but everyone came out better than if the business had gone under precipitously — including the former owner,whose inventory position kept its value.

In some situations a bankruptcy filing can prevent a creditor who won't cooperate with a reorganization plan from getting a judgment against the company and sapping its resources. In disputes with landlords, a company can use bankruptcy to stop large past-due rent payments from piling up when attempts to renegotiate a workable lease have met with resistance.

Nevertheless, bankruptcy is a double-edged sword which should be used only with extreme caution to settle conflicts. The process is very costly in terms of time, fees for professionals, and loss of control over decision-making. In addition, many companies suffer even more from the loss of customers and valuable suppliers. The uncertainties in the legal process are such that even before considering bankruptcy, 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 filing for bank-ruptcy. Most recently, a $50 million manufacturer of fishing gear succeeded in evading the trammels of bankruptcy court by reorganizing sales management, overhauling it's marketing plan, and radically cutting costs. A new cash infusion from the owners and some excellent legal advice helped us carry 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 the family 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.