Alternatives to Bankruptcy

Options for Corporate Recovery

Overview

• Strategic guidelines

• Analytical framework

• Causes of business failure

• Restructuring options

• The turnaround process

• DIP financing structures and sources

• Valuation influences

• Priority of claims

• The Chapter 11 benchmark

• Out-Of-Court workouts

• Assignment for the benefit of creditors

• Receiverships

Strategic Guidelines

• Out-of-court restructuring options should be evaluated using the provisions of

Chapter 11 of the Bankruptcy Code as a benchmark

• The net benefits of an out-of-court restructuring should exceed those of a

Chapter 11 reorganization

• Out-of-court restructurings generally entail either a voluntary

– renegotiation of the terms of the debtor’s existing liabilities, or

– an exchange of interests with its key creditors

• An out-of-court restructuring may not be effective or feasible if

– inappropriate give the nature and scope of the debtor’s operational and financial

problems,

– not all creditors are willing to consent to the proposal

Analytical Framework

Are the firm's problems internal or external,

operational or financial?

What is the current value of the firm's total

assets as a going concern and in

liquidation?

Given the current value of the firm's total

assets, what is the current value

of the related interests and

claims?

What capital structure is

appropriate for the firm

considering its future prospects,

expected operating results

and requirements?

What is the reorganization

value of the restructured

firm?

In what form and amount might the debtor’s

reorganization value be

allocated among remaining

interests and claims?

Causes of business failure

•Ineffective management

•Inadequate internal control, planning, budgeting and information systems and processes

•Inflexible organizational structure and culture

•Under/over capacity

•Excessive operating and financial leverage

•Fraud/Torts

Internal

•Competition

•Macro- and micro-economic cyclicality

•Changes in product and geographic markets, technology and regulation

•Natural disaster

External

Restructuring Options

• Selection of an appropriate turnaround strategy will be influenced by factors

including the history, size and prospects of the debtor, as well as the

perspectives, types and amounts of creditor claims

– Sale or divesture of the business as a going concern as swiftly as possible to

minimize diminution of, and obtain, a reasonable fair value

– Liquidation/wind down where specific assets of the business have greater value if

otherwise deployed

• In place, but not in current use

• In exchange in an orderly disposition

• In exchange in a forced liquidation

– Reorganization if feasible and debtor worth rehabilitating as a going

concern

The turnaround process

Stabilization

•Reduce losses and cash requirements

•Establish controls over cash to eliminate negative CFFO

•Raise interim financing needed to develop plan

•Improve working capital management

•Reduce operating costs

•Rationalize product portfolio

•Sell noncore assets

SWOT analysis

•Assess debtor viability through analysis of its industry, competitive position, management, operations, cost structure and capital

•Organization structure

•Product and geographic markets

•Customers, suppliers and competitors

•Production and distribution functions

•R&D pipeline

•Regulation

•Profitability, liquidity, solvency, efficiency

Operational and financial restructuring

•Formulate turnaround objectives, strategies and action steps to increase profitability and shareholder value

•Operational

•Increase revenue

•Decrease costs

•Divest assets

•Product differentiation

•Financial

•Develop a capital structure consistent with expected operating results and requirements

Normalization

•Develop and institute controls, policies and procedures that serve to maintain focus on factors underlying profitability and shareholder value

•Sustained revenue growth

•Operational efficiency

•Low cost production

•Internal control processes

•Relevant and reliable cost of production data

•Optimal capital structure

•Alignment of management compensation plans

DIP financing structures

• Unsecured debt

– Court authorization not required

• In the ordinary course

– As between the debtor and lender and in the debtor’s industry

– No significant alterations in debtor’s pre-and post-petition activities

» If not , lender may not be granted administrative claim for post petition loan

• Outside the ordinary course

– If for legitimate business purpose

» Otherwise, administrative claim not sufficient to assure repayment in case of

administrative insolvency

DIP financing structures (continued)

• Secured debt

– Court may authorize if adequate financing unavailable on an unsecured basis

• Super priority claim senior to all other administrative claims

• Lien on debtor’s unencumbered property, or junior lien on encumbered property

• Lien senior or equal to any encumbering prepetition collateral

– Only if unable to otherwise obtain credit,

» No duty to search for credit from all sources, however

– Requires that prepetition lien holder be adequately protected from diminution of

collateral value during reorganization

» Measured as the “equity cushion”, or excess of the going concern or fair market

value of the collateral over the debt

DIP financing structures (continued)

• Extraordinary provisions ― must be disclosed conspicuously and justified in a motion for

approval of postpetition financing

– Grant of superpriority claim superior to, or a lien on, Chapter 5 claims including

preferences and fraudulent transfers to a postpetition lender

– Funding of DIP loan preconditioned on judicial rulings and debtor waivers

• Perfection

– Prepetition credit facility is a valid and binding liquidated obligation not subject to any

defenses or counterclaims

– Prepetition lien is valid, enforceable and encumbers substantially all assets

• Good faith ― DIP loan is fair, reasonable and an arm’s length transaction

• Absent lender’s consent, waiver of debtor rights to seek use of cash collateral, file a plan of

reorganization or challenge perfection and scope of DIP lender’s prepetition liens

DIP financing structures (continued)

– Cross collateralization

• A security interest given to a prepetition lender covering all assets of the debtor, both those

existing on the date of the DIP financing order and those created during the Chapter 11

proceeding, for new loans funded in Chapter 11 and for its prepetition debt

– Roll-up of prepetition secured debt

• Prepetition debt repaid by postpetition facility

• Can be structured to take place at once or over time

– DIP waiver of right under Section 506(c) to surcharge a secured lender’s collateral to

the extent an administrative claimant has benefited from the collateral

– Carve-outs from the lender’s collateral to provide for payment of administrative costs

– Commitment fees

– Expedited relief from the automatic stay

DIP financing structures (continued)

• Second lien loans

– Debt secured by liens on some or all of the collateral encumbered by first lien loans

• Structured such that the lender has secured claims against the borrowers and guarantors of the

first lien financing that are not subordinate to the first liens

• First and second lien lenders typically enter into intercreditor agreements wherein the second

lien lender agrees to limit its rights as a secured creditor and to shared collateral

• Regarded as senior secured debt and of interest to nontraditional institutions

– Unlike traditional subordinated debt, second lien lenders are not

• Required to give up payments received to the first lien holder until it is paid in full

– Only required to relinquish proceeds of shared collateral

• Subject to payment stoppage provisions

• Junior in priority to unsecured creditor claims

DIP financing sources

• Prepetition secured lenders

– Often lender of last or only resort given debtor inability to provide adequate protection,

resulting in the ability to

• Levy high rates of interest

• Exercise control over debtor’s day-to-day operations through provisions requiring

– Expedited sales of substantially all of the debtor’s assets

– Approval of cash expenditures, advances under the financing agreement and sale or use

of property outside the ordinary course of business

– An event of default if reorganization plan filed or confirmed absent consent

– Changes to or replacement of senior management; i.e., CRO

DIP financing sources (continued)

• Section 363 acquirer

– Opportunity to preclude a third party lender from acquiring a superior claim

– Provide unique access to debtor’s books, records and operations

– Place the acquirer in a position to compel the transaction

• Provide only enough financing to facilitate sale process

• Tie DIP loan to purchase agreement such a default under the agreement causes the DIP loan to

become due and payable

• Customers

– Ensure sources of supply with title to goods transferred immediately to lender without

first becoming property of the estate

• Equity sponsors and venture capitalists

– Preserve interest or option to acquire equity under advantageous terms

Valuation influences

Lower value Higher value

Priority of claims

Secured claims

Superpriority claims

•DIP Financing

Priority Claims

•Administrative expenses, Wages, salaries and commissions, Employee benefits, Claims against facilities that store grain or fish produce, Consumer deposits, Alimony and child support, Taxes, Unsecured claims from commitment to federal deposit regulatory agency

General unsecured claims

Preferred stock

Common stock

The Chapter 11 Benchmark

Advantages

•Automatic stay from any action against debtor

•Access to Court approved DIP financing and use of cash collateral

•Ability to reject or assign executory contracts and leases

•Right to sell property free and clear of any interest

•Power to bind dissenting creditors

•Mechanism to estimate contingent and unliquidated claims

•Extension of period to avoid fraudulent and preferential transfers

•COD income not taxable; amount discharged used to reduce favorable tax attributes

•120-day exclusive right to file reorganization plan

Risks

•Loss of control as debtor operations subject to supervision and review by the Court and creditors

•Extensive operating and financial information disclosure requirements

•Negative publicity

•Loss of management and employees

•Disruption to operations and relationships with customers and suppliers

•Time and expense required to develop and confirm a plan

Out-of-court workout

Advantages

•Existing management able to retain control of the restructuring process

•Time and expense required to reach agreement potentially lower

•Avoidance of negative publicity

•Comparatively limited disclosure of operating and financial information

•Less disruptive to operations, customer and supplier relationships

Risks

•Inability to reach consensus with creditors and bind dissenters

•Absent automatic stay, debtor subject to creditor attack

•No formal process for the recovery of fraudulent and preferential transfers

•Difficulty in rejecting executory contracts and leases

•Tax treatment of COD income

An ABC is a transfer of legal title to all of a debtor’s assets to an

assignee with authority to sell them and distribute the proceeds

to creditors equitably under state law

Advantages

•Orderly liquidation

•Quicker and less costly than Chapter 7

•Debtor has right to choose assignee

•Places property out of reach of creditor’s direct collection actions

•Less negative publicity

•Ability to recover fraudulent transfers

Risks

•Does not discharge debts, allow for reorganization or sale of property free and clear of liens

•Does not preclude a voluntary or involuntary bankruptcy filing during pendency of the case

•Applicable laws vary widely between states

•Consent of secured creditors required for liquidation of collateral encumbered prior to assignment

•No automatic stay

•Recovery of preferences not allowed or limited by state law

A receivership is a remedy in which a disinterested person is

appointed by a court to protect or collect property that is subject

to diverse claims

Ability to avoid fraudulent transfers

Claims less likely to be barred by in pari delicto doctrine

Ability to consolidate assets into a single fund and treat all entities in the estate as a unitary enterprise

Faster and less costly then bankruptcy

Assets may be sold free and clear of liens

Does not discharge debt

Reorganization unlikely

Unable to recover preferential transfers

Automatic stay does not apply

Lack of rules regarding notice to creditors, filing of claims and objections

Unwillingness of other jurisdictions to recognize authority of presiding judge

Receiver appointed by and works as an officer of the court

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Alternatives to Bankruptcy

Options for Corporate Recovery