Most restructuring professionals will tell you that there is no "typical" restructuring. That is absolutely true. Every financially distressed business is different and the character and direction of its restructuring will be highly dependent upon, among others, its capital structure, its liquidity profile, and the level of support it can build for its reorganization among key stakeholder bodies. Nevertheless, there are some important similarities in the way that any company should initially address a distressed situation. We discuss below a variety of key tasks, or "commandments," that we recommend any company should undertake as soon as it anticipates possible financial distress.
Number 1: Thou Shall Effectively Manage Thy Runway
Once the company has consulted restructuring advisors, it should turn to negotiating with its principal creditors and other key stakeholders on the terms of an out-of-court restructuring, recapitalization, or sale transaction. In doing so, the company and its advisors should consider, among others, the following:
- The company's liquidity position—the amount of cash and cash equivalents the company has on hand and any availability under existing credit facilities; and
- The critical dates facing the company, including, without limitation, maturity dates, borrowing base redeterminations, upcoming interest payments, financial reporting obligations, termination dates under default notices, and the dates on which litigation liabilities may become due.
These factors should give you a general sense of the company's "runway"—how long the company has until it needs to reach a deal with its creditors or, as an alternative of last resort, commence a case under chapter 11 of title 11 of the U.S. Code (the "Bankruptcy Code"). As you might expect, cash is critical. All else equal, a stronger liquidity position and manageable deadlines will allow a company time to negotiate with creditors and avoid making hasty outcome-determinative decisions.
As such, we often advise companies to completely draw down their existing lines of credit and, as appropriate, place the proceeds in an account that the company's lenders have no immediate right to access. This will ensure the company maximizes its liquidity and minimizes lenders' practical ability to take control of the funds should a default occur under the relevant loan documentation. In addition, a financial advisor and, potentially, a chief restructuring officer, can help the company manage its liquidity by, among others, negotiating more favorable payment terms with vendors and suppliers and minimizing outstanding receivables.
Number 2: Thou Shall Attempt to Develop an Out-of-Court Solution that Avoids Chapter 11
The company's runway or lack thereof, notwithstanding, we always seek to reach an out-of-court solution to financial distress before pursuing in-court strategies because an out-of-court deal is almost always cheaper and quicker. In many cases, the company may not reach a deal with its creditors on the terms of an out-of-court transaction to address its debt obligations before a default is anticipated to occur under the company's debt documents. If negotiations are ongoing, and will proceed past any maturity or default events, the company should seek to have its creditors agree to enter into a short-term forbearance or waiver of the default to allow the parties time to negotiate without fear that creditors will exercise remedies or any cross defaults will occur. Typically, the initial forbearance or waiver lasts between 30 and 60 days, but such periods are often extended one or more times by agreement of the parties.
A successful out-of-court restructuring almost always requires the unanimous support of the company's funded debt holders, which is frequently difficult to obtain. Specifically, any out-of-court transaction that contemplates the modification of amounts, interest rates, maturity dates, or amortization—i.e., "amend and extend" transactions—is likely going to require unanimous lender consent in order to be consummated out-of-court. As a result, a lack of consensus among key stakeholders is among the most common reasons why we see out-of-court workouts fail or a chapter 11 bankruptcy becoming necessary. The Bankruptcy Code allows a chapter 11 debtor to force the terms of its restructuring on recalcitrant lenders and equity holders under certain circumstances.
Number 3: Thou Shall Engage in Contingency Planning
It may be tough medicine to swallow given the expense of doing so, but it is critical that a distressed company prepare for a chapter 11 filing long before the company and its advisors determine that a filing is necessary. As discussed above, there is no guarantee that a company will reach a deal with its stakeholders on the terms of an out-of-court restructuring. We have seen many cases in which an out-of-court deal seemed likely, but fell through unexpectedly at the very last minute and necessitated a crash chapter 11 filing to obtain the benefit of the automatic stay to prevent creditors from exercising remedies.
In those unfortunate circumstances, the last thing a company wants is to be caught unprepared to file given the advantage that an orderly filing provides and the sheer volume of work that adequate preparation demands. In order to ensure that its transition into chapter 11 is seamless and that its business operations continue uninterrupted during the pendency of its case, a chapter 11 debtor typically files a number of pleadings on the first day of its case seeking operational and procedural relief. The company and its advisors typically work together to prepare these documents as they require detailed information about, among others, the company's capital structure, financial performance, business operations, and the events that lead to its chapter 11 filing. The point here is that these documents require significant time to prepare, and having sufficient time to plan the chapter 11 is also advantageous to resolving issues that may be problematic if they are discovered after a chapter 11 filing.
In our experience, there is also potentially a tactical advantage to preparing the company for filing weeks in advance in that these documents can be shared with stakeholders as a means to demonstrate that the company is serious about a chapter 11 filing. Often the threat of a chapter 11 case—including the Bankruptcy Code's cramdown provisions—is a strong incentive for stakeholders to agree with a distressed company's proposed out-of-court restructuring. The alternative for recalcitrant stakeholders is to incur significant legal fees in chapter 11 only to have the terms of a less favorable restructuring imposed on them by the bankruptcy court. In this way, therefore, quite ironically, the preparation for a chapter 11 case can make it less likely that such a case ever occurs.
Finally, the company and its advisors should give serious thought to exactly where they might file a chapter 11 case if bankruptcy becomes a necessary eventuality. Much ink has been spilled on the merits of "forum shopping" in the bankruptcy context, but from a distressed company's perspective, we can unequivocally tell you that the venue in which a company commences its chapter 11 cases can have a significant effect on the outcome of the case. And because the current venue rules are fairly permissive—a debtor can file chapter 11 in any jurisdiction in which it has its principal assets, principal place of business, domicile, or any of its affiliates currently has a bankruptcy case pending—we often see debtors engage in pre-filing activity designed to create circumstances that allow them to file for chapter 11 in a particular jurisdiction. Among the primary reasons that corporate debtors seek to commence their cases in these jurisdictions is that the judges in these jurisdictions preside over many of the large chapter 11 cases that are filed, and, as a result, a company and its advisors can be relatively confident of the outcome that a case in these jurisdictions can provide.
Number 4: Thou Shall Consult Restructuring Advisors
One of the most significant mistakes we see distressed companies make is to wait too long to talk to restructuring advisors and thereby significantly hamper their ability to successfully address financial distress out of court. It is imperative that the company consult restructuring advisors, including lawyers, bankers, and financial advisors, as soon as possible financial distress appears on the horizon. Experienced advisors will not only help you determine the best path forward, but they will be able to begin negotiating with creditors on a potential consensual transaction long before the company needs to make any final decisions regarding its restructuring. They will also provide a layer of protection to the company against possible future claims for improper actions or inactions. Frequently, creditor groups will organize and hire counsel as soon as they suspect financial trouble, and it is best if the company assembles its own experienced team of legal advisors to meet creditors' counsel head-on. Similarly, proactively engaging an experienced investment bank allows a company to run a longer, more robust marketing process to find new capital or potential buyers that are willing to purchase the company as a going-concern on value maximizing terms.
Number 5: Thou Shall Consider Appointing Independent Directors
The company should also consider who will actually be tasked with deciding which restructuring proposal the company should pursue. At all times, directors should be free from conflicts of interest, and should place the interests of the company ahead of their own.1 In many cases, therefore—even if the company has D&O insurance (and it better)—we advise distressed companies to appoint one or more independent directors to the company's board of directors to help ensure that any restructuring proposal that the company eventually decides to pursue is not later successfully challenged on the basis that one or more members of the board was self-interested.
Whether to appoint independent directors is of particular importance in the context of private companies, sponsor-backed companies, or companies in which members of the board are also affiliated with one or more of the company's debt holders. For example, we often see a company's existing private equity sponsor or junior creditors among the only stakeholders willing to support a transaction to recapitalize the company. If that is the case, then we highly recommend that board members affiliated with these groups recuse themselves from any decision-making regarding the company's restructuring. That, in turn, may necessitate the appointment of independent directors. Competent restructuring counsel will be well-versed in these issues and will be able to help with the appointment of independent directors at the outset of counsel's engagement.
Number 6: Thou Shall Consider Purchasing "Tail" Coverage for Your D&O Policy
Given the contentious nature of financial restructuring, especially in the chapter 11 context, claims and causes of action against a company's directors and officers are often threatened by numerous constituencies seeking to exert leverage and extract value. To make matters worse, a company may find itself unable to indemnify its officers and directors or otherwise advance their defense costs while the company is in chapter 11. As a result, director and officer liability insurance ("D&O Insurance") is crucial for a company in a distressed environment to prevent directors and officers from bearing the economic burden of any personal liability for claims brought against them in connection with their roles at the company.
Most D&O Insurance policies provide for a limited period during which the insured can make claims for coverage under the policy. Often, claims can no longer be made upon a "change of control" as defined in the relevant policy. The consummation of a restructuring often results in a "change of control." For these reasons, we typically advise companies to purchase runoff or "tail" coverage to allow claims to be made long after the policy has expired. This gives directors and officers peace of mind that acts covered by the relevant D&O Insurance policy will benefit from coverage, including related defense costs, notwithstanding that a particular claim or cause of action may have been brought against them in a financial restructuring after the original reporting period has expired.
Number 7: Thou Shall Consider Whether to Pay Retention Bonuses to Key Executives Before a Chapter 11 Filing (If Any)
In recent years, several large chapter 11 debtors have elected to pay retention bonuses to certain of their senior executives on the eve of their chapter 11 filings. The Bankruptcy Code forbids companies from paying such bonuses to executives while in chapter 11. Although paying retention bonuses to executives prior to a chapter 11 filing is arguably a risky strategy as these payments could, in theory, be subject to clawback under various causes of action, we are not aware of a prominent circumstance in which an executive has been ordered to turn over a pre-bankruptcy retention bonus. Furthermore, as a practical matter, would-be challengers to these bonuses may find it more trouble than it is worth to seek an order to disgorge the payments given the cost of the related litigation relative to the size of the bonuses. As a result, any distressed company that may be inclined to pay retention bonuses should consider whether it wants to make such payments before commencing a chapter 11 case. Doing so is certainly not without risk, but if past results are any prediction of future success, there may be a good argument for making the retention bonus payments. As an alternative, the company could consider seeking approval from the bankruptcy court to create a performance-based bonus plan (otherwise known as key employee incentive plan or "KEIP") rather than a retention bonus program.
Although the foregoing "commandments" are all critical for any distressed company, we do not mean to suggest that this list is exhaustive in nature or a fulsome remedy for addressing financial distress. The facts and circumstances of a particular situation will always drive the ultimate outcome in a restructuring. Still, by following these commandments, a troubled company will have positioned itself well on the road to a successful outcome.
1 For a more detailed discussion of directors' fiduciary duties, please see Precautionary and Prudency Measures for Boards Addressing COVID-19 Business Uncertainties – Finance & Bankruptcy Law Blog (financeandbankruptcylawblog.com).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.