“While bankruptcy alternatives have always been around, they are becoming more popular because bankruptcy is less attractive today compared to how it was a few short years ago,” says Jonathan Friedland, head of the Restructuring and Insolvency Practice at Levenfeld Pearlstein, LLC.
When a company is faltering, the owner needs to first determine whether he or she wants to stay in business or close up shop, and then explore the options to achieve that end. For example, a composition may allow a company to stay in business. Under this agreement with creditors, reached out of court, the debtor satisfies its indebtedness through partial payments or payment over time.
But if the goal is to get out of business, a foreclosure might be the best option.
Smart Business spoke with Friedland about how to keep your company out of bankruptcy by pursuing alternative solutions.
Is bankruptcy the best option for ailing businesses?
When a business is in distress, bankruptcy is the most well-known option. It is not, however, the only option, nor is it always the best option. The best option depends on what the source of the trouble is and what the owners of the business and their creditors want to achieve.
For instance, if the business is viable but the balance sheet simply has too much debt on it, it may be possible to do a composition agreement rather than a bankruptcy.
On the other hand, if the company is ready to throw in the proverbial towel and it wants to throw the keys back to the secured lender, a friendly foreclosure and/or turnover agreement might make the most sense.
Lastly, an Assignment for the Benefit of Creditors (ABC) may also be a very good option if the goal is to liquidate the company. In an ABC, the company transfers its assets to an assignee. The assignee sells the assets of the company and then distributes the proceeds of the sale to creditors according to a priority scheme established by state law.
What are the advantages of pursuing a composition agreement?
The ultimate goal of a Chapter 11 bankruptcy is to confirm a plan for repaying creditors. The advantage of using a composition agreement is that it can achieve a similar result while avoiding the time, expense and notoriety of a Chapter 11 bankruptcy.
A typical scenario might involve a company making a written proposal to its creditors, requesting that they each accept only a portion of what is owed to them in lieu of the entire amount and/or asking that they accept payment over time.
A composition agreement typically includes a disclosure of the company’s financial condition, so that creditors can evaluate how they might fare if the company were forced into bankruptcy, as compared to what they would receive if they accept the company’s proposal under the composition agreement.
If you are dealing with management that is mistrusted by the creditor body, a composition agreement is less likely to succeed.
But in the vast majority of commercial cases, that’s not the case. You simply have well-meaning and reasonably good management that failed, but failed for a legitimate reason.
What should be included in a composition agreement?
It’s standard to include a provision stating that the proposal will remain open for a specified period of time, but it won’t be open-ended. Also, the agreement won’t become effective unless it is accepted by creditors holding a specified percentage of claims, usually 90 or 95 percent.
If this debtor’s proposal is accepted by this minimum percent of dollars owed, the company can move forward. But let’s say 10 percent of the creditors are holdouts. To those creditors, the company will still owe 100 percent of what it owed before. That’s OK, because there has been a mathematical business calculation that can deal with a small percentage of holdouts.
That’s why it’s only effective if a specified percentage of creditors accepts. That way, the company can decide ahead of time what it can live with. If the minimum percentage of creditors does not accept the composition, the company may file a bankruptcy.
In a bankruptcy, the company can bind the holdouts if it gets enough creditors to accept the plan. That is one of the powers that bankruptcy offers in return for the time, expense and notoriety.
Can a composition agreement work for a company of any size?
The more creditors you have, the harder it becomes to do. It’s really a numbers game. Typically, it’s good for a company that has upward of a couple hundred creditors. But if it’s the kind of company that has thousands of creditors, the cost of bankruptcy quickly begins to make more sense. At some point, bankruptcy actually becomes more cost-effective.
jonathan friedland leads the Restructuring and Insolvency Practice at Levenfeld Pearlstein, LLC. He also is the principal author of “Strategic Alternatives for Distressed Businesses,” (West, 2008), which provides a detailed examination of alternatives to bankruptcy. Reach him at (312) 476-7528 or firstname.lastname@example.org.