What is Restructuring?
Corporate Restructuring (RX) refers to the financial reorganization of distressed companies with capital structures deemed unsustainable.
Restructuring Guide: Corporate Financial Reorganization
In an out-of-court or Chapter 11 in-court corporate restructuring process, the distressed company must urgently reduce its debt burden and “right-size the balance sheet” to better align its capital structure.
A lower debt-to-equity mix lessens the burden of debt financing, allowing the company to once again be a “going concern.”
The goal of corporate restructuring is to avoid liquidation, which is when the company permanently goes out of business (and liquidations lead to significantly lower recoveries to creditors).
Thus, it is not just the debtor that loses in liquidation because everyone loses in a liquidation.
Corporate Restructuring Catalysts: Causes of Financial Distress
At a high level, there are two primary causes of financial distress:
- Capital Structure (Excessive Use of Debt Financing)
- Financial Underperformance
For companies in distress, the amount of debt-related payments (and other payments related to contractual obligations like pensions and leases) is too high relative to the operating cash flows of the firm.
The issue stems from the company having a capital structure (debt to equity mix) that is misaligned with the current enterprise value of the business.
So how does a company get to a point where it needs to restructure?
While each distressed situation is unique, we can break down the common catalysts that decrease a business’ value and cash flows into three main types:
|Causes of Financial Distress||Examples|
|1. Macro and External Events||
|2. Secular Shifts and Trends Disrupting Industries||
|3. Company-Specific Factors||
Any catalyst by itself could lead to distress and force a restructuring, however, the most vulnerable businesses are those that face challenges arising from more than one catalyst.
Companies can become distressed and face a growing risk of a cash (liquidity) shortfall for a multitude of reasons. Of course, the most common reason is an unanticipated deterioration in business performance. But a company under distress tends to also demonstrate common red flags such as:
- Fully Drawn Revolving Credit Facility
- Deteriorating Credit Metrics Signifying Diminished Liquidity
- Delayed Payments to Suppliers/Vendors (i.e., Stretching of Accounts Payable)
- Sale Leasebacks (i.e., Selling of Assets & Leasing Them Back Straightaway)
Financial distress does not instantaneously mean that the company is in default. As long as the company does not breach any covenants or miss due payments (e.g., supplier invoices, interest on debt, or principal repayments), it can continue operating even if it is losing cash, as long as it has sufficient reserves.
However, most lenders put protections in place that could still put a debtor into a technical default if certain “triggering” events occur. Examples include a credit rating downgrade, breach of a debt covenant, or failure to remain in compliance with other agreed-upon terms.
In each of the scenarios stated, the lender can pursue litigation against the company (i.e., foreclosure), which is why companies file for bankruptcy protection.
Out-of-Court Restructuring Strategies
Out-of-court restructuring is usually best suited for a company with a limited number of creditors. Debtors ordinarily prefer out-of-court restructuring, which attempts to come to an agreement with creditors without having to go to Court.
In contrast to a Chapter 11, an out-of-court restructuring is:
- Less Costly (Fewer Legal and Professional Fees)
- Often Resolved Faster
- Creates Less Business Disruption
- Reduces Negative Attention from Customers/Suppliers
Since all the parties involved understand that Chapter 11 is the alternative to an out-of-court restructuring, creditors will only agree to an out-of-court plan if they believe they will be better off than by insisting on an in-court bankruptcy.
Challenges of Out-of-Court Restructuring
Despite the benefits of an out of court process, there are some cases where an in-court process may still make more sense:
- Unfavorable Contracts: Unfavorable leases, as well as pension and collective bargaining (union) agreements can only be rejected in court
- Holdouts: Since you can’t compel a creditor to accept a debt restructuring out of court, holdout problems exist in out-of-court restructurings – this problem increases in tandem with the number of impaired claim holders
Out-of-Court Corporate Restructuring Remedies
Negotiations at this stage are usually centered around restructuring debt obligations. The chart below lists the most common out-of-court solutions:
|“Amend and Extend” Provision||
|Interest Payment Schedule Adjustment||
|Cash Interest to Payment-in-Kind (PIK)||
|“Standstill” Agreements (or Forbearance)||
|Covenant Waivers (or “Relief”)||
In-Court Restructuring: Chapter 11 Bankruptcy
An out-of-court restructuring may not work if there are too many creditors to gather sufficient consensus (i.e. “holdout problems”) or because there are particularly unfavorable contracts like leases and pension obligations that are better dealt with in-court. In these cases, a company in distress will go to Chapter 11.
Listed below are the most notable benefits offered in Chapter 11 over an out-of-court restructuring:
|In-Court Chapter 11 Benefits|
|“Automatic Stay” Provision||
|Debtor in Possession Financing (DIP)||
|Cancellation of Executory Contracts||
|Section 363 Sale & “Stalking Horse” Bidder||
Free Fall, Pre-Pack and Pre-Arranged Bankruptcies
In general, there are three main types of approaches to filing for Chapter 11:
Priority of Claims in Chapter 11
Perhaps the most important part of Chapter 11 is determining the priority of claims. Under the Bankruptcy Code, a strict structure is established to determine the order of payouts – thus, the priority of claims and inter-creditor dynamics play a critical role in creditor recoveries.
This hierarchy the distribution must abide by is set forth by the absolute priority rule (APR), which requires that senior claims must be paid in full before any subordinate claim is entitled to recovery – albeit, there are instances when senior claim holders give consent for exceptions.
At a high level, the pecking order is as follows:
- Super Priority & Administrative Claims: Legal & professional fees, post-petition claims, and claims by lenders that provide capital during bankruptcy (e.g., DIP loans) will typically receive “super-priority” status above all claims generated pre-petition
- Secured Claims: Claims secured by collateral are entitled to receive value equal to the full value of their interest in the collateral before any value is given to unsecured claims
- Priority Unsecured Claims: Claims such as certain employee claims and government tax claims that are not secured by collateral can receive priority over other unsecured claims
- General Unsecured Claims (GUCs): Claims on the business that are not secured by collateral and receive no special priority, GUCs typically represent the largest claim holder group and include suppliers, vendors, unsecured debt, etc.
- Equity: Last in line and at the bottom of the capital stack (and thus usually receive nothing)
Treatment of Equity Claims
Pre-petition equity interests are typically wiped out in Chapter 11. However, equity holders can occasionally receive a “tip” for their cooperation to expedite the process.
Additionally, there are anomalies like the 2020/2021 bankruptcy of Hertz, in which equity owners fared famously well – serving as a rare exception to the typical recoveries of equity holders.
Pre-Petition vs. Post-Petition Claims
Chapter 11 typically starts when the debtor voluntarily files for bankruptcy. Technically, Chapter 11 can also be filed as an involuntary petition by creditors, but this is a rare occurrence as the debtor will preempt such a filing to avoid missing out on the benefits of being the one to file (e.g., selecting the jurisdiction).
The filing date creates an important red line between all claims created before and after the filing date. Specifically, “post-petition” claims (i.e. after the filing date) generally receive priority treatment over “pre-petition” claims (i.e. before the filing date) – excluding Court-approved exceptions.
- Pre-Petition Claims: If an incurred claim is prepetition, it is accounted as being “subject to compromise” until the reorganization process is settled. Post-petition debtors are strictly prohibited from paying off prepetition claims unless permission was granted by the Court
- Post-Petition Claims: Post-petition claims are incurred after the filing date and receive administrative status due to being deemed necessary for the debtor to continue operating. Post-petition claims receive priority treatment since incentives are often necessary to encourage suppliers/vendors and lenders to continue doing business with the debtor.
First-Day Motion Filings
First-Day Motion Filings
- “Critical Vendor” Motion
- DIP Financing Requests
- Cash Collateral Usage
- Prepetition Payroll Compensation
Early on in the Chapter 11 process, the debtor can file first-day motions, which are requests to obtain Court approval for certain tasks or access to resources.
For the most part, nearly all actions are overseen by the U.S. Trustee and require the authorization of the Court from this point onward – but in complex reorganizations, the benefits can outweigh the drawbacks of this tedious process (which are often menial in comparison).
Plan of Reorganization (POR)
The reorganization plan represents the proposed post-emergence turnaround roadmap – and includes details on the classification of claims and treatment of each class.
Once a debtor files for Chapter 11, the debtor holds the exclusive right to present a plan of reorganization to the Court within 120 days of filing – called the “exclusivity period”.
By the end of the Chapter 11 process, the objective of the debtor is to emerge with an approved POR and then shift to implement the outlined strategy.
Extensions are often granted in 60 to 90-day increments after the initial period of exclusivity has passed – but up until around 18 months for proposal and 20 months for acceptance, if a POR has yet to be agreed upon, then any creditor is permitted to file a plan.
The disclosure statement is a report that contains “adequate information” for the creditors to make an informed decision on the upcoming vote. Before the vote can proceed, the document must be submitted alongside the proposed POR. Collectively, the POR and disclosure statement must disclose all material facts pertinent to creditors participating in the vote.
Upon filing the required disclosure statement, the Court holds a hearing to assess whether the disclosure statement submitted by the debtor contains “adequate information”.
The depth of the documentation and supplementary data varies case-by-case, but one of the main purposes of the disclosure statement is the:
- Classification of Claims by Priority
- Proposed Treatment of Each Class of Claims
POR Voting Process: Approval Requirements
Once approved, the disclosure statement and POR will be distributed to the impaired claim holders deemed entitled to vote.
The acceptance of the proposed POR requires two conditions to be met:
- Greater than 1/2 in Numerical Votes
- At Least 2/3 of the Dollar Amount
And to be confirmed by the Court, the following tests must be passed:
|Minimum Standards of Fairness|
|“Best Interests” Test||
|“Good Faith” Test||
Chapter 11: Timeline Flow Chart
To summarize the Chapter 11 restructuring process, the chart below lists the main steps:
Emergence from Chapter 11 requires payment of administrative claims in cash unless the terms are re-negotiated (e.g., DIP financing with admin status to exit financing conversion).
The debtor must also obtain “exit financing” – which represents how the debtor intends to fund the POR post-emergence from Chapter 11. In the final stage, assuming confirmation, the debtor distributes the agreed-upon consideration to each creditor class and emerges as a new entity discharged of all unpaid pre-petition claims.
Emergence from Chapter 11 ≠ Successful Turnaround
For a POR to be approved, it must pass the “feasibility test” which means the capital structure, among other things, is set up in such a way that there is “reasonable assurance” of long-term success. But “reasonable assurance” is not a guarantee.
In fact, some companies have found their way back to bankruptcy, which is informally called “Chapter 22″. Or in other cases, the company will return to be liquidated after only a few years post-emergence.
The uncertainty of outcome is an unavoidable attribute of financial restructuring, but it is precisely the role of RX advisors, whether advising on a debtor’s or creditor’s mandate, to help their clients navigate through these complicated proceedings and negotiations.
Restructuring practitioners, when advising a debtor, have the central goal of contributing as much useful guidance to the debtor to put it back on the pathway of sustainable growth – whereas, on the creditor’s side, the RX bankers should strive to protect the client’s interests and ensure receipt of maximum recovery.
Chapter 7 Bankruptcy: Liquidation Process
While a debtor undergoing Chapter 11 attempts to come up with a plan to emerge from bankruptcy, a Chapter 7 bankruptcy refers to the straightforward liquidation of a debtor’s assets. In a Chapter 7 proceeding, the debtor has deteriorated to the point that a reorganization is no longer a viable option.
Certain firms become distressed by poor decision-making (i.e., fixable mishaps or short-lasting catalysts) and can change course despite the mistakes made.
But other times, there is seemingly little hope in even attempting a turn-around.
These are the scenarios whereby undergoing liquidation would be ideal, as the source of difficulties stems from an ongoing structural change. A Chapter 7 Trustee is appointed to liquidate the assets of the debtor and then distribute the sale proceeds by the priority of each claim.