New beginnings: life as a Chapter 11 emerged entity
June 2015 | COVER STORY | BANKRUPTCY & RESTRUCTURING
Financier Worldwide Magazine
For most companies, entering bankruptcy represents a nightmare scenario with no easy means of escape. Some organisations immediately crash and burn when finances hit the buffers. Some seek to avoid all liabilities. Others take the Chapter 11 option, which allows insolvent companies to continue their business operations with substantially reduced levels of debt.
The United States Chapter 11 process is complex and can often be exceedingly expensive, involving interim management, reorganisation plans, recovery alternatives and exit strategies – all under the watchful and expectant gaze of a multitude of stakeholders with myriad demands.
However, with market conditions having steadily improved over the past few years, an increasing number of companies are successfully navigating their way through the Chapter 11 maze to emerge as restructured entities. According to the most recent figures compiled by FTI Consulting, 550 companies have emerged as reorganised entities since 2010.
Clearly, companies entering into a bankruptcy or out-of-court restructuring face complex challenges, with extensive implications, irrespective of whether reorganisation or an ownership change is the ultimate objective. Moreover, for those companies that do emerge from Chapter 11 bankruptcy proceedings, substantial challenges remain. These include tackling issues such as fresh-start reporting and the overall need to set realistic expectations that are shared by extant stakeholders.
In a post-financial crisis world, the ability to satisfy and surmount these challenges is a key requirement for a restructured entity, not only for sustaining the company in the short to medium term but also for targeting realistic growth in the long term.
Driving the rehabilitative process
For many companies, the best strategy for tackling the challenges they face upon Chapter 11 emergence can be elusive. In the short-term at least, it can be difficult to identify the mechanisms that will help drive the rehabilitative process.
How the company fares post-exit depends, in large part, on the type of Chapter 11 the company went through. “Ironically, a faster bankruptcy – such as a pre-packaged plan or prearranged plan – often results in a more challenging post-emergence environment than a Chapter 11 resulting from a ‘freefall’ bankruptcy, followed by significant operational changes during bankruptcy,” suggests James H.M. Sprayregen, a restructuring partner at Kirkland & Ellis LLP. “The reason for this is that a quick pre-packaged or prearranged bankruptcy for the most part only results in a write-down of debt or a conversion of debt to equity, and very little in the way of operational improvements. By contrast, a freefall bankruptcy, while much messier, costlier and lengthier for the company, often results in greater operational changes that improve the profitability of the company.”
One legacy of the boom in quick bankruptcy processes is that, too often, companies emerge without addressing their fundamental operational problems, and are still encumbered by overleveraged balance sheets. Unfortunately, Chapter 11 bankruptcy rarely facilitates the kind of cultural overhaul that such companies require, which presents a huge challenge post-emergence.
Many of the reorganisation cases in recent years have been characterised by increasingly complex capital structures, greater diversity of investors and severely compressed timelines. The result, according to Robert J. Duffy, global segment leader of corporate financing & restructuring at FTI Consulting, is that senior executives are often unduly consumed by issues surrounding capital structure fixes and may not sufficiently address fundamental business issues that inevitably cause companies to fail. “The common characterisation, ‘good company/bad balance sheet’, is a flawed one – it’s never just a ‘bad balance sheet’ that causes failure,” he says. “Operating deterioration is ultimately what causes a capital structure to become inappropriate or unsustainable. Rightsizing a balance sheet is certainly a very high priority in bankruptcy but is not itself a remedy.” He adds that there is a wealth of empirical evidence indicating that companies emerging from Chapter 11 frequently fail to sufficiently reduce their debt, and therefore remain highly leveraged post-emergence.
Moreover, bankruptcy processes typically put debtors under considerable financial and emotional distress. “They are an exhaustive, demoralising, costly process,” notes H. Jack Miller, a partner at GFCIB and Advisors LLC. “The key is to come out of it with a plan that you can live with and build your business around. The business owner and management team need to keep their energy and enthusiasm for the business and not be too beaten up by the process.”
Cutting a way out of trouble
Chapter 11 reorganisation inevitably involves substantial changes to the financial and cost structures of a company and the jettisoning of underperforming assets – actions designed to improve the overall cost structure. But scaling back and rightsizing the business is just the first step on a long road.
“A company cannot cut its way to growth for the mid or long-term,” says Mr Sprayregen. “Cutting is a way to staunch the blood flow, much as in amputating a leg can save the rest of the body. However, growth requires investment, capital expenditures, and increased and improved human capital. It is an error of many companies in restructurings and Chapter 11s to try to cut their way to growth. A far-seeing leader needs to do what is necessary in the short term to create the liquidity to grow the company’s way to growth.”
Cutting a path back to profitability seems counterintuitive, but Chapter 11 provides a framework for this approach to unfold in a way that could be vital to a company’s survival. “The legal remedies available to a company via the bankruptcy process do make this possible, at least conceptually, by enabling a company to be extricated from highly burdensome contracts and leases far more economically than it could outside of Chapter 11,” explains Mr Duffy. “If there were one or two very specific reasons that cause a company to fail which are related to such contracts or arrangements, such as an unfavourable supply contract of a critical commodity, then such remedies can be hugely beneficial to a debtor. But as we know, it’s rarely one or two factors that cause a large company to fail; rather there are likely to be myriad causes that permeate the enterprise.”
Maximising a ‘clean slate’
Of course, emergence from bankruptcy does much more than provide a company with a new beginning; it also provides a clean slate for the restructured entity to re-engage with stakeholders and delineate its future from its past. Overall, it is an opportunity for management to set out a fresh strategy which not only establishes a new set of financial metrics with which to evaluate success, but which re-establishes the company in the marketplace. As Mr Miller notes, it allows the company to deliver what it promises and to demonstrate the value.
To this end, a company’s credibility throughout the entire bankruptcy case – from entry to exit – is key. “Credibility in the marketplace should be front and centre in the management team, the board and the stakeholders’ minds,” states Mr Sprayregen. “Many first day motions in Chapter 11 cases are directed at maintaining a company’s credibility in dealing with its suppliers and customers. Nevertheless, while Chapter 11 is not as brand damaging as it used to be, it is still a black mark on the company.”
The impact of this ‘back mark’ varies from industry to industry, according to Mr Sprayregen, where differing degrees of fallout are associated with bankruptcy. Retailers, for example, tend to fare quite well; as long as customer programs such as gift cards, returns and refunds are honoured once the company exits Chapter 11, customers are unlikely to hold a grudge. By contrast, manufacturers operate on long lead times for orders, so credibility is incredibly important. Distributors, too, fare very poorly in bankruptcies because it is so easy for customers who are in doubt about distribution capabilities, such as a trucking delivery company, to switch to other providers. “The company needs to understand what type of credibility hit it will take on the filing to begin planning for emergence even before the filing happens,” says Mr Sprayregen. “Companies should focus on letting their customers and suppliers know that, as most bankruptcies are, it is not about whether the company will stay in business, it is about who will own the company. Also, they need to emphasise that all obligations of the company – to its customers in particular, and to its suppliers to the greatest extent possible – will be honoured.”
Whatever its industry, an emerging debtor can do a number of things to give itself the best chance of succeeding post-emergence. For Mr Duffy, chief among these is that the debtor should exit bankruptcy with as much liquidity as it can – more than what is reasonably expected to be needed, if that is possible. “This should put suppliers and other key business creditors at ease and provide a cushion for unanticipated developments,” he says. “The debtor should also make sure it has addressed the operational issues which led to the company’s initial decline and implemented a path forward to ensure the company doesn’t experience the issues again. It can replace select board members and key executives so that outsiders perceive there has been a changing of the guard offering fresh perspectives and guidance. Lastly, it can implement a communications strategy that effectively conveys the transformation story to outsiders and employees.”
Laying the post-bankruptcy groundwork
In a Chapter 11 scenario, companies need to consider their post-bankruptcy narrative well in advance of actual emergence. Laying the groundwork early in the process is an essential part of long-term success. This requires a convincing explanation for the company’s new capital structures and why it should be considered more manageable now than it was pre-Chapter 11.
Some advisers, like Mr Sprayregen, encourage debtors to prepare their exit story even before they enter bankruptcy. “Treat the first day speech at the beginning of the first day hearing as the opening argument as if there were a lengthy trial occurring. The closing argument should be prepared before the opening argument – to me, that is the post-bankruptcy narrative. This groundwork should be laid throughout the case as to what is often the ‘good news’ of the bankruptcy; that is, the company will have a more sustainable, less levered capital structure enabling it to better deliver goods or services to its customers and deal with its supplier obligations,” he says. Communication with all stakeholders, as well as employees, is critical to getting this bankruptcy narrative across.
Indeed, effective communication is vital throughout the Chapter 11 process. A strong message is required to maintain focus on the debtor’s end goal, and to explain why this difficult path is worth taking. “It’s hard to imagine a reorganisation being completed without a dedicated communications apparatus engaging in an ongoing dialogue with employees, business creditors and investors,” confirms Mr Duffy. “Proper and consistent messaging is critical throughout this precarious period and a cornerstone to successful turnaround efforts. By the time reorganisation nears completion, an appropriate communication strategy should firmly be in place and capable of pivoting the messaging as needed upon emergence. Ultimately, it’s about telling a compelling story to an eager audience.”
Conclusion: bankruptcy – a lingering taint?
Reconciling Chapter 11 emergent status with the forward-looking outlook expected of a revitalised entity is a formidable task facing all reorganised companies in the post-bankruptcy phase. Boiled down, the contention is this: to what extent is a Chapter 11 legacy likely to impact a company’s future performance and should it even be considered an issue at all?
“I don’t think these distinctions are top of mind for anyone once a debtor emerges from Chapter 11,” believes Mr Duffy. “Everyone is forward-looking at that point. The notion that there may be a lingering taint or stigma from having been through a bankruptcy pretty much ended many years ago. Suppliers want to do business with you again, prospective employees want to work for you, customers want your products and it’s a matter of conveying to all these stakeholders that remedial actions have been effective and you’re going to be around for quite a while.”
How much the debtor struggles to shake off any perceived stigma depends largely on whether it addressed the core problems that caused the bankruptcy in the first place. “Often the Chapter 11 legacy affects companies’ future performance because a company has not dealt with the types of recommendations set forth during the bankruptcy process. The legacy impact can be removed very quickly if a company is proactive and properly plans for it. Often this does not occur, and the negative Chapter 11 taint lasts for quite a while. This is unnecessary,” says Mr Sprayregen.
Patience is also important. “It takes time to reinvent a company and get over the fight of the Chapter 11,” says Mr Miller. “The new company should keep focusing on the future and it will happen before they know it.”
Such optimism, whilst recognising that the management of stakeholder relationships following emergence can be a tricky and complex task, is couched in the understanding that companies filing or contemplating a Chapter 11 need to consider the post-bankruptcy narrative well in advance of the actual emergence, so that they are well-placed to meet the many challenges ahead and ensure their heralded new beginnings do not lead back to the courtroom.
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