Out-of-court restructuring alternatives
June 2016 | TALKINGPOINT | BANKRUPTCY & RESTRUCTURING
FW moderates a discussion on out-of-court restructuring alternatives between Jeff Zappone, senior managing director at Conway MacKenzie, James Feltman, managing director at Duff & Phelps, and James Sprayregen, a partner at Kirkland & Ellis LLP.
FW: How have bankruptcy case rulings impacted the landscape for out-of-court restructuring?
Zappone: The ABI is actively working toward a 2018 target for potential changes enacted to the Bankruptcy Code. As these changes are made, it will likely be more necessary for companies undergoing distress to reconsider their options for both in and out-of-court restructuring. In the struggling oil & gas sector, the recent ruling in the Sabine Oil & Gas case opens the door to potentially allow energy companies to reject pipeline contracts, which were previously not subject to rejection in bankruptcy. If upheld, this could motivate struggling oil producers – of which there are many – to use the bankruptcy process to reject or renegotiate midstream contracts.
Feltman: The re-establishment of the Trust Indenture Act and rulings like Marblegate have shifted some bargaining powers away from borrowers enhancing the negotiating position of bondholders generally and ‘holdouts’ more particularly. These factors have complicated the out-of-court process, but preserving something of value for holdouts may be the non-consensual path forward, at least for now.
Sprayregen: Certain bankruptcy court rulings can help facilitate an out-of-court solution. When faced with more transparency and certainty of their potential in-court alternatives, creditors and other stakeholders may be more willing to compromise out-of-court. Of course, there is a degree of uncertainty in any in-court restructuring – based on any party’s right to be heard and the court’s discretion in issuing rulings – that often isn’t present in a fully negotiated, out-of-court transaction, and bankruptcy cases are often much more expensive than out-of-court transactions. The combination of factors can be used to broker a deal in certain circumstances.
FW: What preconditions are favourable to undertake an out-of-court restructuring? What should companies be thinking about in terms of their options?
Feltman: Out-of-court workouts remain the ‘ready, aim’ part of the equation for restructuring. Debt repurchases and equity swaps are the two key tools available to recuse businesses creditors deem worthy of preserving. Garnering sufficient support from creditors is the best path forward, even after the ‘make-whole’ decisions in Energy Future Holdings and Momentive. There needs to be a motivation by the creditors to do an out-of-court restructuring, otherwise they will push the company into Chapter 11.
Sprayregen: To successfully implement an out-of-court restructuring, a company must be fortunate enough to have required stakeholders with a willingness to engage in constructive negotiations and a manageable-sized group of such stakeholders. It also helps if parties share a common goal of keeping the company operating and minimising the potential disruption and costs of bankruptcy. That said, companies should always engage in prudent contingency planning with skilled advisers. Deals can change without notice and unexpectedly, and it’s important for a company – particularly a distressed company – to be ready.
Zappone: While a company considers its options it should decide whether a number of preconditions are in place for an out-of-court solution. First, it knows what loans or other obligations are in default and why. Second, knows what it’s near term possible defaults could be during the work-out period. Third, it has enough liquidity or financing to operate while the negotiations are happening. Fourth, it has a smaller number of creditors and is able to negotiate. Fifth, it understands its short term cash requirements and the needs for a long term fix to the issues. Finally, it possibly has unencumbered assets to leverage in the negotiations. One major benefit of filing is that the debtor can impose an outcome on dissenting creditor classes, therefore out-of-court restructurings are most common when there are relatively few constituents that need to approve the restructuring. In terms of options, a company first needs to identify how value can be maximised – that means looking at all options such as liquidation, sale or a financial restructuring. Once the best option is identified, the company’s options depend on whether or not the impacted constituents can be convinced to support the plan. In my experience, this is achievable but it requires transparency, candour and information such as analyses that show creditors their recoveries in the various possible scenarios.
FW: What are the main advantages for companies that utilise an out-of-court debt restructuring mechanism? Conversely, are there any disadvantages when avoiding the court process?
Sprayregen: Out-of-court restructurings have the benefit of being less expensive and more quickly implemented than in-court restructurings. They also avoid increased disclosure obligations, public scrutiny and litigation risks from interested parties. Of course, there are disadvantages to out-of-court restructurings. Disadvantages include the loss of the many tools offered to debtors by the Bankruptcy Code, including the ability to bind holdouts and reject unfavourable contracts and the protection of the automatic stay – which is especially important where parties have not achieved consensus before a Chapter 11 filing. There are also important potential tax benefits – at least in the US – to restructuring through a formal court process.
Zappone: Bankruptcy is a tool of last resort. First off, it’s expensive. Professional fees are the most obvious cost. Typically all major groups – debtors, secured creditors, unsecured creditors, and so on – will have their own financial and legal advisers that are, one way or another, paid by the estate along with various filing and trustee fees. There are also significant unquantified costs as a bankruptcy consumes time, energy and focus of internal resources. Second, while bankruptcy doesn’t quite have the stigma that it once did, there is no doubt that the public process has a negative impact on enterprise value. Competitors may use it to poach customers or take market share, key employees may leave and suppliers may become nervous, particularly when they learn that their receivables from the company are frozen as of the petition date. Out-of-court restructurings are challenging, however, because not only do they depend on consensual agreement, but that consent must be universal among all constituents.
Feltman: The costs of a bankruptcy proceeding can be extremely high and it is generally recognised that this is the wrong venue to negotiate a major capital restructuring from the vantage point of speed and transparency. Conversely, pre-packaged and pre-negotiated restructurings have the dual advantages of having a court order in place to approve what the parties seek to accomplish and the bankruptcy venue offers a safe haven for protecting certain tax benefits including COD recognition and net operating loss carry-forwards.
FW: What are the optimal or suboptimal conditions to undertake an out-of-court restructuring? Are there alternative strategies where conditions do not favour an out-of-court restructuring?
Zappone: A debtor has the advantage of binding 100 percent of the creditors of a certain class to accept less than they are entitled and selling assets to potential purchasers free and clear of most liens. The optimal contentions to undertake an out-of-court restructuring is when there is a fairly simplified capital structure with few classes of equity and debt and a limited number of constituents involved in negotiation and approving the transaction. Besides bankruptcy and an out-of-court restructuring is an assignment for the benefit of creditors. This is a liquidation of a business under state law and an alternative to Chapter 7 bankruptcy, which is liquidation under federal bankruptcy law. There are a number of benefits to Chapter 7. First, the assignee is selected by the company and is not court appointed. Second, there are fewer filing requirements. Third, there are cost savings over bankruptcies and companies have the ability to move quickly. Finally, asset sales can happen with few ways for the creditors to object and no court order as long as the ‘maximum value’ is being realised.
Feltman: Establishing – or re-establishing – trust between the parties is key. Gaining a consensus view on the options facing a company is also a critical next step. Business managers should seek assistance from third-party experts in evaluating alternatives of the debt bearing capabilities of their operations. Negotiations should ‘base line’ reasonable expectations of future performance to minimise the risks of serial defaults and the lender fatigue over failures to meet company expectations.
Sprayregen: The facts of every case are different, and there is no single ‘optimal’ template for a consensual, out-of-court restructuring. Nevertheless, it certainly helps to have a capital structure controlled by a limited number of parties that are willing to negotiate – with the company and each other – and share the ultimate goal of effectuating a successful restructuring. Generally, an out-of-court restructuring isn’t possible unless all or a critical mass of stakeholders is willing to cooperate with the company. And that isn’t always the case. If a company needs or would otherwise benefit from some of the provisions of the Bankruptcy Code, then an in-court restructuring might be preferred over an out-of-court restructuring. In this scenario, even if there is consensus among a company’s stakeholders, formal bankruptcy may be preferred – perhaps on a pre-packaged or pre-arranged basis.
FW: How do you maximise the potential for managing intensive negotiations with creditors? What are some of the common pitfalls?
Feltman: The more complex a company’s debt structure, the more difficult it becomes to find a sufficiently consensual path forward. The ‘hold-out’ risk and minority interest holder protection cases, along with the rise in attention paid to the Trust Indenture Act, taken together are creating new challenges in the out-of-court restructuring environment.
Sprayregen: Companies and their advisers should evaluate and be careful to engage with creditors at the right time – early enough to avoid being faced with an imminent liquidity event, but not until timing constraints can put pressure on stakeholders to act – and thereby avoid a downside alternative. By imposing reasonable time pressure on their stakeholders, either through natural time-imposed constraints or contractually imposed triggers, companies can motivate parties to engage in constructive discussions as to reach a consensual out-of-court resolution. Issues are more likely to arise when negotiating among stakeholders if a company has an unmanageable amount of parties that it needs to reach a consensus with. In particular, issues arise when a company’s stakeholders have different objectives or are operating on different timelines than one another or with the company.
Zappone: Managing negotiations with creditors can often become complex and intense. As both parties try and vie for the best outcome it is important for the company or adviser to bear a couple of factors in mind. First, cash is almost always preferred as a payment and having cash on hand to make those payments as soon as possible can lead to a faster solution if those funds can be dispersed quickly. Second, once Chapter 11 has been filed, usually the entire amount owed to the typical creditor is at risk or is discharged – pennies on the dollar is better than nothing. Some of the common pitfalls in negotiating out-of-court are that negotiating with a large number of creditors can be unwieldy or difficult and there is no sure way to bind all creditors in the same class to take less than they are entitled. Another pitfall is that liens can remain on assets sold outside of bankruptcy – making it difficult to maximise value on assets sold. Negotiations are often intense, particularly with parties that are ‘impaired’.
FW: In your experience, what are the factors that improve the potential for success in an out-of-court restructuring?
Sprayregen: An out-of-court restructuring may offer a viable solution for a company that needs to de-lever its balance sheet and does not face operational issues, which may need to be addressed by more advanced bankruptcy tools. Companies that have burdensome contracts or other operational challenges may not be able to successfully resolve those challenges out-of-court. Even if a company can address its restructuring needs through a balance sheet deleveraging, though, much of the potential success of an out-of-court restructuring may depend on, among other things, the stakeholders and other negotiating counterparties, which companies cannot always control. What is in a company’s control is its liquidity runway; companies should be diligent in forecasting their financial needs and determining any issues they may have in the future. Attempting an out-of-court restructuring when a company has little liquidity left and is desperate to reach a deal diminishes both the company’s leverage for a favourable out-of-court restructuring and, logistically, even the possibility of negotiating and finalising the terms of an out-of-court transaction. However, companies should be cognisant of the timing pressures their stakeholders face as time runs out before the companies have to file bankruptcy or otherwise liquidate, and companies should commence discussions to maximise and leverage these timing pressures as to motivate their stakeholders to reach a consensual deal.
Zappone: The chances of success are improved when there is a smaller number of creditors who are willing to or are easier to negotiate with. It is important to find common ground among the company, creditors and owners as to areas of mutual interest. In addition, communication between all parties is key. Creating a reorganisation plan as soon as possible and having clear goals and a timeline set up in advance to track your progress is also hugely advantageous. The availability of inexpensive financing that meets the company’s operational and financial needs throughout the out-of-court restructuring is also extremely important. Whether in or out-of-court, the process needs to be based in financial reality. It’s all about getting various groups to their collective best possible outcome.
Feltman: Each work out situation is different and must be tailored to address the relevant needs of constituencies, which can and often do shift during negotiations. This sector of the restructuring industry has become quite sophisticated and distressed lenders are adept in extracting the maximum returns possible from financially distressed borrowers. Business managers should not underestimate the risks of dealing with these counterparties in an out-of-court scenario.
FW: Looking ahead, do you expect to see an increase in corporate distress and out-of-court restructurings?
Zappone: Looking forward I expect to see an increase in corporate distress and out-of-court restructuring because of a continued downward trend in key economic indicators and underperformance in influential industries. Oil prices are expected to remain depressed and a study of 500 energy companies released by Deloitte earlier this year found 35 percent were at risk of bankruptcy through 2016 alone. Metal and scrap exports have fallen 30 percent in the last 12 months and 80 US scrap companies – representing 11,000 jobs – have shuttered their doors. The US economy is approaching its 88th month of economic expansion while on average a recession has occurred every 54 months since WWII. The percent of corporate bonds that the S&P rates as junk is at 52 percent – the highest level since 2007.
Feltman: I think we will continue to see restructuring for businesses reliant on more moderate commodities prices – especially in the energy and mining space. Traditional retail is showing more signs of retrenchment and ocean shipping is impacted as the volume of exports slow down. In the US, unless the credit markets thaw, there will be fewer traditional refinancing sources. The expected returns of ‘rescue finance’ may be unrealistically high and set up the dynamic for the next round of restructuring or liquidations. Rising risks of defaults for non-investment grade debt raises the overall costs of refinancings and adversely impacts the willingness of lenders to ‘kick the can down the road’.
Sprayregen: We’re already seeing some interesting things in the capital markets across the globe, along with increased activity in the restructuring space in terms of both industry-specific and market-specific activity. There are some clear challenges facing the Brazilian markets and Brazilian issuers, as well as the well-publicised activity in the energy sector and among firms with significant exposure to the commodities market. Of course, some of the more recent developments in the Trust Indenture Act case law in the US, in particular, may influence market appetite for out-of-court alternatives. One additional point, though, is that I’d challenge the premise that an out-of-court restructuring automatically means distress – there’s not always a correlation. I’d expect to see creative issuers or borrowers using broader or macro issues to their advantage, by capturing value through exchange offers, discounted repurchases or other ‘restructuring’ transactions on an opportunistic basis.
FW: In your experience, should advisers press for early intervention or wait until circumstances demand action? How does timing influence outcomes?
Feltman: The successes or failures of out-of-court workouts are significantly influenced by two factors, namely timing and the severity of the borrowers’ business and financial conditions. Borrowers who initiate the process should understand that they may be putting the company into ‘play’ depending on the severity of the company’s circumstances and the significance of the effects they hope to achieve in resetting the capital structure. Timing is also a critical factor because events like the conditions in the borrowers industry, competitor M&A transactions, changes in credit ratings and the trading values of debt and equity are not controllable by management. Waiting too long before beginning a workout can unintentionally shift too much bargaining power to debt holders and complicate management’s plan going forward.
Sprayregen: Every situation is different. In certain engagements it maybe prudent to let circumstances play out a little bit, let the situation develop, and get to know the players and their intentions. In other situations, time may be working against us, and we want to move quickly – particularly if there is a chance to capitalise on near term opportunity. The key things are to understand the situation, understand the parties’ goals, and then use that knowledge to help drive the process towards the outcomes parties want to achieve.
Zappone: Advisers should press for early intervention but be wary of when to actually begin bankruptcy actions. A financial adviser, especially at a distressed or underperforming company, should always be aware of what is currently and will be happening to a company’s financials and projections, and cognisant of upcoming loan and other obligations for timings of significant events. This way they will be able to take preventative methods to avoid an out-of-court restructuring and attempt to turnaround the business before any restructuring or bankruptcy takes place. As with any problem, addressing it early is always best.
Jeff Zappone is a senior managing director and leader of Conway MacKenzie’s Chicago office with over 25 years of experience in turnaround management with specific expertise in interim management, including profit and cash flow enhancement and organizational improvements. His experience spans in a wide range of industries. He has extensive expertise in all of the following specific sectors: metals, automotive, furniture, food and beverage, consumer products, employee leasing and all aspects of freight forwarding. He has served companies as an adviser as well as in the role of chief executive, operating, restructuring and financial officer. He can be contacted on +1 (312) 220 0100 or by email: email@example.com.
James Feltman is a managing director in the Disputes and Investigations practice at Duff & Phelps. He has over 30 years of experience providing a broad range of litigation, forensic and investigative services and he provides both consulting and expert testimony specialising in the areas of money laundering, Ponzi schemes, asset tracing and recovery, accounting and financial statement reporting issues, causes of action against officers, directors and third parties, securities fraud, misrepresentation, hedging and trading in complex securities schemes and bankruptcy and insolvency issues. He can be contacted on +1 (212) 450 2854 or by email: firstname.lastname@example.org.
James H.M. Sprayregen is a partner at Kirkland & Ellis and is recognised as one of the outstanding restructuring lawyers in the US and around the world, and has led some of the most complex Chapter 11 filings in recent history. He has extensive experience representing major US and international companies in and out-of-court as well as buyers and sellers of assets in distressed situations. He has experience advising boards of directors, and representing domestic and international debtors and creditors in workout, insolvency, restructuring and bankruptcy matters. He can be contacted on +1 (312) 862 2481 or by email: email@example.com.
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