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Thomson Reuters Bankruptcy Series: Out of Court Restructuring vs Chapter 11 Bankruptcy

April 13, 2020Publications / Mentions
Thomson Reuters

Goulston & Storrs bankruptcy attorney, Doug Rosner, recently worked with Thomson Reuters to create a three-part series that explains some of the various options for companies in financial distress. This first video gives a general overview of the out of court restructuring process and how it differs from the Chapter 11 Bankruptcy process. 

Key Takeaways:

  • An out of court workout differs from a traditional Chapter 11 reorganization primarily in that it is an informal process without court supervision.
  • Out of court restructurings are becoming more frequent with certain middle-market companies as well as in the real estate industry.
  • Companies and borrowers are gravitating towards the out of court alternative primarily because it's less expensive, it's less disruptive and it's less litigious than a traditional Chapter 11 bankruptcy:
    • A Chapter 11 bankruptcy can sometimes run in the millions of dollars in professional fees and other costs.
    • An out of court restructuring is a private process making it less disruptive to the company. It's also less disruptive to management as there is considerable preparation required for a Chapter 11 that can be avoided with out of court restructuring.
    • Out of court restructuring is less litigious as filing for bankruptcy opens up a forum in a bankruptcy court wherein parties can more easily litigate.
  • There are a few distinct disadvantages to out of court restructuring:
    • The lack of a court can translate to a lack of finality.
    • When a company files bankruptcy, there is an automatic stay that prevents creditors from pursuing their claims. There is no such protection with an out of court restructuring.
    • Out of court restructuring doesn't have the finality of a court order that it would have in a Chapter 11 case.

If you have questions about this topic, please visit our Bankruptcy & Restructuring page or reach out to your usual Goulston & Storrs attorney. 


    Full Transcript:

    Hello and welcome. This is a video about Out of Court restructurings as an alternative to Chapter 11. My name is Doug Rosner. I'm a bankruptcy and restructuring partner at Goulston & Storrs in Boston, Massachusetts. In the video, I'm going to discuss generally out of court restructurings as an alternative to bankruptcy. In addition, I'm going to talk about the advantages and disadvantages of reorganizing outside of bankruptcy versus reorganizing in Chapter 11. An out of court workout differs from a traditional Chapter 11 reorganization primarily because it's a more informal process and it's outside of court and so you don't have a court overseeing the process itself and we find that companies and borrowers are gravitating towards the out of court alternative primarily because it's less expensive, it's less disruptive and it's less litigious. And what we see, for example, are out of court restructurings becoming more frequent with middle-market companies that have a finite number of creditors and maybe one or possibly more secured lenders and it's a finite enough group that they can at least try to sit down with their creditors and attempt to negotiate a compromise with their credit or body and forgo the Chapter 11 process.

    We also see it in the real estate context and there we see it primarily because under current real estate loan structures, these loans are non-recourse but they have a guarantee where the guarantor agrees to guarantee the entire loan if the borrower were to file for bankruptcy and so those borrowers and guarantors want to avoid bankruptcy if they can and they would prefer to reach a consensual restructuring with their mortgage lender or cooperate with the mortgage lender in a sale of the property.

    The advantages of an out of court workout versus a Chapter 11 filing are primarily that it's less expensive. A Chapter 11 bankruptcy can sometimes for a middle-market company run in the millions of dollars in professional fees and other costs. It's also less disruptive because an out of court restructuring is more of a private process. It's not a public process, so it's less disruptive to the company. It's less disruptive to management because there's a lot of preparation for a Chapter 11 that you can avoid by doing an out of court restructuring. In addition, it's less litigious because then if you file for, if a company were to file for bankruptcy, it creates a forum in a bankruptcy court where parties can litigate. Outside of bankruptcy, it's consensual and a negotiated compromise with the creditors, so it's less litigious and being less litigious, it's less expensive.

    In addition, a Chapter 11 bankruptcy case establishes a forum, as I said, for creditors to sue and it's a forum for creditors, for example, a creditors committee or a trustee to sue the board of directors, the officers, the lenders, and all of that is avoided in an out of court restructuring where it's much more difficult for creditors to sue the board and the officers if they have to initiate the lawsuit themselves as opposed to having a forum already created for them in the form of a Chapter 11 bankruptcy case. Those are the primary reasons why an out of court restructuring is probably a better way to do it if you can than a chapter 11 reorganization. It's also better for the lender because it's as expensive as a Chapter 11 process is for a borrower, it's equally expensive for the lender.

    In many cases, the lender has to fund the Chapter 11 because the borrower doesn't have enough money to fund it itself. And so the lender can avoid all of those costs and risks. In addition, the lender avoids the litigation and investigation that occurs in a Chapter 11 by doing it out of court and doing it consensually. For vendors, it's the same thing. A less expensive process to reorganize their customer means that there might be more money available for the creditors as part of a distribution. It also might mean less disruption so that the creditors can continue with a customer. And third, there's a concept in bankruptcy that if a vendor's been paid on an old debt within 90 days before the bankruptcy filing, a trustee can claw back that money. The vendor avoids all of that and all of that risk and cost by agreeing to an out of court restructuring where there won't be any avoidance lawsuits. So for the vendor, it's a better way to resolve the financial challenges of their customer than a Chapter 11 bankruptcy. 

    The disadvantages of an Out of Court workout, it's sort of the flip side of the advantages. You don't have a court overseeing the process. So the disadvantage might be that creditors or a buyer doesn't have the finality of a court order that it would have in a Chapter 11 case. Another disadvantage is in bankruptcy there's an automatic stay that prevents creditors from pursuing their claims. So outside of court, creditors can still sue the company and if that litigation becomes too burdensome, it might force the company to have to file for bankruptcy protection to stop the litigation. Another disadvantage of an out of court sale, for example, is that out of court you can't sell free and clear of claims free and clear of liens and encumbrances other than maybe a UCC foreclosure sale. But in a bankruptcy sale, a court can approve a sale free and clear of liens, claims encumbrances and other interests and you can't do that consensually unless everybody agrees.

    So there's an advantage to bankruptcy of having the court order and the cleansing of all the assets through the bankruptcy process. You do get some of that cleansing in an article nine foreclosure sale or real estate foreclosure sale. But there it's more limited because you're extinguishing junior liens but you're not, it's not as expansive as a bankruptcy sale where you can extinguish all claims, unsecured claims as well as interests and things like that. The other disadvantages some buyers like the comfort of a bankruptcy court order because it insulates the buyer from successor liability claims and that's when creditors can bring claims against the buyer for debts that accrued prior to the sale closing. So in that context in bankruptcy, the buyer can get a court order that insulates them from successor liability while outside of bankruptcy there's no court order. And so there's no certainty as far as successor liability exposure.

    Out of court workouts are becoming more frequent. And I think primarily because Chapter 11 reorganizations, especially for middle-market and smaller companies are becoming much more expensive. For many middle-market companies, a Chapter 11 reorganization, the professional fees alone can run up to the millions of dollars and a lot of companies cannot afford that, especially when they're in financial distress. And if they're relying on their lenders to pay the cost of the Chapter 11 process, there are many lenders that would rather avoid that if they can. So they are becoming more frequent. Anecdotally, just through our practice, we've seen many more out of court restructurings, assignments for the benefit of creditors, consensual foreclosure sales than we've seen in the past. And the primary reasons, as I said, our expense. And the other reason is a lot of boards and board members are reluctant to jump into a chapter 11 bankruptcy process and expose themselves to lawsuits and they would prefer to start with or at least attempt an out of court restructuring and avoid the Chapter 11 process altogether.

    There has been one change in the bankruptcy code, which is probably worth noting and that is Congress recently enacted an amendment that makes it easier for small businesses and small businesses are businesses with two and a half million or less of indebtedness. So it makes it easier for them to reorganize and to do it more quickly and in a less expensive way than under the prior bankruptcy code or under the general Chapter 11 process for larger companies. So that makes bankruptcy perhaps a more viable alternative for smaller businesses. But again, if it's a smaller business and you have a finite number of creditors, it might make sense and it would be less disruptive to at least try an out of court restructuring. And then in all cases, even if you try and out of court restructuring and it fails and you end up in Chapter 11 in any event, those out of court negotiations could form the foundation for a Chapter 11 plan or a Chapter 11 sale process that would effectively accelerate the Chapter 11 process, which would then make it less expensive and probably less litigious because you would have already negotiated with your critical creditors and your senior lenders.