Bankruptcy 'Cramdown' Is Not a Silver Bullet: Financial Executives Need to Think Twice
When a company faces financial distress, CEOs and CFOs often confront the choice between an out-of-court settlement or filing for Chapter 11 bankruptcy. However, the value destruction caused by bankruptcy proceedings far exceeds the numbers on the books, including hidden costs such as credit downgrades, customer attrition, and strained supplier relationships. Even if a 'cramdown' reorganization plan appears to significantly reduce debt, the law still requires protecting the minimum interests of secured and unsecured creditors. This article advises financial executives to prioritize quickly overcoming distress and restoring business operations, rather than fixating on extracting the maximum concessions permitted by law.
Editor's Note:Kenneth A. Rosen is the Chairman Emeritus of the Bankruptcy and Restructuring Department at Lowenstein Sandler LLP. This article reflects the author's personal views only.
The costs of financial distress vary depending on a company's specific circumstances, but there is no doubt that, absent special situations, Chapter 11 bankruptcy proceedings diminish enterprise value. With the surge last yearin the number of companies filing for bankruptcy to seek a fresh financial start, financial executives who want their companies to sustain long-term operations should think twice.
When a company falls into financial distress, CEOs, CFOs, and their lawyers must decide whether to reach an out-of-court settlement with creditors or initiate Chapter 11 proceedings. Similarly, for companies already in bankruptcy and facing lengthy litigation, executives may need to consider cutting losses and reaching a settlement at some point. In either case, before taking action, companies should fully weigh the indirect soft costs and benefits of settlement.
The longer a company takes to restructure its operations and adjust its balance sheet, the greater the loss in value. Specifically, lenders become less tolerant of underperformance; as distress persists and becomes increasingly public, customers begin seeking second suppliers; salespeople may jump ship if they believe the employer might fail; and management is forced to spend valuable time dealing with distress rather than focusing on core business.
C-suite analysis should begin with a question: What needs to be done to preserve and enhance the company's future value? How much creditors can recover in liquidation is only part of the problem. So, what other aspects should be analyzed?
First, if considering an out-of-court settlement with creditors, one must consider the direct costs of bankruptcy, which are relatively quantifiable, including professional fees and rising borrowing costs. Indirect costs—equally harmful to the company but harder to quantify—include higher financing costs due to credit rating downgrades, declining customer trust, strained supplier relationships, and reduced decision-making autonomy.
Another scenario is when a company is already in bankruptcy proceedings but hopes for a so-called "cramdown" restructuring plan—where the court, under certain conditions, can approve a reorganization plan without the consent of some creditors. This prospect is tempting for bankruptcy filers seeking significant debt reduction.
But this is not always achievable. A restructuring plan must ensure that secured creditors receive at least the value of their collateral. Under the law, the plan's treatment of secured lenders must also be "fair and equitable," and unsecured creditors should receive at least what they would get if the debtor's assets were liquidated under Chapter 7. This is known as the "best interests of creditors" test.
The potential benefits of cramdown and the best interests test may be attractive to companies considering the pros and cons of initiating Chapter 11 proceedings or settling with creditors. Management can easily be persuaded by professionals—who advise clients to file for bankruptcy and then hold out until creditors agree to figures close to liquidation value—but this is actually irresponsible to the client.
Sometimes, it is reasonable to pay creditors more than they would receive in a liquidation scenario, if the ongoing financial distress costs the company more than the additional settlement amount creditors demand, or if the extra cost is lower than the value gained from quickly emerging from distress.
Reaching a settlement with creditors that allows the company to successfully restructure before financial distress reaches an irreversible point and extends the debtor's operational runway should be the goal, rather than merely extracting the maximum possible concessions from creditors under bankruptcy law, whether in theory or in practice.
It is important to consider the economic benefits that ending negotiations could bring to the company, even if it means paying more than liquidation value, and then genuinely set about repairing the business. I would bet that Chapter 11 may not be so attractive, but it should at least be given the full consideration it deserves.