Crisis Management

         Crisis Management often requires changes in the capital structure of an organization or concessions by the lenders, either in the form of changed terms of repayment or changed in covenants that are part of the lending agreement.  These changes are not welcomed by the lenders, and are often bargained for under strained circumstances.  In the back of the minds of all parties interested in the health of the company is the question "what are the alternatives?".  In most cases, the alternative considered to be the choice of last resort is Bankruptcy.   For this reason, understanding the bankruptcy process and the implications for the parties in interest is essential to the understanding of Crisis Management.  

Bankruptcy   

        The laws that govern bankruptcy in the United States are rooted in Article 1, Section 8 of the United States Constitution, which gives the Federal Government sole authority to enact uniform laws concerning bankruptcy throughout the Country.  For this reason, Bankruptcy Courts are all Federal Courts, and the Code used is the same regardless of where the case is filed. 

The United States Congress modifies the Code from time to time and the current code is the result of two hundred years of modifications.  Despite the intention of uniformity throughout the country, the Bankruptcy Courts can and do establish local rules which govern the conduct of the cases before the Court, which can affect the way a case proceeds through the process.  Like any system that relies on different Judge’s interpretations and priorities, subtle differences in the way cases are viewed and conducted can also affect the outcome. 

The Bankruptcy Code

The Bankruptcy Code is divided into Chapters, Sub Chapters, and Sections as follows:

Chapter 1 contains General Provisions and Definitions.
Chapter 2 is no longer applicable.
Chapter 3 deals with the Administration of the Case.
Chapter 4 describes the Administrative Powers of the Court.
Chapter 5 deals with the Creditors, Debtors, and the Estate.
Chapter 6 is no longer applicable.
Chapter 7 sets out the procedure for liquidation of various estates.
Chapter 8 is no longer applicable.
Chapter 9 sets out matters concerning the debts of a Municipality
Chapter 10 is no longer applicable.
Chapter 11 sets out procedures for reorganization of various entities.
Chapter 12 concerns debts of a family farmer.
Chapter 13 concerns debts of individuals with regular income.

The Chapter that concerns the reorganization of a business is Chapter 11, which is the primary focus of this website.  Following the above chapters is a section on Rules that govern the general conduct of the cases, which precedes the local rules.  You can obtain a complete copy of the current code from Fulfillment-DM Sales  Matthew Bender & Company, Inc. 1275 Broadway  Albany, NY 12214-4024.

Ownership versus Management

To understand the bankruptcy process, it is important to recognize the difference between the issues of ownership and the issues of management.   The following diagram depicts these matters separately. 


 

The important concept to note, is that management of both the assets and business of the company can exist independently from the ownership of the company.   Therefore, ownership can be severed or modified without necessarily changing the way the company is managed or the people managing it. 

The primary reason that a company files for bankruptcy is to protect itself from the demands of creditors that render it unable to conduct its business in an orderly manner.  Companies that file generally cannot pay obligations as they become due or have assets diminished in value to the point that they have less value than its debt.  Creditors can also file a petition demanding that the affairs of the company are conducted under the auspices of the Court.  If the Court determines that the company is insolvent, it will grant the petition whether the company objects or not.

Once a company files, creditors and others who claim causes of action against the company can no longer pursue their claims through the regular court process.  Instead, settlement of the claims that arose prior to the filing becomes part of a plan of reorganization. Existing management is generally left in place and is referred to as Debtor in Possession, although there are provisions to replace management when the Court deems it appropriate.  The Court and whatever committees are created can review and comment to the Court on management’s efforts during the reorganization.  Ownership, however, especially in larger companies, does not generally emerge in the same form as it was prior to the filing. 

Reasons Companies Fail

There are a number of reasons that companies fail, and understanding them is important to taking corrective steps in reorganization.  According to a survey done by Dun and Bradstreet in 1993, the primary cause of business failure is excessive operating expenses.  The results of the survey on causes of failure are shown below.

Neglect                                                 3.9%

Fraud                                                     3.8%

Disaster                                                 6.3%

Insufficient Profits                              11.6%

Industry and competition                  22.3%

Inadequate Sales                                  2.2%

Excessive operating Expenses          40.5%

Too much debt                                     3.6%

Insufficient Capital                              3.2%

Accounts receivable                               .8%

All others                                               1.8% 

 A study by Buccino and Associates in conjunction with the American Bankruptcy Institute conducted in 1995 identified three top reasons for corporate failure accounting for 86% of business failures.  They were: ineffective management, under capitalization, and excessive leverage.  External factors such as economic conditions or legislative changes accounted for less than 14% of failures.

Donald Bibeault did another study that gives insight into factors that lead to failure in a 1982 doctoral thesis that was later published in book form.  He found that a disproportionately high number of distressed companies had centralized management. The conclusion is that centralized managers are too distant from the sources of difficulty to effectively manage.   A finding that 40% of the companies with centralized management going into bankruptcy emerged with decentralized management based on product lines reinforced the conclusions about managements role in the events leading to bankruptcy.

Bibeault also found that 37% of distressed companies rank lack of adequate control systems in the area of budgets as their number one cause of failure.  Product costing ranked as number two with 25% , responsibility accounting was number three at 15% and asset accounting was fourth at 15%.  The implication of these findings is that managers are making decisions with inadequate or inaccurate information.

While each of these studies point to correctable management issues, the Bibeault study clearly articulated that the number one management behavioral offender was autocratic management.  Other managerial issues included lack of managerial depth; problems caused by changes in management; and inbred bureaucratic management. The implication of each of these matters should be considered with the realization that most Chapter 11 filings leave the existing management in place, while management change can be one of the causes leading to distress.

It can be complicated to sort out what changes to make in the operations of a company at the same time that owners, creditors, employees, customers, and suppliers are all being affected by the outcome of decisions made within the process.  For this reason, the average time spent in bankruptcy is about 2 years.  Once a company files for bankruptcy protection, the process takes a reasonably well-defined path.  The steps in the Bankruptcy process are as follows.

Steps in a Bankruptcy

 1.  The company files a petition for bankruptcy protection.

2.  An automatic stay of action by creditors and claimants is put into effect and a number of administrative orders are routinely granted to facilitate the orderly conduct of business during the bankruptcy process.

3.  A committee to represent the creditors and such other committees as deemed appropriate is established by the Bankruptcy Trustee, an officer of the Court.

4. A meeting is held between the creditors and other stakeholders and the management about matters relevant to the operations of the company leading to the bankruptcy as well as the intentions of the current management with regard to the future operations.

5.  Contracts, leases and agreements between the company and others are reviewed and either confirmed or canceled.

6.  Any matters such as sale of assets prior to a plan of reorganization that are outside of the normal operations of the company are reviewed by the court and commented on by the representatives of various stakeholders.

7.  A Plan is written and proffered by the Debtor in Possession during a period of time in which the Debtor has the exclusive right to present a Plan for Reorganization.

8.  The plan is reviewed by the Trustee to determine if it meets the requirements of the Bankruptcy Code.

9.  The parties who have a legal right to do so vote on the Plan.

10.  If the plan is accepted, it is implemented and the company or a successor company emerges from the Bankruptcy Process as a viable entity.

11.  If the plan is rejected, the Debtor may retain the exclusive right to submit an alternate plan or the court may end the exclusivity period allowing other stakeholders to submit a competing Plan of Reorganization. 

12.  If insufficient Stakeholders vote in favor of a plan, the Court may impose a plan on the dissenting Stakeholders (called a cram down) or it may convert the case to liquidation.

13.  When called for in the Plan, the old stock is cancelled and new securities are issued according to the distribution provided for in the plan. 

 Priority of Claims

The Plan of reorganization will provide for the settlement of obligations in order of priority as set out in the Code.  That hierarchy of priority is as follows:

 1.  Super priority claims that are designated by the Court.  These claims often include provision for payment of the professionals and administration expenses before secured lenders are paid.  Such provision is referred to as a “carve out” provision.

2.  Secured claims up to the value of the asset securing the debt.

3.  Administrative expenses of the bankruptcy.

4.  Claims incurred in an involuntary bankruptcy between the time the petition for bankruptcy is filed and the Court declares the company to be under its Jurisdiction.

5.  Wage claims up to $4,000

6   Employee benefit claims within 180 days of the bankruptcy and up to $4,000

7.  Farmers and fishermen with crops or fish held by the bankrupt.

8.  Consumer deposits up to $1,800.

9. Tax Claims.

10. Unsecured creditors including originally secured debt in excess of the value of the security.

11. Preferred Stockholders.

12. Common Stockholders. 

 Absent a Plan to the contrary, the assets are used to settle the debts in the order of priority until there is nothing left.  If the assets exceed the amount of claims, the existing stockholders get what is left.  If the assets are less than required to settle all claims, they are used to settle the claims in order of preference shown above until the assets are consumed and the rest of the debt and equity is eliminated. 

Short of liquidation, “getting the asset” may mean getting stock in the new company equivalent to the cash value of the asset being retained for use by the company.  Obviously, the value of the assets being distributed has a major effect on the outcome of who gets what. The issue of valuation is one area that gives rise to disputes within the process as various contingencies jockey for positions that are in their favor. 

Committees

In order to participate meaningfully in this process, the various interests need to be represented by a committee.  It is unlikely, for instance, for a committee of secured creditors to look out for the interests of the unsecured creditors, or for an attorney representing taxing authorities to look out for stockholder interests.   Without a specific committee, it is left to the Debtor in possession to look out for the interests of the stockholders and un-represented creditors.

        The reasons are clear.  First, the existing management was intimately involved in the choices that brought the company to the point of Bankruptcy.  As discussed in the section of this website titled Crisis Management, the resistance to change lends a rigidity to the organization at a time when change is required.  The indicators of management problems cited above that led to bankruptcy clearly indicate that changes must be made if the corporation is to survive in its current form and with the current ownership. 

However, an alternative to running a company in a way that services existing debt is to reduce the debt by swapping out the stockholders equity to the debtors.  This allows a less capable management to continue to run the company under less demanding circumstances, or gives a capable management team a far easier task.  Clearly this is an incentive for existing management to trade out the existing stockholders equity to reduce the debt for management’s self-interest. 

Creditors as a rule have no interest in running the company that owes them money.  All they want is to avoid diminishing their stake in the outcome.  Changing management is often seen as unnecessarily disruptive, and creditors will typically offer retention and severance bonuses to existing employees to assure continuity until a plan is confirmed.  These funds come from the lowest priority class in the bankrupt estate, often the stockholders or unsecured creditors, and gives further incentive for the existing management to align their loyalties with the desires of the creditors above the cut off point for distribution of funds.  

The Bankruptcy Process exists primarily because the parties cannot work out their problems outside of the process.  Instead, the parties begin to look out for their own interests with out regard to the interests of others.  (See Chapter 12 of The Four Laws of Productivity elsewhere on this site for a discussion on self-interest versus community interest.) 

Valuation of Assets

The ultimate outcome of the reorganization will result to a large measure on the values placed on ownership of the assets.  There are as many ways to value a company as there are reasons to value it.  It is important for a turnaround effort to realize that there can be a wide difference between the values established by various interests.  In some cases the most aggressive valuations can be several times higher than the least value.   Common approaches to valuation include:

Book Value
Tangible Book Value
Appraised Value
Excess Earnings Value
Liquidation Value
Replacement Value
Start up Value
Enterprise Value
Capitalized Revenue
Capitalized Earnings
Capitalized Pre-tax Earnings
Capitalized Cash Flow
Stock Price Capitulation
Similar Market Capitalization
Discounted Cash Flow
Leveraged Buyout Evaluation
Combination Value with another Enterprise

Creditors with higher priorities are unlikely to support valuations that give anyone beyond them an interest in the assets of the corporation without a fight.  The odds of those who do participate in the process through their representative committees leaving a piece of the pie on the table in case someone who is not represented at the table stops by in the future is non-existent.

For that reason, it is important for any class of creditor or equity (stockholder) that has a stake in the outcome of the bankruptcy process to be represented by a committee and adequate legal consul. 

Informal groups can hire consul and can generally be heard by the Court on any legitimate issue.  However the Trustee overseeing that particular case is the only person that can appoint an official committee to represent a particular class.  If the Trustee does appoint a committee, the money to hire legal consul and other professionals such as Turnaround Professionals and valuation experts is paid by the estate as part of the administration expenses. 

In general, a Trustee will appoint a committee if it is likely that the assets are enough to pay all claims with priorities above the class petitioning for a committee and still leave some value for the class represented by the committee.  For instance, a test of whether the stockholders should have a committee is whether the assets of the estate exceed its obligations at the time of the filing.  The idea is that if there are insufficient assets to reach to the stockholders, any diminution of the estate as a result of paying for a committee that is otherwise out of the money is wasteful to those who are legitimately entitled to the assets of the estate.

If the estate does not have significant assets, such as many of the dot.com companies that have filed for bankruptcy, it is unlikely that committees beyond the secured creditors will be appointed. On the other hand, if assets exist whose value is disputable, such as real estate holdings, or intellectual property, it is more likely that committees will be named to look out for legitimate interests of the parties affected (often referred to as stakeholders).

If a committee is appointed, it is up to the Trustee to determine who will be offered the position on the committee.  Generally, the Trustee will chose representatives of the larger holdings of the claim or equity, but will consider recommendations. 

Richard Johnson, a Certified Turnaround Professional, can help you evaluate whether a committee is likely to be formed, guide parties of interest through the process leading to its formation and identify appropriate qualified legal consul to represent the interests of the committee.  Should the committee desire, they can hire Richard Johnson to provide reports and input necessary for informed judgments about the steps to be taken during the Bankruptcy Process in order to look out for the best interests of the committee.  If you are interested in a no obligation review of a situation regarding a bankruptcy case or establishment of a committee, please indicate the circumstances leading to your request, your objective, and contact information in the response form below or through the feedback form at the top of this page.