Monetary Wisdom - February 2009

By Charlie Ragland

One of your customers or suppliers has filed Chapter 11 bankruptcy. What does it mean to you? What is the impact on your business? It all depends on the type of business relationship you have with the company filing bankruptcy.

A Strategic Business Option
In the face of a quickly changing business environment, companies can find themselves in trouble with little warning. Strategic options are suddenly limited and bankruptcy is often promoted as an early and proactive strategic choice to manage the elements that are a threat to the survival of the corporation. Many companies are using Chapter 11 bankruptcy or the mere threat of a bankruptcy filing to modify the terms of existing contractual relationships. Chapter 11 bankruptcy has become a strategic business option.

Companies file for reorganization to avoid litigation, cancel contractual obligations, or obtain new financing, claiming that without bankruptcy protection from these difficult challenges their operations could be forced to go under. Some common reasons for pursuing Chapter 11 bankruptcy include the following:

•Financial restructuring. Companies may not be able to continue to operate under their current financial structure. They may be in violation of their loan covenants or unable to carry the current debt structure. Often companies will seek to renegotiate their financial obligations in an effort to be profitable on a go-forward basis. The company may need to restructure its balance sheet or acquire new financing.

•Product liability litigation. Companies may seek to avoid or delay litigation. Several companies such as Owens Corning and Armstrong World Industries have filed for Chapter 11 in order to deal with the massive asbestos liabilities.

•Labor contracts. Companies may seek to terminate labor agreements that put the company at a competitive disadvantage among other firms in the industry. An example can be seen in the automotive industry as companies seek to renegotiate labor contracts with the United Auto Workers.

•Real estate leases. Companies may seek to terminate contractual obligations. Retailers that are closing many stores are filing Chapter 11 bankruptcy in order to terminate leases. Many national retail chains are pursing this option as they restructure in the current economic environment.

Chapter 11 Bankruptcy
The bankruptcy law operates under the belief that businesses, which are allowed to move forward and generate revenue, protect jobs and provide potential for repayment of debts. Liquidating the business would lead to less optimum utilization of company resources.

When a company files for Chapter 11 bankruptcy protection, it is given immediate protection from creditors while it restructures its business, usually by downsizing and narrowing its focus. Payment of interest or principal is suspended, and creditors must wait for their money. Generally the current management is allowed to run the company, but sometimes an outside trustee is named to operate the company. Creditor committees are formed to watch over the operations and to negotiate with the company.

Chapter 11 bankruptcy buys time for the troubled company, which has 120 days to come up with a reorganization plan and 60 days to obtain acceptance of the plan by creditors. Under the reorganization plan, debt can be extended or restructured. Interest rates can be increased, and convertible provisions can be introduced to compensate debt holders for any increase in risk resulting from the restructuring. Occasionally, debt holders take part of their claim in the form of equity. Trade creditors can be asked to take equity as payment, and occasionally they may obtain only partial payment. If liquidation is the result of the reorganization plan, partial payment is the rule, with typical payment ranging from zero to 30 cents on the dollar, depending on the priority of the claim.

Bargaining Power
Management often considers the threat of bankruptcy as a source of bargaining power. Just the hint of bankruptcy can send creditors to the bargaining table. In many instances the creditor prefers to negotiate directly with the company as opposed to the judicial system along with all of the other creditors. The creditor’s goal is to maximize payment on its debt and avoid the time and expense of the bankruptcy process. Keeping the business operating is often the best option in a bad situation.

The law defines the priority of creditors’ claims, providing the company with insight into who might be willing to negotiate. Trade credit has the lowest claim (except for owners) and is often the most willing to negotiate. As long as the company can generate cash from operations, the trade has the opportunity of being repaid. It is in their interest to negotiate with the company and keep it out of bankruptcy. Secured creditors have a higher repayment priority. The strength of their collateral and their confidence in management may impact their willingness to negotiate. Bankruptcy is still something they wish to avoid.

Impact on Your Business
The potential impact on your business depends on the type of relationship that you have with the company filing bankruptcy. The bankruptcy act allows for current management to remain in place and implement the restructuring plan. Goods and services are paid for on an ongoing basis. The presence of the existing management team and the payment for goods and services can calm customer and supplier fears that a firm might be in immediate danger of liquidation, thus enabling a firm to continue business as usual.

Customer: If the business that has filed Chapter 11 is your customer, your current receivables may be placed on hold until a payment plan is established by the bankruptcy court. You will have the option to continue supplying the company on a go forward basis and being paid on a current basis.

Supplier: If the company filing Chapter 11 is your supplier, you may not notice a change in business conditions. It’s in the company’s interest to continue supplying you and generating an operating profit.

Understanding the implications of Chapter 11 bankruptcy is important in determining the proper course of action for your business. No matter how Chapter 11 touches you, arm yourself with the proper knowledge and make informed decisions. A Chapter 11 filing need not be a cause for panic, but it may change how you approach your business relationship in the future.