In the coming year, corporate bankruptcy filings are certain to increase. Most of these companies will file for a Chapter 11 proceeding. This provision in the bankruptcy code is designed to help protect creditors and give the company time to reorganize itself so that it can service all of its debt obligations. This sounds noble and efficient, but in reality does it work this way?

Bankruptcy is designed to help commerce. However, the problem is that bankruptcy takes a business process and makes it a legal process. Chapter 11 states that the “debtor is in possession” of the company, but this is far removed from practical truth. The debtor is still legally signing documents, but from the beginning to the end others are actually in control — and their intentions are not the same as management’s.

The idea of filing for bankruptcy protection typically does not begin within the company — it begins with the senior lender. Most owners, executives, and board members do not want to file for bankruptcy because they fear losing their equity in the company. However, a senior lender doesn’t care about the owner; they’re only interested in protecting the collateral that secures the loan. It’s the bank and their lawyers that inform the company: “We will only continue to provide funding if you file for Chapter 11. Either reorganize or sell the assets so our loan can be repaid.” Rarely do banks give enough funding to a company for it to have time to operationally restructure itself , so a sale of assets is the only real option presented.

It’s understandable that a bank doesn’t want to see the value of assets disintegrate at the hands of a troubled company. However, when a lender forces a bankruptcy filing, they create a tide pool that is a feeding frenzy for some and a wasteland for others. Taking an operating company into a legal process involves many lawyers, financial advisors, accountants, investment bankers, and court administrators. All of these people feast on the cash provided by the company and the senior lender. Millions of dollars — if not tens of millions — can be spent organizing, filing, monitoring, and processing a business through bankruptcy. In fact, the bankruptcy process is so generous, it allows all of the professionals the right to bill for the time it takes them to prepare their invoice. They think so highly of these lawyers and advisors that the court tells them, “You can bill us…for billing us.” How many other professions can do this?

Meanwhile, at the other end of the spectrum, are the unsecured creditors — a group that consists of people and companies that sold products and services to the “bankrupt” company. This group of people, despite having sold products and services in good faith, is pushed to the back of the money line. They are the last of the creditors to be paid. If they are lucky, they may be paid a small fraction, down to pennies on the dollar, of what they are owed. Generally they get nothing, despite the fact that they are the largest group in the entire pool. For every company that files for bankruptcy there can be hundreds and sometimes thousands of suppliers that are unsecured creditors — unsecured creditors that employ thousands of people who are also waiting to be paid. Yet in the bankruptcy world, they are treated as the least significant.

At the end of a corporate bankruptcy a small group is happier and wealthier than when this process started; the senior lender gets repaid, all the professionals are paid their fees, and the new owner of the company has bought assets at a bargain. However, there is a very large group that is very frustrated and worse off than before they were dragged into court.

Is there a better way for a troubled company to deal with outstanding debt?

There is.

It’s called a “composition agreement.”

A composition agreement is simply a contract between the company and its creditors. Rather than filing for bankruptcy, a company always has the option of negotiating to restructure the outstanding debt outside of a court-supervised process. Senior lenders force companies to file for Chapter 11 because they fear mounting lawsuits from unsecured creditors. However, if a company can get these creditors to agree on a repayment schedule and forgo suing them, a senior lender will continue with the relationship when they see that stability.

Typically, a composition agreement includes a plan for operational restructuring. It will demonstrate to suppliers a practical and achievable turnaround plan for the business. This plan will then show improved cash flow that will allow for a repayment of past due debts. Repayment is rarely 100 percent of the past debt, but it certainly can be. It can also be structured where the creditors can also obtain a portion of equity in the company. In either case, the money repaid to them is far greater than what they would receive in a bankruptcy filing.

The actual structure of a composition agreement can be simple and straightforward. It is also much more beneficial for a greater number of people. However, many companies don’t choose this path because they fear the unpredictability of trying to obtain consensus among all of these disparate parties. Bankruptcy gives you structure; you file, then the law tells you what to do, each step of the way. Bankruptcy is very expensive but it’s intellectually easy, whereas pursuing a composition agreement involves rethinking how the business operates, forecasting how much cash the new business will generate, and then selling this plan to each and every one of the creditors. Then, if they have accomplished all of this, the hard work of actually implementing these changes and paying off all of the debt begins. Often this takes years of commitment, creativity, and perseverance. It’s not easy but it is a financially and morally superior outcome for all stakeholders.

What will senior lenders across the country do in this uncertain economic environment? Will they push companies to file bankruptcy in record numbers? Only they know the answer. If companies have doubts about their lender’s commitment to them as they struggle to regain their footing, they should begin exploring options right now for an out-of-court restructuring like a composition agreement. Despite the unpredictability, they will have much more control over the fate of their company and all of their employees than they would under the supervision of a judge and trustee in a Chapter 11.

If you need help, call me.

Domenic