For your information, FactorLaw has prepared the following discussion of how and when chapter 11 can be a viable option for small businesses (or their owners) that are dealing with financial distress caused by the Covid-19 Crisis (the “CVC”). Although the Courts in Cook County and the collar counties right now are largely closed for civil matters, the Bankruptcy Courts in Chicago are open and new cases can be filed and administered during these unprecedented times. We hope you find the following discussion useful and we welcome any questions you might have.
The Highly Vulnerable Business
The first tranche of businesses likely to face immediate and severe financial distress due to the CVC likely will be those where demand for goods or services is immediately and drastically reduced (or eliminated) and that have high costs that cannot be easily ratcheted down without impairing the business or incurring unsustainable liabilities. Businesses whose cash flow or business model have otherwise suffered critical disruption due to the CVC also are likely to suffer extreme financial distress, as are businesses that were teetering before the CVC. The likely candidates in this category include restaurants, small hotels/motels, small retailers, and businesses that support these establishments.
Highly vulnerable businesses are less likely to have sizeable long-term debt and usually do not fund operations through a revolving line of credit, although some may, particularly if the business owns real estate. In many cases, credit relationships exist at the vendor level and major stakeholders are suppliers and landlords. Such businesses also may have used shareholder loans, merchant cash financing or other high-interest products to sustain operations.
Depending upon cash reserves and the ability to reduce operating expenses swiftly, the optimal strategy for the highly vulnerable business is to (1) reduce operating expenses as much as possible during the CVC, with the hope of reengaging in the future and (2) exacting concessions from creditors. Highly vulnerable businesses also might try to take advantage of the myriad programs at the Federal and State levels to assist troubled businesses, although the response time for these programs currently is not known and some of these programs may not be available if a business reduces its work force.
Pursuing these options may require contacting landlords and other creditors, including high interest rate lenders and labor unions, and requesting some type of forbearance or waiver, which should be reduced to writing if possible, particularly in light of the requirement for modifications to be in writing under the Illinois Credit Agreements Act. Such businesses also need a unified response from management/ownership and if the key decision makers are not aligned, the most effective responses may be unachievable.
Although the wisdom of a chapter 11 filing for a highly vulnerable business should be carefully explored, particularly because chapter 11 relief can be a drastic remedy, it can help preclude a recalcitrant lender or creditor from exercising non-judicial remedies, including setting off bank deposits, sweeping cash to apply to the loan or refusing to perform under a bilateral agreement. A chapter 11 bankruptcy also can help to preserve asset value to the extent the CVC or other issues threaten that value, particularly if an operational shutdown threatens important contracts because of termination clauses. On the other hand, the automatic stay may be less relevant to stopping judicial remedies right now because most civil court proceedings and enforcement actions in Cook County and the collar counties have been shut down as part of the shelter in place orders issued in Illinois.
Thus, highly vulnerable businesses might consider a bankruptcy filing to (1) liquidate the business in an orderly fashion, including by selling assets, to avoid the loss of all value, (2) impede a pesky lender or other creditor that threatens to exercise nonjudicial remedies or rights that, if implemented, will make re-engaging impossible or very costly once the CVC has passed, (3) stabilize an imploding business so that it can obtain a breathing spell to pursue other options, including the lending programs recently implemented, (4) limit the forfeiture of rights and property, or (5) facilitate prompt access to additional capital.
With respect to the first item – liquidating or selling assets in a coordinated fashion – section 363 of the Bankruptcy Code authorizes the sale of assets free and clear of liens. It also gives the purchaser protection from trailing claims, including successorship liability claims. If a highly vulnerable business wishes to engage in a substantial sale transaction and has identified a purchaser, bankruptcy may be a good option for implementing the sale, particularly because it can preserve asset value during the sale process and it sometimes enhances value because of the protections discussed above. Absent a stalking horse that has expressed substantial interest in acquiring assets, chapter 11 can be used to avoid a panicked shutdown and might allow a more measured approach that seeks to generate the best price under the circumstances.
With respect to the second item – dealing with a pesky creditor – the automatic stay generally freezes creditor action and thus a bankruptcy filing allows the business to catch its breath and devise a strategy for dealing with the CVC. It also prevents a creditor from continuing to exercise control over property in which the business has an interest, including accounts receivable. And although a bankruptcy cannot force a lender to make advances against its wishes, it can be useful in allowing the use of cash from the collection of rents or receivables or the sale of inventory.
A bankruptcy filing also has the potential to facilitate access to certain types of capital sources because the Bankruptcy Code authorizes a debtor to obtain financing on a secured basis, including a senior secured basis. These measures may induce existing owners to put additional debt into the business with greater security of repayment. They also may facilitate access to other sources of capital from specialty lenders not willing to accept a subordinate position, particularly if the CVC leads to new forms of financing or existing lenders are willing to sell their debt at a discount. However, attention should be paid to whether a bankruptcy filing will make the business non-financeable through certain sources, including SBA-backed programs.
Bankruptcy relief also may preserve the loss or forfeiture of intangible property rights, including leasehold and other contract rights. In addition to preventing creditors from exercising rights with respect to receivables, inventory and PPE, the automatic stay also prevents creditors from terminating contracts that are in effect as of the bankruptcy filing, including leasehold interests and potentially franchise rights. Thus, a highly vulnerable business whose important contract rights are at risk because of the CVC, may be a candidate for a bankruptcy filing to preserve those rights.
Moderately Vulnerable Businesses
Moderately vulnerable businesses are likely to be those that provide professional services, manage or own real estate, or that can more easily weather dormancy during the CVC, either because of cash reserves, low debt, or nimble management. Moderately vulnerable businesses also are generally healthy and even may have been thriving prior to the CVC, either because of robust demand for services or goods, low interest rates or other variables. Unlike the highly vulnerable businesses, those that are moderately vulnerable are more likely to rely upon institutional lenders and other traditional sources of capital.
The moderately vulnerable businesses are candidates for a bankruptcy response in at least four instances: (1) to obtain additional capital that otherwise would not be available outside of a bankruptcy filing, (2) to address a covenant default that a lender is unwilling to waive and thus intends to enforce as a means to stop the flow of capital to the business, (3) to preserve asset value during a protracted sale process or (4) to get a jump start on what will be an inevitable business failure due to an extended shutdown or material and permanent dislocations in the relevant market.
As discussed above, a bankruptcy filing sometimes facilitates access to new capital either from existing stakeholders or from sources that are more comfortable making a loan that has the imprimatur of a court. A filing also can be useful to the extent the CVC leads to a covenant default (e.g., a “go dark” provision in a loan document is triggered) and the lender uses that event to enforce remedies or stop funding, or is unwilling to enter into an acceptable forbearance document.
A bankruptcy filing also can be useful for the moderately vulnerable business that already has implemented a sale process, that wishes to implement a sale process, or that believes the market dislocations will be permanent and wants to implement an exit strategy. The automatic stay prevents creditors from taking actions that have the potential to threaten the viability of the business or that threaten asset value (e.g., contract rights). Because of the stay protections, a chapter 11 filing can preserve the status quo while the due diligence process unfolds, the business and its advisors identify potential buyers or the business implements an orderly wind-down.
Least Vulnerable Businesses
The least vulnerable businesses are those that provide goods or services that are essential for dealing with the CVC and will thus experience greater or at least parallel demand during the CVC. Businesses in this category include those in transportation, hi-tech geared towards work at home solutions and those that supply front-line equipment or services for addressing the CVC. And although businesses in this category may experience substantial demand for goods or services, they may not be able to satisfy that demand because of capital or material shortages or because of financial distress that occurred prior to the CVC.
A bankruptcy filing can be a wise option for a business in the least vulnerable category to (1) stabilize an otherwise struggling business so that it can focus on production, delivery and sourcing, (2) address a lack of capital, (3) implement a relatively quick sale of assets to a more well funded business, or (4) forestall creditor action and allow access to receivables, including advance payments from vendors.
As discussed above, chapter 11 of the Bankruptcy Code provides a platform to attract new capital and helps to stabilize a business so that it can implement a sale process or gain a firm footing that enables operational reliability.