Bankruptcy Recovery Strategies

A firm is said to be bankrupt or in financial distress if it is unable to meet its current obligations to the creditors. Bankruptcy may occur because of a number of external and internal factors. The primary cause of a firm encountering financial distress starts when it finds it difficult to meet the scheduled payments or when the cash flow projections of the firm are indicative of the fact that it will soon be unable to do so.

Bankruptcy Recovery Strategies

Some important business bankruptcy recovery strategies are:

1. Settlements without going through Formal Bankruptcy

When a firm goes through the period of financial distress, it is very important for its management and creditors to decide whether the problem is a temporary one and it is possible for the firm to continue its operations or whether the problem is more serious and permanent in nature that has the possibility of endangering the life of the firm. So having done this, the parties involved in the process decides upon solving the problem either through the intervention of the bankruptcy court or through informal process. If the firm goes for filing a formal bankruptcy under chapter 11 of the Bankruptcy Act it involves certain costs. Coupled to this, there is also the possibility of the fact that when the creditors come to know that the firm has resorted to the Court, it might lead to disruptions. Thus it is preferable to go for reorganization and liquidation through informal means. Here we first start our discussion with the informal reorganization and then go into the details of the procedures of the formal bankruptcy.

2. Informal Reorganization

Those companies that possess more strong economic fundamentals, are always prepared to work with these companies so as to help then to come out of their distress conditions and to re-establish themselves on a sound financial basis. Such voluntary plans rendered by the creditors, generally termed as the “workouts”, involves restructuring of the firm’s debt; because of the fact that the current cash flows of the firm are insufficient to service the existing debt. The restructuring process typically consists of extension and composition. In the former case, the creditors postpone the dales of the interest or the principal payments as well as both. In case of the latter, the creditors voluntarily reduce their claims on the debt by accepting a lower principal amount or by reducing the interest rate on the debt. They may even take equity for debt or they may resort to the combination of all these three possible ways.

The process of debt restructuring begins with the initiation of both the firm’s managers and the creditors meeting for seeking a proper balance. The creditors form a committee with four to five representatives of the larger creditors and a few of the smaller ones so that each side is equally represented. The meeting is often arranged and conducted by an adjustment bureau that is associated with and run by local credit manager’s association. The first step involves drawing up a list of creditors with the amount of debt that is owed to each. This follows by developing the information that shows the value of the firm in different scenarios. One such scenario may be the firm going out of business, selling off its assets and then distributing the proceeds to the various creditors as per the importance of the claim that is associated with each of them with the surplus going to the common stock holders. The firm may even take help of an appraiser who can appraise the value of the firm’s property that can be used as a basis for ascertaining the value of the firm in different scenarios. Other scenarios may include continued operations, frequently with some improvements in the capital equipments, marketing and perhaps some management changes. This information is then shared with the bankers and the creditors of the firm. It has been frequently observed that the debt capacity of the firm exceeds its liquidation value and it is further observed that the legal fees and the other costs that are associated with the formal liquidation process under the bankruptcy lowers the proceeds available to the creditors. Added to this, the process of resolving the case through formal procedure is also very time consuming, it may take a year or even more than a year. This reduces the present value of the proceeds to much lower level. When the creditors are supplied with this information, they might be somewhat convinced to accept something less than their full value of the claim. In case where the management and the primary creditors agree for a resolution, then a formal plan is drafted and is presented to all the creditors providing them the reasons why they should be willing to compromise on their claims.

While framing the reorganization plan, creditors offer extension because that promises them their full payment at some point of time. In certain cases, the creditors may agree to not only postpone the date of payment but also to subordinate the existing claims to the vendors who show their willingness to extend new credit during the workout period. In a similar way, the creditors may also be willing to accept a lower interest rate on the loans during the extension period. This may be perhaps in exchange for a pledge of collateral. Because of the sacrifices that are involved, the creditors should have more faith than the debtor firm will able to solve the problems.

In comparison to this, the creditors agree to reduce their claims. Typically, the creditors receive the cash and the new securities that have a combined market value that is less than the amounts owed to them. Generally it is observed that bargaining is taking place between the debtors and the creditors over the savings that in turn results from avoiding the cost of legal bankruptcy, administrative cost, legal fees, and investigative cost and so on. In addition to get away from such costs the debtor feels relieved that the stigma of bankruptcy is not put on him. It is also sometimes seen that the bargaining process may lead to the process of restructuring that may involve both extension as well as composition. As an example, the settlement may provide for a cash payment of 25% of the debt amount immediately, along with a new note that promises six future installments of 10% each for a total payment of 85%.

The process of voluntary settlement is both informal as well as simple. They are also relatively cheap because the legal and the administrative expenses that are associated with it are limited to the minimum amount as a result of which the voluntary procedures normally result in the maximum return to the creditors. Although the creditors do not receive the payments immediately, and may some times have to accept an amount that is lower than that owed to them, they generally recover more money and sooner than in case the firm were to file a bankruptcy. Restructuring process also enjoys the benefit of avoiding the loss that is incurred by the creditors. So a bank that is facing distress with its regulators over weak capital ratios may even agree to extend further loans that may be used to pay the interest on the earlier loans in order to keep the bank from having to write down the values of the earlier loans. It is to be kept in mind that the informal voluntary settlements are not limited to the smaller firms. Recent studies have confirmed that they can extensively be used even by the larger firms. The biggest problem that is encountered by informal reorganization is getting all the parties to agree to the voluntary plan. This problem termed as the hold out problem.

3. Informal Liquidation

When the management of the firm realizes that the value of the firm is more when it is dead than it is alive, it may resort to informal procedures to liquidate the firm. Assignment is an informal procedure for the purpose of liquidating a firm. This process generally yields them a greater return that they would have received in formal bankruptcy liquidation. However, the feasibility of the assignments finds its significance only when the firm is small and the affairs of the firm are not that complex. Assignments enjoy certain advantages over the process of liquidation in the American bankruptcy Courts, in terms of time, legal formality, and expense. The assignee has more flexibility in disposing a property than does a federal bankruptcy trustee. So an action can be taken much faster when the inventory becomes obsolete or the machine rusts. At the same time it is to be remembered that the assignment does not automatically result in a full and legal discharge of all the debtors liabilities and neither does it protect the creditors against fraud. Formal liquidation in bankruptcy can help in solving both these problems.

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