How to make a good impression in bankruptcy court
How should a Chapter 11 debtor’s financial information be presented in bankruptcy court to create the best first impression? To give the court an accurate picture of the results of operations during Chapter 11 and to ensure that the debtor has sufficient bankruptcy time to achieve his goals?
The pandemic has caused painful cuts in revenue for many businesses. The return to normal is happening; but, in many sectors of the economy, business has not returned to pre-pandemic levels.
For some companies, the pandemic was just the last straw, and Chapter 11 may now be necessary to achieve an orderly liquidation of the debtor’s assets. For other businesses with good fundamentals, the debtor may need Chapter 11 relief. Why? Despite being well run, making a product that continues to be in demand, or investing adequately in themselves (or all three), some companies just don’t have enough capital to resist any further. long to the storm.
Finally, when interest rates inevitably rise, over-leveraged companies, and in particular companies that have survived only with the help of Paycheck Protection Program funds, will be forced to consider debt restructuring, whether either in court or out of court.
At the start of a bankruptcy case, all interested parties – especially the bankruptcy judge – want to know what precipitated the bankruptcy filing. Did the debtor file his petition because he makes an obsolete product like Polaroid cameras, and business has steadily declined? Has the debtor filed for bankruptcy because he suffered an unfavorable judgment? Is the deposit due to excessive leverage taken in a previous acquisition? Or, perhaps, the company is simply in an industry that has become oversized?
The answers to these questions influence a judge’s initial impression of the case and, perhaps, what follows: (1) whether he or she grants expedited relief requests (such as the bulk sale of assets debtor) (2) how long the debtor must promulgate a reorganization plan and (3) whether the judge grants a secured lender the power to seize collateral.
If the reorganization is unlikely and the debtor has a very negative cash flow, the judge does not wish to delay the liquidation.
In some cases Rome can appear to be on fire – until you look deeper. Judges do not want to prematurely liquidate a debtor and cause job losses if they believe the odds are favorable for a successful reorganization. On the other hand, if the reorganization is unlikely and if the debtor has a large cash deficit, the judge does not wish to delay the liquidation.
In the cases of Chapter 11, this is usually cash flow. Cash flows are reported monthly as required by the United States Trustee, the bankruptcy administrative arm of the Department of Justice. Normally, an income statement is not required (but as discussed below, the best practice is to file a three column income statement anyway). Lenders are more interested in whether the debtor is burning money. If they are burning money, lenders fear they will have to inject more capital, which they would rather not do. Depleted liquidity is also a sign that the debtor’s underlying core business has not stabilized.
Although the court may only require a monthly cash flow statement, the best practice is to present the court with a cash flow statement with and without (1) the items related to Chapter 11 (such as professional fees and one-off financing costs) that would not occur outside of Chapter 11 and (2) non-recurring items unrelated to ongoing operations (such as lease payments being rejected and severance payments that are part of reduction in staff). This is because Chapter 11 expenses and non-recurring items either exaggerate negative cash flows or will reduce positive cash flows.
At the start of a Chapter 11 case, the big question is whether the recent actual financial results of the debtor are a good approximation of how the debtor will behave in Chapter 11. Every debtor wants time to settle their affairs, reduce expenses, negotiate with creditors and prove that it is viable. Unfortunately, few, if any, debtors initiate bankruptcy proceedings and suddenly see the pendulum swing towards profitability.
Often they can know what needs to be done but need time to implement the solutions. And it will be time before the solutions show up in the debtor’s financial results. Or, the debtor may need time to “burn off” certain extraordinary expenses which are not recurring but which, in the meantime, have a material adverse effect on the financial results. Finally, the debtor just needs time for a disrupted market to return to normal in some cases.
The initial financial presentation to court should be in three columns. The actual financial results alone can present a distorted picture to the bankruptcy judge. Instead, the court should see a three column presentation. The first column corresponds to the actual results. The second column is the list of item adjustments required to restate actual financial results to eliminate the effect of extraordinary items. And the third column is the restated financial results – what actual results would have looked like without the extraordinary items.
Each item in column two must be explained for the court to determine whether it warrants restating that item in column three. This process should be applied to both the cash flow statement and the income statement (although an income statement is generally not part of the US Trustee’s monthly reporting requirements). The idea is for the court to see how the debtor’s main business works in the absence of the headaches that brought him to bankruptcy court.
Failure to give the bankruptcy judge a bridge to see (1) what the debtor’s performance of the pending transactions before the bankruptcy would have been in the absence of extraordinary events and (2) the “normalized” results during the bankruptcy. Bankruptcy can reduce the chances of Chapter 11 success. It is imperative that the debtor’s financial advisor adequately explains the basics of adjustments. Without them, the court sees a distorted picture.
Kenneth A. Rosen is a partner and Chairman Emeritus of the Bankruptcy and Restructuring Department of Lowenstein Sandler LLP.
The opinions expressed here are those of the author alone and are not necessarily shared by others at Lowenstein Sandler LLP. The law is subject to interpretation. Each case is unique. This article is not intended to provide legal advice.