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Bankruptcy Is Never Easy for Lenders!

Date: Sep 11, 2020 @ 04:00 AM
Filed Under: Bankruptcy

The annual number of bankruptcies peaked at 60,837 in 2009, but financial and bankruptcy experts expect the level of bankruptcy filings to explode well over that peak during the next 12 to 24 months. During the first six months of 2020, there were 3,604 business bankruptcy filings, which is up 26 percent from the 2,855 filings during the first six months of 2019 (Epiq/AACER). June year-over-year Chapter 11 bankruptcy filings increased 43 percent from 2019 to 2020. The June increase is expected to be the start of a wave of business bankruptcy filings as the economic impact of the COVID-19 virus manifests itself in lost businesses.

This anticipated increase in bankruptcy filings means lenders will be challenged to manage an increasing number of borrower relationships through the bankruptcy planning process and during the bankruptcy.

Lenders, borrowers and their advisors will need to focus on two key items:

  • Funding issues, including DIP Budgets or Cash Collateral Budgets
  • The End Game, which will typically include a Sales Process.

That means lenders will need to be prepared to review and analyze DIP and cash collateral budgets, and monitor performance of the business through a sales process in bankruptcy.

Analyzing a Borrower’s Budget Related to a Bankruptcy

The analysis of a budget for a bankruptcy process is more complicated than the analysis of a normal course of operations budget. Some of the key items to consider include:

First day motions:

o    Cash management processes: This motion addresses the ability of the debtor to continue to use existing cash management processes or allows the debtor to change its cash management processes. This motion may also address the payment of checks or disbursements that are in float on the filing date.
o    Joint administration or substantive consolidation: For related entities, in some districts, this motion addresses the reporting requirements for each entity or whether the entities can be combined as one entity for procedural or substantive purposes, including for cash flow and monthly operating reporting requirements.
o    Payroll and payroll-related items including benefits: This motion addresses payment of employees for prefiling payroll-related expenses and strategies for dealing with benefits such as paid time off, employee expense reimbursement and other employee-related matters.
o    Utilities adequate assurance: This motion identifies the amount of adequate assurance payments expected to be paid to utilities to ensure the uninterrupted receipt of services. Depending on the jurisdiction, this could be between two weeks and six months of usage and may require deposits.
o     Critical vendor designation: This motion seeks to pay vendors who are necessary to maintain the going concern or preserve substantial value, and contemplates payment for pre-petition claims during the early stages of the bankruptcy. This critical vendor approach essentially moves those vendors ahead of the secured lender and other creditors.
o    Assumption of any leases or obligations: This motion could identify contracts that are immediately assumed. Generally, the company waits as long as possible to seek this sort of relief to avoid paying cure costs and to preserve liquidity and options. There are some limited circumstances where critical vendor treatment may not be available and assumption of a contract may be desirable.
o    Rejection of any leases or obligations: This motion could identify contracts that are immediately rejected, and could result in cost savings by avoiding ongoing costs under the contract.
o    Insurance assumptions: This motion addresses insurance premiums that need to be paid or financed.
o    Hiring of professionals: These motions are specific for each professional and show hourly rates and payment practices during the case. These motions also disclose any retainers paid, including those that may not have been previously disclosed to the lender.

DIP Financing or Cash Collateral: These motions address whether the borrower will be receiving financing from its lender (debtor-in-possession or DIP financing), or will be able to survive on the cash that is collected (Cash Collateral). Depending on the specifics of the situation, borrowers and lenders may disagree on the approach or the conditions to attach to the funding. Because of that tension, a detailed weekly cash flow analysis and a 13-week cash flow is a critical deliverable in any potential bankruptcy situation. A lender’s advisors will be able to review the cash budgets under various financing and cash collateral options, and relative to the first day motions, to provide detailed insight on the liquidity and liquidity needs of the business leading up to and during a bankruptcy.

Each of the items listed under first day motions and the approach to the use of cash has an impact on the dollars expended during the time leading up to the bankruptcy and immediately thereafter. Additionally, the forecast needs to address:

Working Capital Management:

o    Accounts receivable:

  • The possibility, and likelihood, of delayed receipts and cash flow sensitivities need to be considered.
  • Future sales: Depending on the type of business, the bankruptcy filing may impact future sales at different times during the budget period.

o    Inventory:

  • Borrowers may want to identify critical vendors which would allow prepetition payables to be paid with funds collected or funded during the bankruptcy.
  • Suppliers may require COD payments to continue the supply of goods or services.
  • The sale at discounted prices of obsolete or slow-moving inventory could be a source of cash receipts.

o    Accounts payable:

  • It is critical to establish tracking procedures to identify accounts payable as pre-petition and post-petition obligations. Lenders need to be sure that the borrower is prepared from an accounting perspective and a staffing perspective. If a borrower is not careful with this tracking, post-petition collections could be used to pay prepetition amounts in violation of the bankruptcy laws and the rights of secured creditors.

At a minimum, secured creditors need to require the following:

√ Weekly cash receipts and disbursements, including a roll forward of book and bank cash balances.
√ Weekly reporting of collateral, including any reporting previously provided to the lender.
√ Monthly reporting previously provided to the lender.

Analyzing Considerations for a Sales Process

Secured creditors are often asked to fund operations leading up to a filing to ensure a stalking horse bidder for the borrower’s assets is identified prior to the filing. While this is often a more comfortable approach for a borrower and its advisors, this approach may not be the best for the lender.

Absent a substantial equity cushion, a lengthy sales process by an investment banker that results in the identification of a potential buyer is probably not ideal unless collateral values are increasing or there is a meaningful prospect of substantially higher offers. These are the arguments the borrower and its advisors will make. However, the costs of going through an extended sales process prior to the bankruptcy filing, and the level of communication that takes place with potential buyers, are negatives lenders need to consider.

A cash flow analysis for the sales process through the pre-bankruptcy period followed by the bankruptcy filing and through the sale process MUST be compared against a cash flow with a short planning period followed by a bankruptcy filing and a quick sales process during the bankruptcy.

Without a detailed analysis of the cash flow under both options, the likely economic impact to the secured creditor under the alternative approaches cannot be properly evaluated.

Although there may be more risk in certain situations, a borrower does not need to have an identified buyer to file for bankruptcy. Despite confidentiality agreements signed by potential buyers, the borrower’s financial condition will not generally be kept secret during a sale process, and expecting that the financial condition will remain confidential is a mistake for the lender. While borrowers often reason they will be able to find a buyer at a higher price before a bankruptcy filing, lenders need to consider the costs of going through a prefiling sale process and the cash burn from operations during that period to evaluate risk and reward.

With the support of its lender, a borrower can move through a sale process relatively quickly with or without a stalking horse bidder. In most bankruptcy courts, the process post filing could take 60 to 90 days, if there are no unexpected circumstances and a buyer is found. It should also be considered that a pre-filing sale process could take the same 60 to 90 days, and may not result in an acceptable offer. After that failed process, a bankruptcy would still be required.

Bankruptcy Cases Do Not Have Certainty of Outcome

Proper planning for a bankruptcy requires the evaluation of cash flows and risks of delays while preparing for and moving through the bankruptcy process. No borrower or its advisors will be able to guarantee a speedy process or specific results. Lenders and their advisors must be prepared for uncertainty and be able to forecast and monitor cash flows (and all of the underling variables) both before and after a bankruptcy filing to minimize costly mistakes.

Lenders who are armed with experienced legal and financial advisors to evaluate cash flows and bankruptcy options will be able to negotiate, structure, and implement liquidity and funding solutions that are most likely to maximize value and recoveries through the bankruptcy process.

Juanita Schwartzkopf
Senior Managing Director | Focus Management Group
Juanita Schwartzkopf, Senior Managing Director at Focus Management Group, has over 25 years of experience in commercial banking, financial management and operations and systems management. She has dealt with asset recovery situations involving bankruptcy, dissolution and liquidation. Schwartzkopf has an extensive background in credit risk assessment and loan portfolio appraisal, and has reviewed asset-based lending and commercial lending loan portfolios of various financial institutions. She has worked with nearly all major financial institutions in the evaluation of credit risk of borrowers and has held key management positions including CEO and CFO in a variety of industries, such as manufacturing, agriculture, lumber, health care, consumer finance, sporting goods, apparel and electronics. She earned an M.B.A. from the University of Wisconsin and a Bachelor’s degree in Accounting from Carthage College. She holds a CPA certification and is also a Certified Fraud Examiner.
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