If you haven’t yet read Part 1 of this series, we recommend you do so in order to build a strong foundation around the vocabulary of restructurings used in Part 2. Click here to read Part 1.
This is the second edition of our blog series related to debt restructurings. This week we will touch on what happens once a default occurs.
In part 1 of this blog series, we explained that a grace (or cure) period is a period of time following a default in which an issuer is contractually permitted to either make a scheduled payment without incurring penalty, or to repair the condition that caused a technical default, as applicable. If a grace period expires before the issuer has remedied (or otherwise obtained a waiver of) the underlying default condition (e.g., non-payment of interest), an event of default occurs under the debt documents and accordingly, certain creditors may have the right to enforce remedies (including the right to accelerate the debt in full, as described is Part 1). Creditors are unlikely to enforce remedies for “minor” or technical defaults, as the costs of enforcing such remedies often dwarf the expected benefits (as compared to a negotiated resolution); however, the occurrence of a significant event of default for which lenders are likely to enforce remedies leaves an issuer with, essentially, two choices: to seek an out-of-court reorganization or to seek protection from creditors through a bankruptcy proceeding.
Out-of-Court Restructuring: a process in which the issuer and its creditors work together to restructure its balance sheet outside of a bankruptcy court. An out-of-court restructuring is typically faster and less expensive than bankruptcy and the issuer is able to avoid the negative connotations associated with a bankruptcy filing (e.g., to its creditors and suppliers). Conversely, the biggest downside to an out-of-court restructuring is that all creditors need to agree on contractual modifications of certain “sacred rights” held by the creditors, such as extensions of maturity or changes in security type, which frequently need to be altered for the restructuring to be successful. Depending on the total number of creditors throughout the affected classes, obtaining the consent of each creditor may be a momentous task. In addition, without a court’s involvement, an issuer has fewer options available to improve its financial condition unilaterally. For example, in a bankruptcy, issuers can reject certain types of disadvantageous contracts and completely “wash away” certain liabilities; such an option is not available to issuers that pursue out-of-court restructurings.
Bankruptcy Protection: for a corporate issuer, there are two kinds of bankruptcy processes that it can elect to pursue through the U.S. legal system.
Chapter 7 - Liquidation: a court-driven process by which the assets of a debtor are sold for cash, with the creditors receiving all proceeds (after expenses) until paid in full. Once all proceeds from asset sales are distributed to creditors (and, if any remain available, to equity holders), the debtor is dissolved.
Chapter 11 - Reorganization: in this type of proceeding, the debtor remains in control of its business and the bankruptcy court acts as an intermediary between the debtor and its creditors. Seeking to reorganize through a bankruptcy proceeding provides the debtor with numerous benefits, including the inability of its creditors from enforcing on their claims (such as selling off the debtor’s assets) as well as the aforementioned ability by the debtor to reject certain liabilities.
Also, unlike an out-of-court restructuring, which requires the unanimous consent of creditors to modifications of certain important terms of a debt instrument, approving a plan of reorganization, which will usually modify some of these “sacred rights” discussed above, requires only the consent of both two-thirds of the total claim amount of such debt class and a majority of the number of holders within such class. Furthermore, a debtor can obtain approval from the bankruptcy court to unilaterally eliminate certain liabilities that are deemed to be detrimental to the going concern of the business, subject to a court–approved payment to the creditor for such rejection. For example, in many retail bankruptcies, the debtor may close money-losing stores and reject any remaining lease obligations of that store, simultaneously cutting expenses and eliminating debt.
The downside to a Chapter 11 bankruptcy is mostly related to cost and time; it is a slow, time- consuming, legally-intensive process that can take years to complete and the debtor must obtain court approval for any significant action taken during the proceeding. Such a route may prove to be administratively cumbersome, as well as quite costly to the debtor (which generally is responsible for the oftentimes significant legal costs incurred by its creditors in connection with such bankruptcy). Moreover, the debtor’s image may be indelibly tarnished simply for seeking bankruptcy protection in the first place.
In the next edition of this blog series, we will be touching on what happens once an issuer files for Chapter 11 bankruptcy reorganization. Be sure to subscribe to our blog to be notified when we release future editions.
NOTE: This blog is an excerpt from an in-depth thought piece, “A Rosetta Stone for “Workouts”. To read the piece in full, click here.
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