Chapter 7
Insolvency and the Law

In 2010 I was liquidating a lumberyard for the bank and owners; it's not unusual for a beleaguered entrepreneur and bank to agree to a voluntary liquidation in exchange for something like releasing the entrepreneur from a personal guarantee. We were selling off inventory and had already contracted an auctioneer to sell off whatever remained after 30 days. I got a call from a local business owner who had recently sold a bunch of product to the store but was never paid. My heart went out to the guy; he'd gotten screwed. I explained the situation, that the secured lender (bank) had liened every asset and was still likely to come up short, so there would be no recovery for him. He said, “I was just in your store, I've seen my product on your shelf, let me just take it back and sell it to someone else.” Gosh, it made so much sense and I really felt for the guy, but the inventory, his product, now belonged to the bank. They had the liens on it.

“No, it belongs to me! I was never paid for it,” he declared.

“Well, actually not. It belongs to the bank,” I responded.

You can imagine his response.

I explained: “They ordered, you delivered, and you delivered on credit terms. You transferred the ownership to them when they obligated themselves for it and they gave you a receivable in exchange. In doing that you completed the transaction and subordinated your interests to that of the bank. I know, this is the downside of vendor financing, and it is terrible. If it makes you feel better, have your attorney call me and I'll explain our situation to him.”

He didn't like it and neither did, I but that's how the law is written and you're not going to change it.

The United States deals with distressed commerce through two sets of laws. There is the U.S. Bankruptcy Code that is federally administered through U.S. Bankruptcy Court. There is also the Uniform Commercial Code (UCC) that states interpret in their courts. Until a business enters the federal bankruptcy system, they operate under the Uniform Commercial Code and other state laws.

So what is distress and how do you know if you're in it? The technical term is the zone of insolvency, which is a strange gray area that often defies conventional wisdom. Normally management has a fiduciary duty to the shareholders, and that's how they conduct themselves. But in an insolvency that duty expands to include creditors, in addition to shareholders and the corporation. Said another way, the shareholders have failed to adequately protect the creditors, and now they must act also in the best interest of the creditors. There are few clear markers on the path to insolvency, but it can be argued that one day you were running the business normally and the next day rights and duties shift. Perhaps, it's because your biggest customer didn't pay you and you're cash‐broke. But the next day you collect a bunch of cash and you're no longer insolvent, sort of. You can see the murkiness here.

Insolvency is defined as either cash‐flow insolvency, when you can't, or don't, foresee the ability to pay your bills on time. Any entrepreneur knows that most small businesses move in and out of that ability over the course of a month. And how would you define it? A conservative cash‐flow forecast might show a path toward insolvency while hopeful projections wouldn't. This could simply be the difference between how a CPA and an entrepreneur interpret the same set of facts.

Balance sheet insolvency is the other type of insolvency, when your liabilities exceed your assets. It is argued whether this is all balances or just current balances. Or, whether we use liquidation values or book values. Should we even consider goodwill or leasehold improvements, which have no liquidation value but often keep a balance sheet positive? Interestingly, most startups would be defined as balance sheet insolvent, which again illustrates how fuzzy the definition of insolvency can be.

As discussed in Chapter 1, the hierarchy of creditors is one of the best‐named laws ever: the Absolute Priority of Debt Rule, which is codified in federal bankruptcy statutes. Most collectors don't understand this (and even many commercial and collection attorneys act like they don't fully understand it) so I get to remind people that the rule is named such because it is both Absolute and Priority and they really should quietly wait in line while we try to fix the business.

Liquidation value versus going concern value is another way of valuing a company and shows the stark reality of value erosion that (almost certainly) entrepreneurs and (likely) banks have ignored. The following values represent a healthy economy with healthy equipment values.

Figure 7.1 shows the destruction of value as a business slips into insolvency.

Entrepreneur balance sheets are often overstated for a variety of reasons; bad accounting and ownership fantasy are the main causes. Over time, errors on the asset side of the ledger stack up, usually with a CEO who doesn't quite understand the underlying accounting issue but is happy to see equity increasing. The bank underwriters understand all the accounting issues and are only partially deluded over time. It's not uncommon for a lending officer (sales department) to look at the balance sheet (see Figure 7.1) during a review, nod his head approvingly about $1 million in equity, and move on, never really noticing how weak the balance sheet actually is. The dilution of value on a balance sheet as it nears insolvency is silent and unseen but it can add up to a considerable shortfall in a liquidation, primarily in the following ways:

• Receivables are automatically worth less in a liquidation because they become harder to collect when the customer–vendor relationship is ending. Collectors also need access to clean and current accounting records, which can be hard to come by in a liquidation. Also, customers use the liquidation as an excuse not to pay, and they don't like paying banks. Although the cost of collection goes up, results decline, and this reduces the recovery on this most‐liquid asset.
• Inventory loses value quickly without customer demand. Finished goods may be sellable, or not, whereas WIP (work in progress) is probably worthless (who wants a half‐built anything?) and raw‐material inventory usually only has scrap or high‐return‐cost value.
• M&E (machinery and equipment) immediately loses value. The cost of a liquidation auction might be 25% all in, and that's subtracted from the value received at auction. This can result in a steep decline from the book value listed on the balance sheet.
• Intellectual property is almost always overstated on a balance sheet. It might contain a few patents, of limited remaining shelf‐life and of limited value, though there may be brands. It's common for entrepreneurs to rave about the value of their patents or brand names even though they have yet to extract profit dollar number one from them. Trademarks, copyrights, and so forth have little attributable value in a distressed business.
• Furniture and fixtures are worth nothing or close to nothing in a liquidation. I've knocked myself out trying to sell really nice office furniture and have probably never exceeded 10% of the original purchase price. The last liquidation I did we just abandoned the furniture and fixtures (F&F) to the landlord. One crazed CEO, spent $20,000 per office on furniture and another $500,000 on black walnut conference room paneling. All of which netted zero in liquidation.
• Computers, well you know how fast they lose value. A two‐year‐old PC work station might be worth $50 on Craigslist? The software license cannot be transferred, so it's hard to gain value from that investment.
• Leasehold improvements? Well that was your special gift to the landlord because you can't sell them or take them with you.
• Goodwill is hangover from a former acquisition that, apparently, has left little real value on the balance sheet.

What keeps an insolvent business above auction value is a pulse, any form of ongoing life or activity in the business. This is called going concern value and is covered in Chapter 9.

Corporate distress is a fact of life and economies have found productive ways of dealing with these issues over the years. The U.S. Bankruptcy Code is considered the best around and what other nations seek to replicate in their own countries. In Article 1 of the U.S. Constitution, our founding fathers called for bankruptcy laws to be written. America had broken free of Britain and memories of the horrible debtor's prisons in England inspired a feeling that society is best served when honest but unfortunate people and businesses are provided a fair and final release. Before we get too deep in the weeds on the rules of modern day bankruptcy, let's review the concept of insolvency and how it's been handled through millennia.

History of Bankruptcy

Leviticus 25:10 in the Old Testament, New American Standard translation, proclaims:

You shall thus consecrate the fiftieth year and proclaim a release through the land to all its inhabitants. It shall be a jubilee for you, and each of you shall return to his own property, and each of you shall return to his family.

This verse is accepted to mean that every 50 years property will be released from debt, indentured servants released from obligation, and slaves released from captivity. Let me focus on my interpretation of the debt part here, and let's consider debt as it existed before the laws and limits we know today in the United States, when debt calculations were not uniform, interest not regulated, and so on. How would people be protected from predatory debt practices? How would people, families, and even tribes be protected from what could become generational indebtedness? The Lord's solution was simple, a jubilee in which all debt must be fully released every 50 years. This allowed debtors a “fresh start,” and it modulated the greed of creditors who knew that eventually they would be back to zero. In one simple verse, it created balance. Today the U.S. legal system has achieved a similar (but uneasy) balance, though with far more detail and not nearly such a long wait.

My understanding of history is that Mosaic Law (Law of Moses) called for a sabbatical year that provided the release of all debts owed by members of the Jewish community, not gentiles, every seventh year. (Remember, Moses predated political correctness, so this sort of discrimination did happen.)

In ancient Greece a man and his family could be forced into debt slavery until the debtor repaid his debts through physical labor. The modern‐day version of this might be working in the kitchen when you can't pay for your meal. Back in ancient Greece city‐states enforced variants on this theme with limits usually around five years and protection of life and limb for debt slaves, a benefit not enjoyed by physical labor slaves.

The term bankruptcy comes from the Italian banca rotta, which means “broken bank” though many translate it as “broken bench.” The common story I hear in the insolvency community is that in ancient Rome when a merchant did not pay his debts (and we assume failed to provide a specific plan to satisfy his creditors) his merchant bench would be broken, putting him out of business in the market and making a public statement for other merchants.

As you might imagine, Genghis Khan dealt with bankruptcy more seriously. His Yassa (book of laws) mandated the death penalty for anyone experiencing insolvency three times.

England formally dealt with insolvency in the Statute of Bankrupts published in 1542. In grade school, I learned about debtor's prisons in England in which debtors would be forced into a cruel and ironic purgatory of sitting in prison until they repaid their debts – with, of course, no way to earn money to repay those debts. Modern‐day China, I am told by an American who recently fled a bankruptcy there, will “detain” registered agents of insolvent companies, giving them the inside of a locked room and a phone to fundraise for the amount owed. This could amount to years of dialing for dollars and hoping for release.

Conventional wisdom is that the U.S. founding fathers, after earning their independence from Britain, were determined to do things right in America. Although they had a long list of grievances with Britain, bankruptcy must have ranked pretty high since it was called for in Article 1 of the U.S. Constitution. Article I, Section 8, Clause 4; “The Congress shall have the Power to … establish … uniform laws on the subject of Bankruptcies throughout the United States …”

Bankruptcy laws were established as America's nascent economy grew, and these laws continue to be updated over time. The first U.S. bankruptcy laws were established in 1800, the second laws in 1841 in response to the financial panics of 1837 and 1839. The third bankruptcy laws were established in 1867 in response to the panic of 1857 and the Civil War.

Perhaps the most fascinating development in U.S. bankruptcy law came during the age of railroads. Bondholders supplied much of the debt needed to finance these massive projects and collateralized their debt with sections of rail. When railroads failed to make bond payments, the bondholders were entitled to foreclose on and liquidate those sections of rail. Imagine a railway from New York to Pittsburgh and some bondholder wants to rip up and sell off (for scrap value) 20 miles of track near Altoona. This action would destroy value to the entire line, to all debt and equity holders, as well as to the larger economy.

Isaac Redfield in his 1859 Treatise on the Law of Railways explained: “The railway, like a complicated machine, consists of a great number of parts, the combined action of which is necessary to produce revenue.” Courts, understanding that combined action along with the impacts of contagion damage and the semi‐public nature of railroads, applied principles of reorganization to deal with these insolvencies. The Bankruptcy Act of 1898 and its amendment in 1933 allowed for the reorganization of railroads, corporations, and individual debtor agreements. This provided what is the most significant part of bankruptcy law in my line of work – reorganizing broken companies.

Although U.S. bankruptcy law is well established and emulated, some nations are just now coming to grips with the concept. The United Arab Emirates just created a bankruptcy law in 2016 and Saudi Arabia has announced it will introduce a bankruptcy law in 2018. “The measure not only aimed to remove the threat of jail for executives of business in distress but also to increase the foreign financial inflows in the country.” Yes, the threat of jail remains how distress is handled in many developing nations. (Startup MGZN, September 24, 2017)

Modern‐Day U.S. Bankruptcy Law

Avoid bankruptcy if at all possible. It is expensive, demanding, fraught with risk, and almost everything that can be accomplished in bankruptcy court can be accomplished out of court through persuasion. Although bankruptcy may save your skin as a last resort, it is often better used as a threat, direct or unspoken, than as a directed course of action. Expect a minimum cost of $100,000 for a Chapter 11 filing, though we're currently involved in the bankruptcy of a $70 million revenue company that has already spent over $9 million on legal fees.

Bankruptcy law is complicated and a little bit murky. A bankruptcy attorney friend of mine says that murkiness appealed to him as he was selecting a specialty of practice. “Insolvency allows for a lot of interpretation and I thought that would allow me more creativity and challenge in my practice. Plus, insolvency is so counterintuitive that commercial attorneys simply don't understand it, and that gives me a huge leg up in insolvency issues outside of the bankruptcy court.” Personally, I'm intrigued by any area of law that uses such intimidating terms as absolute priority, cramdown, and strongarm powers.

I am not an attorney, so I've found simple ways of understanding bankruptcy's modern‐day structure and how it works. In short, there are two types: reorganization and liquidation. Reorganization (Chapter 11) is basically calling a time‐out, reducing secured debt to the value of the collateral securing it, reducing or eliminating unsecured debts, dumping unprofitable leases or contracts, and coming out the other end with a clean balance sheet. Those remnants might be your business intact, just as planned, or it may be much less because you didn't have a good plan. But overarching all these machinations are the personal guarantees, such as the ones I signed in my youth, which will generally not be adjusted by a corporate restructuring. The guarantor will have to reckon with these in one manner or another after restructuring.

Liquidation (Chapter 7) is simply that; the auctioneer is called in, employees are terminated, properties abandoned. But opportunities may exist for stakeholders to acquire valuable assets at bargain prices from the trustee. The renowned outdoor equipment company Black Diamond was founded on assets purchased by its employees after product liability lawsuits forced the original business into bankruptcy (that was an 11, not a 7, but nevertheless a liquidation).

Reorganizations are handled differently among various groups, as a family farm with a failing crop should be treated with different nuance than when, say, the city of Detroit files for bankruptcy. Although these cases can vary dramatically, they mostly have one thing in common – a cadre of divergent stakeholders with vastly differing interests who must be corralled, cajoled, or litigated into cooperation by the plan proponent's counsel.

Exhibit 7.2 helps explain the general structure of bankruptcy chapters in the U.S. Code.

The missing chapters in Figure 7.2 are all part of Title 11 of the U.S. Bankruptcy Code. Chapters 2, 4, 6, 8, and 10 no longer exist because they were either repealed or consolidated into other chapters. Chapters 1, 3, and 5 provide for definitions, administration, and a more thorough explanation of creditors, debtors, and the estate.

Chapter 11: Corporate Reorganization

We are surrounded by companies that have survived only through Chapter 11. These include massive energy companies, national retailers, railroads, airlines, municipalities, and, of course, the real estate empire of a certain politician. Chapter 11 is how Hostess got restructured and was able to regain health. Companies in the airline and retail industry often restructure under Chapter 11 repeatedly and are sarcastically referred to Chapter 22 or 33 filers. Consumers are apparently unconcerned about flying on an airline that is under bankruptcy protection. The legal construct of this process is why companies like Quicksilver, Aeropostale, Chrysler, General Motors, Delta, United, US Air, and Chuck E. Cheese are all still in business as I type this. Clinically, it is fair and increasingly efficient but also costly, risky, and uncertain.

Although Chapter 11 remains a useful tool of last resort, the number of filings and the industry as a whole has been on the decline in the last two decades. Part of this is because lenders have wised up and are drafting bankruptcy resistant loans and partly because of the astronomical expense of a complex restructuring. The filing company, or debtor, generally pays most of the bills on all sides. Your ripped open company is now funding your lawyers, your bank's lawyers, the creditor's committee's lawyers, US Trustee fees and so on. Plus, all parties are likely using a financial advisor and the business is often paying for all of that. And if the debtor is not paying it, the various creditors are. It can be an obscene feeding frenzy of professionals that further drains an already struggling company. In a contentious bankruptcy, you are funding the other side's accusations against your management, which become part of the public record, that you are paying for. It is not for the faint of heart.

Entrepreneurs who personalize the business and its situation have an awful time in Chapter 11. Every part of the process feels like a personal affront, and entrepreneurs spend more time fighting their attorneys and the process rather than taking this rare opportunity to get their houses in order. Rather than minding your business fundamentals, you are learning about cash collateral budgets, defending variations in expected cash flows, and learning about the arcane laws governing absolute priority and the like.

However, wherever there is adversity, there often lies opportunity. More experienced entrepreneurs see bankruptcy as the chance for a thorough cleaning and likely part of a larger strategic plan. Two very clever entrepreneurs I know grew their business on debt then restructured it away in Chapter 11 as growth stalled. They ended up with a healthy, leaned‐down business, a clean balance sheet, and retained 100% control. Again, the lack of or limitation on personal guarantees affords one greater flexibility in such a strategy.

The craftiest capitalists see Chapter 11 as a tool to take over train wrecks and then perform radical surgery on the business, bringing it out lean and clean. These investors have 100% of their energy and emotion focused on the future state of the business – and no personal guarantees with which to contend. This keen ability to see opportunity in carnage and understand how to both fix the business and use the rules of the game to your advantage can net healthy returns.

Bankruptcy can be used as a weapon by both debtors and creditors. Creditors can ally and force the company into an involuntary bankruptcy. If caught flat‐footed, the company can be ripped apart in liquidation, with recovery to the creditors but the loss of jobs and community vitality. In the role of chief restructuring officer to businesses I've been threatened with an involuntary bankruptcy several times, but it always seems to be from a half‐informed unsecured creditor that knows just enough to cause damage. This is probably why it takes two to three undisputed, unsecured creditors to force an involuntary bankruptcy, the logic is that it's hard to find and coordinate that many self‐destructive loons. And if the threat is carried out, the target of an involuntary bankruptcy can deftly convert the case to a Chapter 11 and quickly turn it to its advantage. In large complex capital structures, investors can seek to purchase the fulcrum securities and then force the company into bankruptcy, thereby gaining inexpensive equity control of the business post restructuring.

Debtors can use bankruptcy, or even the threat of bankruptcy, as a weapon to accomplish their goals. Let's face it, simply retaining a bankruptcy attorney is moving onto offense. Threatening a collector with a filing is like a quick jab to the nose that carries the risk, cost, and uncertainty of your options. Filing bankruptcy like the two crafty entrepreneurs I mentioned earlier was a preemptive attack on their creditors. When the tides turned, they figured out how to leave someone else holding the bag. Bankruptcy is most often used as a defensive weapon (a shield) by the debtor to get relief from its creditors. Like a handgun, sometimes just the sight of it is enough to get your point across, without having to deal with messy consequences. But to make this sort of threat effectively, you need to retain legal counsel who knows what they're doing and who has the chops to execute, if necessary. Otherwise the threat will ring hollow.

All these considerations regarding Chapter 11 can best be summed up by the simple notion that if you are playing ball on your toes, you'll see lots of options and control the outcome. If you're playing on your heels, you're going to lose. Too many bankruptcies are filed reflexively or out of desperation rather than strategically. That is why Chapter 11 restructurings typically have a 70% chance of failure. Competent Chapter 11 counsel (who have the luxury of time) will draft the plan of reorganization and size up all the parties before they ever push the button to file the case.

Bankruptcy at its core is about disclosing to the world the machinations of your business and revealing all the mistakes you have made – so it takes fortitude. If done correctly, you will maintain control of your assets and business and ultimately restructure your balance sheet to create an entity that can bring value to your stakeholders, including equity. However, there are dozens of pitfalls that can leave you surrendering control and leading to liquidation. You prepare lengthy schedules of every single entity the business owes money to and every single asset with which those creditors might get paid. It sounds clinical and it is. As an entrepreneur it used to be you and, well, everyone else. It was you on the top of the hill and your employees, customers, and vendors all there cheering for you. In bankruptcy it's you but on a medical examination table being poked and prodded by clinicians in what can feel like a very humiliating manner. You need a talented surgeon to take you through to the other side.

Funding a Bankruptcy

Bankruptcies are funded either by cash reserves, internally generated cash flow, cash infusion, or from loans. A company that can internally fund a bankruptcy likely has a strong income statement and an overburdened balance sheet. The purpose of this filing would be to haircut the debt and give this well‐performing business a right‐sized balance sheet. Companies for which both the income statement and balance sheet need repair are harder to save, and the law only gives you 120 days to create a good plan, with some exceptions. Before filing, you must ensure that if you put aside legacy debt, the business will cash flow. If not, don't waste your time. Additionally, you've got to finance this period of time while paying absurd professional fees.

Loans are possible and they are called debtor in possession (DIP) loans. They enter the debt stack at superpriority position, above all other creditors provided the secured creditors agree to be subordinated. It seems like a pretty big ask for management to tell creditors: “We obviously screwed up but we're going to subordinate you so we can take on even more debt and we've got 120 days to come up with a plan.” But the courts allow it because, like the railroad, the possibility of a going concern has the greatest value to all stakeholders. Likewise, the incumbent senior secured lender is free to offer that DIP loan if they wish to increase their position. Another interesting tension in bankruptcies is that creditors may safely recover their value through a liquidation, whereas equity holders must pursue risk to recover their value.

It would be hard and rare for a business with revenues under $50 million to attract a DIP lender. Below that volume, a business without positive cash flow or significant cash reserves is unlikely to survive a bankruptcy. They will struggle to secure financing, and the base costs of a filing will be disproportionally high to their revenue base. A company that enters weak can be converted to a liquidation by an aggressive creditor. Bigger filings with very secure assets (say a critical parts supplier to Boeing) will attract banks and bank type lenders who simply want a fair return on conservative risk. Filings with less secure assets, like a consumer brand company, will attract “sharkier” type investors including loan‐to‐own investors who simply want an outsized return for their higher degree of risk and/or to wrestle control of the company away from the owners.

Bankruptcy is a safe harbor for beleaguered businesses. A company can file a Chapter 11, get immediate relief from creditors, and have time to formulate a plan and marshal resources before facing up to its debts. Figure 7.3 illustrates the restructuring options facing a troubled business along with the Chapter 11 process.

Activities in bankruptcy proceedings are particularly intense at the start and end of the process, whereas the many months in between are focused primarily on running the company and administering the bankruptcy. If you're lucky, it is all quite mundane. This has been referred to as an inverted bell curve of activity, something I refer to as the Valley of the Grind.

Plan of Reorganization: Six‐Step Process

1. Negotiating the plan with major constituencies.
2. Drafting the plan of reorganization and the disclosure statement.
3. Getting court approval for the disclosure statement.
4. Solicitation process with creditors who are “impaired” or not made whole through the reorganization.
5. Confirmation hearing.
6. Performing to the plan.

You'll see that this requires a bit of shuttle diplomacy. The debtor must get stakeholder consent for a plan, then build out that plan, then get the court to approve the plan, then get the stakeholders to vote on the plan, and then get the court to confirm that vote.

All this starts with a well‐defined exit plan, which is developed by the debtor within the 120‐day exclusivity period. If the debtor fails to develop a successful plan (or get the court to grant extensions, which it prefers to do less of these days), then other parties can suggest plans. This is a distinct debtor advantage to the U.S. bankruptcy system because the debtor has plentiful opportunity to control the process.

The plan of reorganization should ideally detail structural and management changes to the business and then forecast the impact of those changes through the standard financial statements. The plan will also show the balance sheet impact of: asset sales, divestitures, shutting down divisions, debt to equity conversions or reverse, equity issuance or cancellation, restructuring debts through principle, amortization, and/or interest rate, as well as all the attendant legal matters such as adjustments to liens, curing or waiving defaults, and changes in corporate governance or structure.

Think of the disclosure statement as being similar to the details buried in the prospectus of a financial investment package. In effect, you are offering debts and equity in a renovated company for a prescribed amount of money. Interestingly, you will not need to comply with Securities and Exchange Commission (SEC) regulations that might cover this sort of offering because bankruptcy is a safe‐harbor from SEC‐type rules. It's not unusual for a disclosure statement to exceed 50 pages as it reestablishes all creditor claims and classes plus assets. The plan meticulously describes how each piece or class of collateral will be used to satisfy the claims upon them, detailing the percentage net recovery for each creditor or creditor class. The statement will cover voting rules, risk factors, feasibility, liquidation analysis, tax consequences, and perhaps even multiple payout options for the plan. Once prepared, the plan and disclosure statement are submitted to the court for its approval.

Like everything else in life, the entire bankruptcy restructuring process requires salesmanship. The debtors and their professionals will need to persuade each creditor or creditor class (and their professionals) that this is the best possible recovery from a crummy situation and earn their support while the plan is being constructed. The debtors will need to carry that support through the process and manage their creditors who may want to lash out at the debtor. If a class of creditors is paid in full, then those creditors are satisfied and there is no need for them to vote. However, if the creditors are required to restructure their debt in any little way, then they are “impaired” and thus entitled to vote, ideally in favor of the plan. It is only impaired (not fully satisfied) classes who get to vote their approval of the plan. For approval, a creditor class needs support of a majority by number of creditors in that class and two‐thirds support of the creditor dollars owed. There is the possibility that a creditor class will refuse the debtor's offer and seek to hold up the entire exit. Without a better alternative, the court may “cram‐down” or force the dissenting creditors to accept the offer on the grounds that other creditor classes have, and the solution is seen as better than a Chapter 7 liquidation. This is why you'll often see trade creditors receive maybe 10% recovery even though, mathematically, they should have been out of the money. The 10% may be an offering from the senior creditors as the juniors are forced/persuaded to accept the plan. Again, it all comes down to the strength of the reorganization plan. It is required to exit a bankruptcy, and the court will often go out of its way to protect a good plan, because they are a rare and valuable thing when every other option is carnage.

A successful restructuring offers what no other insolvency outcome does – namely, the prospect of future cash flows. So while a liquidation feeds a few quickly (and destroys a community), a reorganization feeds many slowly and protects economic vitality. With future cash flows, low‐ranking creditors can be paid out over time, and the family loan can be converted to equity and benefit through their continued support of the business.

The following pro forma income statement (Figure 7.4) shows a company which declined in 2017 and filed Chapter 11 later in that year. With support from creditors and customers, the business can restructure its debts, stretching some out while haircutting others, cut costs, and reenergize the business. This creates future cash flows to service the ongoing debts and provide long‐term value to all stakeholders.

Future cash flows are not balance sheet items, meaning they can only service debt if the business can be made profitable. That is why a successful restructuring, no matter how deep the losses are, is usually preferred over a liquidation. Figure 7.5 represents these future cash flows and shows a significantly higher recovery in a successful Chapter 11 reorganization compared to a Chapter 7 liquidation. In this situation, two more classes of creditors receive a full recovery, a third class receives a partial recovery, and the family loan is converted to equity. Not illustrated are the cash‐flow benefits from stretching out the company's debts.

With votes solicited, the debtor goes back to the court for confirmation of its plan based on satisfying the following 14 requirements:

1. The plan and plan proponent are both in compliance with the Bankruptcy Code.
2. The plan was developed in good faith.*
3. Bankruptcy Court approves the accrued payments to professionals.
4. The plan provides full disclosure and identity of postconfirmation officers and directors.*
5. Regulatory approval if required.

   ACME Mfg. – Value Preservation in a Reorganization
   Account	Book Value	Chapter 7 Liquidation	Chapter 11 Recovery
   Cash	–	–	–
   Accounts Receivable	1,000	800	900
   Inventory	2,500	625	1,800
   Total Current Assets	3,500	1,425	2,700
   Machinery and Equipment (net)	1,800	1,200	1,200
   Intellectual Property	500	20	100
   Furniture and Fixtures	200	–	40
   Computers and Software (net)	700	10	140
   Leasehold Improvements (net)	800	–	–
   Goodwill (net)	1,300	–
   Bankruptcy Admin Fees		(200)	(500)
   Value of Future Cash Flows			1,725
   Total Long‐Term Assets	5,300	1,030	2,705
   Total Assets	8,800	2,455	5,405
   Recoveries in Priority Rank
   First Bank Revolver	2,100	2,100	2,100
   First Bank Term Note, SBA backed	1,500	355	1,500
   Second Bank – Cash Advance Loan	250		250
   State BDC Loan, no PG	100		100
   Family Loan	1,000
   Accounts Payable	1,500		1,200
   Total Recoveries	6,450	2,655	5,150
   	Recovery	38%	80%
   Equity	2,350	0	255

6. Best interest of creditors test, which requires a result better than liquidation. Otherwise, a liquidation is in the best interest of creditors.
7. The plan is consensual.
8. The plan provides specific treatment of administrative and priority claims.
9. Prohibition on complete “cram‐down” plans, there needs to be some levels of support.
10. Feasibility.*
11. Payment of court, filing, and US Trustee fees.
12. The plan protects retiree benefits.
13. The plan treats transfers to not‐for‐profit entities properly.
14. The plan and the filing are not simply a ruse to avoid taxes.

With the necessary votes of creditors and confirmation by the court, the company exits bankruptcy court with a clean slate. Although there may be some emotional overhang, there is no/none/zero trailing liability exposure. Short of fraud, it is impossible for a bankruptcy process to be unwound or revisited. It is legally impenetrable, which provides the greatest possible comfort to participants and is part of bankruptcy's appeal.

The Stigma of Bankruptcy

Years ago, when I was contemplating my own bankruptcy, an attorney in New Orleans told me that in certain industries bankruptcy can be seen as a badge of honor. In a slow southern drawl he said, “Hell, in the oil business if you don't have at least one bankruptcy under your belt people won't think you've been trying very hard.”

Although I don't know the individual backstories, here is a list of famous people who have filed for bankruptcy protection: Abraham Lincoln, Charles Goodyear (tires), Daniel Defoe (Robinson Crusoe), George Fredric Handel (composer), Henry Ford, James Wilson (Supreme Court Justice), Milton Hershey, Oscar Wilde, Oskar Schindler (Schindler's List), Rembrandt, Samuel Clemens (Mark Twain), Thomas Paine, Ulysses S. Grant, Walt Disney, William McKinley (25th president), and Donald Trump (45th American president).1

Well‐known companies that have survived through bankruptcy include General Motors, Chrysler, Dunkin Donuts, Samsonite, Mrs. Fields, the Chicago Cubs, Gibson Guitars, Pacific Gas & Electric, Delta Airlines, American Airlines, United Airlines, US Airways, Air Canada, and many others.

When Should You Throw in the Towel?

It is rarely clear how long you should fight to stave off bankruptcy or when you should just give in and focus on recovery. Logically, giving in might be the best option, but accepting failure and moving on has a high emotional cost that can stay with you for years.

Emotional Argument – Never file bankruptcy; the regret will tear you up and eat you alive. I've given this speech to clients but I believe it in my soul; I would rather be Cool Hand Luke standing back up to get knocked down again and again than to live with the years of regret. I would torch the whole village – dogs, cats, children – to avoid going through that again. I did it totally wrong and ended up on the very short end of the stick, and the regret has been a burden to bear. I wouldn't recommend bankruptcy to anyone.

Financial Argument – A reasonable rule of thumb that if you can't conceivably pay off your extraordinary debts in five years, then you should consider a bankruptcy filing. It's a reasonable measure, and bankruptcy does give you the certainty of release and a clean slate. There is also some satisfaction of flipping the bird to certain creditors as you grit your teeth and file. You'll drag that clean slate of bankruptcy around like an anchor for 10 years while it's on your credit report, but most of those issues can be solved with creativity. This financial argument also denies the possibility of restructuring your debts out of court, which is usually possible. Every so often, even a logical restructuring is impossible because your creditor simply wants to push you off a cliff. If that's the case and you're trapped with no way out, then you simply need to switch to defense, re‐arrange your assets (legally), put on your helmet, file the bankruptcy and take the hits.