Bankruptcy is like a trip with Alice down the rabbit hole. One never knows what new adventure lies around the next corner. Just a year ago, to the young and striving venture world, bankruptcy seemed only to apply to the Old Economy companies rusting in trash heaps waiting for disposal. Now, the dotcom bubble has burst, and the portfolio companies of venture capital funds are coming to grips with what bankruptcy is and is not, and what those Old Economy companies were doing down there with Alice in the first place.
Innumerable times, entrepreneurs have proclaimed: “If I don’t get that refinancing, I might go bankrupt,” or “If he doesn’t pay me, I’ll have to file.” It seems sometimes that the entrepreneur fears bankruptcy more than death. Understanding the psychological issues that confront entrepreneurs facing bankruptcy is critical to learning to use the bankruptcy process successfully. Our culture treats bankruptcy as something to be avoided, as an acknowledgement of failure and inadequacy. The entrepreneur can accept a lot of pain, but he cannot endure the dishonor of bankruptcy. All of this stems from a misconception of what bankruptcy is and is not. Bankruptcy is not an end or a place. It is not about success or failure. It may never be a badge of honor to wear at cocktail parties, but it is not a form of punishment or a trip to the principal’s office.
Better Late than Never
The most successful bankruptcies are those that start early rather than late. Yet all too often, entrepreneurs and financiers commence the bankruptcy process when the company is too beset with problems for even bankruptcy to solve. Troubled companies with underlying strengths can thrive in bankruptcy. Weak companies will be eviscerated by the process.
Bankruptcy is a legal tool that can save companies and prevent the very failure and dishonor that terrifies the entrepreneur. The United States Bankruptcy Code (the Code) regulates the relationship between a company and its creditors and provides a roadmap for a company and its stakeholders to negotiate a successful reorganization of the business and exit from bankruptcy. One of the most powerful provisions of the Code is the so-called “automatic stay” provision. The automatic stay provides a company with a complete bar from pursuit by its creditors without permission of the bankruptcy court. All lawsuits, foreclosure actions and even self-help remedies are immediately stymied. The automatic stay is designed to provide a troubled company with a respite from pressures exerted by creditors, and allow it the time in which to make strategic decisions and implement a reorganization plan or, if reorganization is not possible, a liquidation strategy that is fair to all of the company’s creditors.
Companies that do have significant debt burdens, pressure from trade vendors, or major contractual disputes can make use of the automatic stay to protect their assets from seizure while they attempt to reorganize or sell the company’s assets. Before attempting bankruptcy, however, it is usually advisable to discuss with creditors orchestrating an out-of-court reorganization plan. While bankruptcy can and often does solve many problems, it is not a cheap solution. Where possible, an out-of-court process can be a more efficient means to an end. Often, management will not want to have those discussions for fear of letting creditors know how difficult the company’s financial condition is. In our experience, creditors almost always suspect that a company is troubled and are more likely to react irrationally if they are kept in the dark, not knowing what is going on, than they would if they were are given an accurate picture in advance. Management has to balance the countervailing risks of disclosure and a failure to disclose. Often, it is best to organize discussions with a group of several large creditors. With most companies, an 80/20 rule applies, i.e., more than 80% of the face amount of the debt is owed to fewer than 20% of the creditors. The larger creditors have a greater vested interest in the success of the enterprise because they have been the vendors making the most profit from sales to the company. If a deal can be struck with large creditors, the smaller ones are likely to fall into line because they will not want to expend significant legal dollars chasing a small claim.
Portfolio companies with secured creditors, usually banks or subordinated lenders, will need to address the unique concerns of the secured class claimants. In a liquidation of the company, the claims of secured creditors are paid before the claims of vendors and other unsecured creditors. Thus, a secured creditor may stand to do better if the debtor goes out of business. In a troubled situation, secured creditors often act in ways that seem irrational to the equity holders and management. These creditors are likely to be constantly reducing their exposure to the company, by ratcheting back on lending advance formulas, setting off cash deposits, refusing to make further advances, and notifying customers to make payment to them directly rather than to the company. These actions inevitably cause the company’s working capital to evaporate and make its troubles worse, not better.
A hostile relationship with a secured creditor is often the broken straw that triggers a bankruptcy filing for a troubled company. Once a company has filed for bankruptcy, the secured creditor can no longer draw working capital out of the company, but the secured creditor is also no longer required to make advances against inventory or collections of receivables. No payments, on account of pre-petition creditors claims, can be made without consent of the bankruptcy court. As a consequence, a portfolio company that can obtain post-petition credit from its equity backers, high-risk lenders or vendors is likely to become quickly able to pay at least post-petition creditors and thus continue operations. Obtaining this type of post-petition financing is often the path of least resistance for a bankrupt company. Again, it does not come without a cost. Post-petition lenders will often require that the bankruptcy court issue orders bolstering their collateral position with respect to their claims, and these lenders will charge hefty fees for extending this type of credit.
Knowing Your Options
If post-petition financing is not available or too expensive, a bankrupt company can attempt to use its own cash collections to fund its ongoing operations. In theory, even after a bankruptcy petition has been filed, collections on pre-petition collateral belong to the pre-petition creditors, but in practice a portfolio company can petition the bankruptcy court for a “cash collateral order,” allowing the company to continue to use the proceeds of its pre-petition assets (i.e., cash generated from sales of inventory and collection of pre-petition receivables) for operating expenses. If the company can demonstrate that the pre-petition creditors are “adequately protected,” i.e., that their collateral position will not be diminished if the company uses those assets to continue to operate, then the company will likely be allowed to operate with those pre-petition assets in bankruptcy. The fight over a cash collateral order usually takes place within a week or two after the filing of the bankruptcy petition, and its outcome determines in large part the course of the company’s bankruptcy. If the company cannot obtain post-petition financing and loses the cash collateral order request, it will likely shut down and liquidate.
The core determination in a cash collateral request is whether the company can demonstrate that it will be cash flow positive over the course of the bankruptcy. No bankruptcy judge is comfortable permitting a company to operate in bankruptcy and build up further losses that have no reasonable likelihood of being paid or that can only be paid by reducing the recovery of the pre-bankruptcy creditors. Therefore, the timing of a filing for bankruptcy is critical to its success. If possible, a filing should only be made at a time in a portfolio company’s cash cycle where it is moving in a cash positive direction. Any portfolio company considering filing for bankruptcy should prepare detailed weekly cash flow projections to demonstrate how it will perform over the course of the bankruptcy.
Certain issues, while not unique to high-tech companies, are more likely to arise in the bankruptcies of venture portfolio companies. For example, the Code has a special set of rules governing what are known as “executory contracts.”
Executory contracts are those agreements to which a bankrupt company is a party that have not been fully performed by either party. Licenses and leases of all kinds typically require continuing performance by both parties and are treated as executory contracts. Under the Code, the debtor has the right, within the first 60 days after the filing occurs (or such longer period set by the court upon the debtor s showing of “cause”), to accept, assume and continue to perform these arrangements, or to reject these agreements as being unduly burdensome to its recovery within the first 60 days after the filing occurs. Once rejected, the debtor no longer needs to comply with an agreement, although any damage that the other party suffers as a result of the rejection of the contract becomes an unsecured claim against the bankrupt company’s pre-petition assets.
A portfolio company with overpriced real estate leases will likely use the Code’s executory contract provisions to escape those leases and move to lower priced space. Similar decisions may be made concerning equipment leases if alternative arrangements for needed equipment can be made at lower cost. Technology license agreements may also suffer the same fate if the royalty provisions are uneconomic or if the underlying obligation of the debtor to perform research or otherwise expend resources are deemed unjustifiable by the company. If a technology agreement or lease of some sort is desirable but too expensive to maintain, the company might want to use the threat of rejection to negotiate new terms. Often, when faced with the reality that once rejected, their claims fall into the class of pre-petition unsecured creditors, parties to executory contracts will prefer to renegotiate rather than be obstructive.
One of the most advantageous results of a bankruptcy filing is that litigation that had been threatened or was ongoing prior to the filing will now need to be continued in the bankruptcy court under rules that at least allow for decisive and speedy decisions. The bankruptcy court has its own set of free-wheeling rules for resolving disputes which are based in the historic status of the bankruptcy court as a “court of equity.” In layman’s terms, this means that a bankruptcy court is free to do what it considers to be fair and in the best interest of the bankrupt estate – the property of the bankrupt company and the interests of all of the stakeholders of the company in that property. Outcomes are no less predictable than in normal litigation, but the consequences are clearer, particularly to plaintiffs asserting claims against the bankrupt company. The reality facing a plaintiff litigating against a bankrupt company is that a victory will result only in an unsecured claim against the company which will be lumped together with all of the other unsecured claims. This will often clarify the minds of a plaintiff who might otherwise engage in a drawn-out and expensive dispute. In fact, a portfolio company facing a draining litigation battle might consider making a bankruptcy filing just to have that litigation conducted in bankruptcy court.
In the days and weeks before a bankruptcy filing is made, the vendor base of a portfolio company often becomes unruly. Management, beset with many fires to extinguish, may choose to prefer one or more creditors over the others simply to buy temporary peace. To confront the inequity of favoring the squeaky wheels, the Code imposes the “preference” rules. Any payment or transfer of assets or an interest in assets made by a company to satisfy an antecedent debt, out of the ordinary course of business, made within 90 days prior to the bankruptcy filing (one year in the case of insider debts) is recoverable in the bankruptcy as a preference. That means that the recipient of such a payment or transfer must return the same to the company or bankruptcy trustee. The payment or asset transfer, once recovered, normally goes back into the pot for creditors, thereby equalizing all creditors, at least back to the 90 day preference window.
Portfolio companies may also pursue “fraudulent conveyance” claims in bankruptcy. Generally, a fraudulent conveyance is any transfer of assets by a debtor made while it is insolvent for less than fair consideration. The transfer does not need to be to an insider to be subject to the rule. The fraudulent conveyance provisions of the Code and of state law prevents an insolvent debtor from giving away its assets or from selling them for unreasonably low prices and thereby depriving creditors of fair treatment. Under the Code, the fraudulent conveyance period looks back one year at least, but with the use of more liberal state laws, transactions can be undone that are as much as six years old. If a transaction is undone as being a fraudulent conveyance, the assets transferred return to the company and whatever consideration was received must be returned.
Where to File?
Determining the courthouse in which to file a bankruptcy petition is a matter of strategy and legality. Because the Code is a federal statute, the bankruptcy courts are all part of the federal court system. A portfolio company can file in any jurisdiction in which it can prove it has substantial contacts. Examples include the state in which its principal place of business is located and the state of its incorporation. Other examples might include the state in which a principal subsidiary is located or in which that subsidiary is incorporated. The rest is strategy and is determined based on an assessment of the nature of the portfolio company and its creditor base and a determination of what jurisdiction might produce the best outcome.
Delaware is often chosen by portfolio companies, primarily because of the sophistication of the judges and the speed with which they process cases and claims. A portfolio company with a difficult litigation case to pursue might want to choose Delaware to take advantage of the sophistication of the judiciary. Delaware does have drawbacks. The Delaware bankruptcy rules permit the lawyers and other consultants to be paid during the course of the proceeding, which can make it more difficult to demonstrate that the debtor is cash flow positive. The Delaware judges may also reject a filing from a smaller company that does not have a clear basis for making its filing in Delaware. The distance of the Delaware courts from the location of the company and its vendors may make it more expensive to conduct the bankruptcy and adversely impact the chances for a successful bankruptcy.
Not to be forgotten for smaller portfolio companies is the possibility of using state court receivership rules as an alternative to bankruptcy. Receivership puts the debtor in the hands of a chosen individual, normally to dispose of its assets. Most receivers will allow a company to continue to operate if it can do so without diminishing the collateral of pre-receivership creditors. While the company continues to operate, the receiver will package its assets for sale. Litigation claims against the company cannot be pursued and claims of creditors are frozen. Management is likely to be allowed to continue to operate the company during this period, subject to the receiver’s supervision. Eventually, the receiver may even conduct an auction for the assets. Typically, anyone can bid, even pre-receivership equity holders, management or creditors.
The beauty of receivership is that it moves at lightning speed and with significantly lower expense than bankruptcy. When the shooting stops and the smoke clears, possibly only 90 days after the filing, the assets have a new owner and home and everyone can move on. Normally considered only for small companies, occasionally receivership can be used successfully for even public companies. Not all states have workable receivership statutes, and the jurisdictional limitations of a state court may make it difficult to conduct a receivership for a portfolio company with assets in more than one state.
Jonathan Bell is a Shareholder and Jeffrey Wolf is Of Counsel in the Corporate and Securities department of the Boston office of Greenberg Traurig LLP.