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As the COVID-19 pandemic continues to cause significant disruptions in the US and global economy, it is likely that US companies experiencing financial difficulties will seek to restructure their debts and other obligations. In anticipation of such restructurings, this article provides a brief overview of voluntary restructurings in the US for non-US parties with investments in or commercial relationships with US companies.
Often a financially troubled company will seek to manage its financial obligations through a voluntary modification of the terms and conditions of its existing debts or contractual arrangements in an effort to avoid bankruptcy proceedings and to continue as a going concern. This process is often referred to as a “work out.” If undertaken successfully, such a restructuring can potentially allow for the continued operation of the business and preservation of value in the company. A voluntary restructuring stands in contrast to the formal bankruptcy process, in which a debtor’s financial obligations are resolved via a court proceeding pursuant to which the debtor company’s debts and operations are either restructured such that it can ultimately continue its business after the conclusion of such proceedings or otherwise liquidated with the proceeds thereof distributed to its creditors. Most US insolvency proceedings are handled in US federal courts under the US Bankruptcy Code, although some forms of insolvency proceedings take place in state courts (such as US insurance companies for which rehabilitation and liquidation proceedings are undertaken pursuant to state insurance laws and in state courts).
Typically, as part of a voluntary restructuring, a debtor will seek to push back the repayment date for principal and interest on its loan obligations or possibly to convert existing debts to equity. However, any such modifications require the cooperation of the debtor’s lenders and other key counterparties. Should the debtor and its creditors fail to agree on such modifications, a formal bankruptcy proceeding may be unavoidable.
When considering what, if any, concessions to make to a debtor as part of a proposed voluntary restructuring, such concessions must be evaluated in light of how the debtor’s assets might be distributed as part of a bankruptcy proceeding. At a high-level, the order of priority of creditor claims in a bankruptcy proceeding is as follows:
Secured creditors have top priority and are paid out of collateral securing their claims – e.g., if a creditor has a security interest in certain property of the debtor, such a creditor is permitted to take possession of the property covered by its security interest rather than having to be paid out under the bankruptcy proceeding. Next to be paid are holders of priority claims which include, inter alia, claims for wages, employee benefits and unpaid taxes. Unsecured claimants (i.e., creditors holding claims that are not backed by a security interest) are next in line. Equity holders are last in terms of priority. The order of priority set forth above may be varied pursuant to a court approved plan of reorganization – i.e., an agreement between the debtor and its creditors which governs the debtor’s reorganization or liquidation including, inter alia, the distribution of the debtor’s assets.
As a general matter, a creditor or counterparty of the debtor may lose bargaining power if the debtor goes into formal bankruptcy proceedings given that the bankruptcy court and other (particularly large) creditors will play a significant role in determining how the bankruptcy estate is reorganized or distributed. Ultimately, whether to work with a troubled company with respect to a proposed voluntary restructuring or to seek redress through formal bankruptcy will depend on the particular facts and circumstances of the parties, including, but not limited to, where a creditor’s claim against the debtor will fall in the bankruptcy order of priority.
Lastly, creditors seeking to secure satisfaction of outstanding debts from financially troubled companies should be aware of the prohibitions on what are known as preferences – i.e., transfers made by the debtor within a certain period of time prior to bankruptcy. If a creditor receives payment from a debtor which is held to constitute a preference, the creditor could be obligated to pay the funds back to the bankrupt entity’s estate; however there are various defenses to such repayment which could be raised including if the payment was made in the normal course of business. In addition, creditors and other parties doing business with a distressed company should be aware that those transactions may also be undone as so-called “fraudulent transfers” when the distressed company is operating while insolvent or where it is actively seeking to frustrate or hinder other creditors through the transaction. Creditors should be aware of the prohibition on preferences and fraudulent transfers to avoid engaging in a transaction that might be subject to a clawback if the troubled company ends up in bankruptcy proceedings in the near term.
Ultimately, any creditor or counterparty of a US company that seeks to undertake a voluntary restructuring must, of course, carefully consider the specific rights and protections that the creditor or counterparty has vis-à-vis the debtor including based on the parties’ contracts as well as the specifics of any proposed voluntary restructuring.